Posts tagged ‘investing’

Feb 8

Advanced Mixology: The Strategic Use of Retirement Assets

(Or How to Thwart the Taxman, Maximize your Retirement Dollars and Sleep 18% Better)

When talking to with retirees, wanna be retirees or children helping their older parents manage their nickels, dimes and c-notes, it’s almost certain that the best way to deplete retirement assets will be part of the conversation. And, that’s exactly as it should be. A well-thought-out retirement strategy can lead to staggering tax savings, greater flexibility and, most importantly, the ability to sleep that much deeper at night knowing that you’ve done as much as reasonably possible to achieve your financial goals, which seldom means making unnecessarily large contributions to our friends in Ottawa.

I’ve written about many different aspects of retirement planning in previous articles, including a series on RRSP / RRIF withdrawals, but I wanted to pull a bunch of different ideas from my previous efforts together, along with some new points to help anyone faced with these conundrums.

What This Article Can’t Do

Despite my strong wishes to the contrary and no matter how pretty or detailed any cashflow projections may look, retirement planning remains a series of educated guesses, many of which will ultimately be off the mark, often within days. How many people predicted the huge spike in inflation following Covid? What about the changes to capital gains taxation in the last Federal Budget? Or the changes to small business taxation over the last 10 years? These examples do not even speak to the more obvious unknowns, like lifespan, income needs and investment returns. Moreover, on that last subject, those of you that have read my previous article on how the “sequences of returns” generated by your portfolio affects your long-term results, you’ll also know that all 7% average portfolio returns are not created equal – bad returns early in retirement can have a disastrous impact on later portfolio sizes, particularly if forced to liquidate capital during the downturns, regardless of later market corrections.

Accordingly, despite my wishes to the contrary, I cannot provide a one-size fits all roadmap, nor can I guarantee that any perfectly plausible plan I prepare today will still be the best way forward if one of life’s surprises strikes you squarely between the eyes. On the other hand, there are a lot of common-sense principles, mixed in with some basic math, that I think can help tilt the odds in your favour. Moreover, the larger your nest egg, the shorter your expected timespan wandering this wonderful world, and the more pessimistic your projections of things like investment returns or spending needs, the smaller the chance of things going drastically awry. Accordingly, despite my dire proclamations, I firmly believe that the benefits of proper planning can usually help you cope with future surprises, provide wiggle room if you need a little more or earn a little less, and hopefully still save a lot of taxes along the way. Although we can’t predict the future, making reasonable assumptions, taking proactive steps and regularly reviewing your numbers are far better than merely shutting your eyes and hoping for the best.

Basic Philosophy

Noting all of these caveats and qualifiers, here are some of the things to consider when constructing your retirement funding plan.

Be Inflexible About Flexibility

As the future is impossible to predict, it’s vital to build flexibility into your plan. Flexibility can take many forms, such as:

Having enough liquid assets that can be accessed without triggering a huge tax bill in case of emergencies, or you don’t want to necessarily wait until you’re pushing up daisies before helping your kids and grandkids. It’s even better if these are in addition to a max-funded TFSA, as using the TFSA to pay for emergencies can carry a huge opportunity cost, since this is the one retirement account that both grows and pays out completely tax-free. In some cases, as you’ll see when I throw some math in your general direction, it might even be better to bite the bullet and pull money from your RRIF instead or borrow.
A HELOC is a great insurance policy. Even if you have the money to pay for big expenses personally, it can sometimes make sense to borrow instead. For example, for a big expense coming due in December, borrowing to pay some of the cost so you can spread out and minimize the tax hit by triggering gains or withdrawing RRIF dollars over multiple years can save you far more in taxes than you pay in interest. The HELOC also provides you with some breathing room while waiting for a market recovery before selling or waiting to sell real estate.
If a couple, plan for what finances will be like if one of you is on their own for many years. A lot of couples minimize their taxes and keep both their OAS pensions while both are above ground, but the survivor is often left dealing with a double whammy of less retirement income if all or most of the deceased’s pensions disappear, but a higher average tax rate on the reduced income since it is taxed on a single tax return. In many cases, it’s worth considering pulling out more RRIF money while you’re both hale and hearty so it can be split across two tax returns if concerned about the survivor being forced into higher tax brackets, or dealing with OAS clawback if you have accumulated significant RRSP/ RRIF savings.
Be willing to adjust your plans if a butterfly in Asia flaps its wings and throws off all of your previous plans off kilter. That means reviewing your situation from time to time and ensuring that you’re up to date with any external factors, like changes to tax rates or law that might mean that it’s now better to zig than to zag.
Be a pessimist. Run any projections on the basis that your investments just might not average 10% per year, you live to 100 and all of those dream vacations cost a little more than you expect. CFPs are required to run retirement projections using rates that might not top 5% and I suggest running one batch of retirement projections on this basis. At the very least, when making assumptions regarding investment returns, run projections using a range of assumptions and, if possible, use a Monte Carlo simulation rather than assuming your investments earn a constant yearly rate of return. A Monte Carlo simulation will randomize each year’s investment returns around your target return, with the maximum yearly high or low capped by how much you estimate returns might vary. The program might run 1,000 different projections, graph the results, and let you know what percentage of these projections didn’t result in you moving into your children’s basement and subsisting on cat food.

Income is Wonderful Thing, Particularly if Tax Efficient

I previously mentioned the impact of your sequence of returns on your retirement portfolio, particularly if you don’t own a yacht. The more income your portfolio generates, the less capital you’ll need to liquidate to pay for golf and groceries. This goes hand in hand with a well-diversified portfolio that is designed to minimize volatility. That said, all types of income are not created equal. Interest income can be taxed at over 50% in some provinces in the hands of the well-to-do. Investing in interest-paying investments in a non-registered portfolio can accordingly come at a steep price, compared to other types of investments that can compound tax-free until needed. Instead, investments that pay eligible dividends are almost tax-free until your taxable income approaches the OAS clawback threshold in some provinces, which is around $93,000. In fact, if in the lowest tax bracket, eligible dividends can actually reduce your tax bill unless you’re receiving GIS, in which case, earning eligible dividends can be a financial disaster.

There are also investments that pay regular distributions through capital gains, such as covered call funds, and, even better, other investment that pay “return of capital,” which is treated as a return of your original investment dollars and is thus tax-free, although it will increase your eventual capital gains bill when selling down the road. Private Real Estate Income Trusts (“REITs”) can provide return of capital distributions in the mid to high single digits and, since they are not initially taxed, they don’t need to generate as much income as less tax efficient investments to pay your hydro bills since, until you sell or are a long-time owner, what you receive is what you keep. Moreover, their tax efficient nature also allows retirees wishing to draw down their RRIFs the opportunity to withdraw more than would otherwise be possible at lower rates or without triggering OAS clawback.

Turning to Registered Plans, I suggest owning more of the interest payers, such as GICs, Mortgage Investment Corporations, bonds or bond funds, and Structured Notes, in those accounts. All types of income are treated the same in these accounts and these types of investments are generally very low volatility. Accordingly, since you’ll eventually be forced to make withdrawals from your RRIFs at one stage, regardless of your need or market conditions, owning these steady eddy investments in your RRIF also minimizes the impact of sequence of returns, particularly if you can increase withdrawals during bad times while you give your stock portfolio the time to recover.

And, if your investments don’t generate enough after-tax money to cover the life you wish to live, having a portion of your portfolio in low volatility, non-registered safe investments that you can use in a downturn can minimize sell low scenarios. Although I hate the opportunity cost having too much money in low, tax inefficient investments and would suggest not overdoing this unless you’re a very conservative investor, having some safe money to draw on when your stock portfolio is down 15% makes sense if your last name isn’t Musk.

Prioritize your TFSAs over your RRIFs

Although there are exceptions to this rule, particularly if the plan is to quickly replace any TFSA withdrawals the next year, I really like continuing to fund TFSA throughout retirement and instead draw down RRIFs. Returning to my mantra of flexibility, having a pot of money that can be accessed tax-free and later replaced is a wonderful thing. And if one spouse dies with a fully loaded TFSA, it can continue to grow tax-free in the survivor’s hands. Moreover, if the survivor never needs the funds, prioritizing preserving TFSAs over RRIFs can ultimately mean more after-tax dollars for future generations, particularly if tax rates continue to climb.

I was puzzling through the issue of trying to best explain the benefits of pulling money from a RRIF instead of a TFSA for living expenses despite OAS clawback for retirees who will likely pay tax at the highest rate at death and came up with an easy comparison. Assume you need $55,000 per year to fund lifestyle and can either draw $100,000 from your RRIF, which assumes a 45% tax cost, or $55,000 from your TFSA for free. In both cases, also assume that all your investments will double by the time you die in 10 years and you currently have $100,000 in both your TFSA and RRIF.

If you withdraw $100,000 from your RRIF but leave your TFSA intact, you’d have $200,000 after tax at death in your TFSA even though your RRIF is kaput. On the other hand, if you left your RRIF intact and withdrew $55,000 from your TFSA, you’d be left with $45,000 in TFSA dollars which will grow to $90,000 at your death, plus $200,000 in your RRIF. If you have to pay tax at 50% at death on that RRIF, however, you’d only be left with $100,000 after taxes. Adding the two accounts together, this totals only $190,000. In other words, if you are able to get the money out at a lower rate now than at death, I suggest taking in from your RRIF rather than your TFSA. My example has the TFSA hoarder passing on an extra $10,000 (5%) to his heirs on the last death. If able to withdraw RRIF dollars at less than 45% during life or paying more than 50% at death, the advantages of melting down the RRIF are even greater. Accordingly, consider funding your TFSA during retirement, even if it means pulling extra money out of your RRIF to do so, if you expect to be in higher tax bracket at death than right now.

As a first aside, it’s important to factor in OAS clawback to these calculations. Although retirees lose $.15 of their pension per dollar for each dollar their income exceeds the clawback threshold, they would have had to pay tax on that $.15 anyway, so the true impact isn’t quite so high. For example, if in a hypothetical 33.33% tax bracket, a retiree would really be out of pocket $.10 (33.33% of $.15) after taxes for every dollar clawed back. Accordingly, the total tax impact of this retiree losing some of her OAS in this scenario is 43.33% (33.33% marginal tax rate +10% extra in OAS clawback.) In some cases, after losing their entire OAS pension and no longer dealing with clawback, some retirees actually pay less tax per subsequent dollar of income until pushed into the highest tax brackets. Ultimately, unless your income is already so high that you consider your OAS pension a lost cause, it’s vital to consider the impact of the OAS clawback when creating a withdrawal strategy.

As a second aside, if comfortable with your own financial situation, consider using some of the extra RRIF money to fund your children or grandchild’s TFSAs or FHSA, or helping them fund another common tax-free growth investment – their home. If the kids are going to get what’s left anyway and you’re confident that you can’t spend all that you have, paying some tax now to fund their TFSAs or homes can make your money go further than waiting until death if you can access the money now at a cheaper rate than down the road. Moreover, gifting with warm hands rather than cold ones allows you to actually witness the fruits of your generosity and, in many situations, a smaller gift now can actually be more impactful than a larger gift later when your kids or grandkids are no longer living in basement suites or struggling with barely affordable mortgages.

As a final point, if you expect to outlive your RRIF, noting that the tax rules currently require 20% annual withdrawals from age 95 onward, you may not need to be in as big a hurry to liquidate your RRIF. Let’s change the previous example to assume that the tax cost of withdrawing the RRIF early remains at 45%, but that the tax cost at death is only 40% because your RRIF is a lot smaller by that point. Using the $100,000 TFSA and $100,000 RRIF scenario discussed earlier, an untouched TFSA would still be worth $200,000 at death, but the smaller TFSA and untouched RRIF would be worth a combined $210,000 net of taxes because of that lower tax bill at death on the RRIF. Ultimately, the right amount of extra money to withdraw (or not withdraw) from your RRIF is extremely situation specific. Crunch the numbers, make honest assessments of your situation and be willing to make course corrections if your investments over or under perform or if you no longer feel confident that you will be tap dancing on your 100^th birthday. If in doubt, my bias is to lean towards the solution that provides you with the most financial flexibility.

As a postscript (yes, I know I promised that the previous paragraph would be my last,) if there aren’t enough dollars to maximize one spouse’s TFSA or if it necessary to make TFSA withdrawals, consider playing the odds. At death, the deceased’s TFSA room vanishes, whereas any TFSA they pass along to the survivor can continue to grow tax-free. Accordingly, if there is a big age between spouses or one of you is looking decided more peaked, consider prioritizing funding or preserving the older / less healthy spouse’s TFSA. On that spouse’s death, the survivor would still have their own unused contribution room to use up if funds permit, plus the deceased’s fully loaded TFSA. I’ve even suggested drawing down the healthier spouse’s TFSA to fund up their partner’s account in extreme situations, such as when that spouse has a terminal diagnosis.

RRIFs vs. Non-Registered Dollars

Assuming your TFSAs are already at capacity, and you’ve already helped your descendants as much as is prudent and affordable, whether it makes sense to accelerate your RRIF withdrawals versus melting down your non-registered portfolio involves more convoluted cogitations. While both RRIFs and TFSA allow tax-free compounding, the same is not true for non-registered portfolios except if a buy-and-hold investor that focuses exclusively on capital gains, thus receiving no dividends along the way. In other words, if your TFSA or RRIF portfolio might double before death, a non-registered portfolio owning the same investments might only grow at 75% due to the increased tax drag resulting from rebalancing and income generated and taxed along the way. Moreover, don’t forget the tax cost of withdrawing money from a RRIF in the first place, which means that much less to reinvest, which might encourage you to draw down the non-registered account first in some cases.

I’ve talked about this issue in previous articles and suggest diving into my article archives if looking for more information on the subject. The magic mix of RRIF withdrawals, whether to fund lifestyle or to merely reinvest the funds in a non-registered account, varies from situation to situation, but some of the things to consider when mulling over these matters are as follows:

What is the tax cost of getting RRIF money out now vs. leaving well enough alone? If you’re expecting to pay a lot more per dollar in the future, including through OAS clawback or in your terminal tax return, paying the piper ahead of schedule may still be your best option even if you don’t look as wealthy on paper at the end of the current tax year and your non-registered money won’t compound as quickly as your tax-sheltered loot.

What types of investments would you sell inside your RRIF and what is their tax treatment if repurchased in a non-registered account? Dividend paying stocks owned inside a RRIF don’t benefit from either capital gains treatment or the dividend tax credit. Accordingly, selling these assets inside a RRIF and repurchasing them with what’s left after appeasing the tax man might eventually allow you to come out ahead. For example, a BC resident earning $80,000 per year would pay less than 2% tax on dividends from her non-registered portfolio each year vs as much as 53.50% at death if those dividends remain in the RRIF, continue to compound, and are eventually taxed at the highest rate. Although those dividends aren’t growing tax-free in the non-registered portfolio in this example, paying a token amount of tax each year along the way is a far better alternative than the estate having to pay through the nose when the grim reaper makes a house call. By the same token, if the same investor is the buy and hold type, (s)he might avoid paying any tax on the growth for many years or even until death, where the tax hit if in the highest tax bracket might be as little as 50% that tax payable on the RRIF balance, depending on how capital gains are taxed at that time. Although this retiree’s investment portfolio may not look as sexy during his lifetime as a neighbour who hangs onto her RRIFs until the bitter end, his heirs might ultimately be the ones able to afford the bigger casket.

Using my earlier hypothetical $100 RRIF and assuming both neighbours had identical RRIF investments and died at the same time, if the parsimonious neighour’s RRIF doubles prior to death but is then taxed at 50%, her devastated descendants would only net $100. If the savvy gentleman down the road withdrew the same $100 from his RRIF while in a 30% tax bracket to reinvest in a non-registered account where it compounds by only 75% until death, where the $52.50 gain is taxed at 26.75%, his initial $70 investment would be worth $108.46 net of tax at his passing. Conversely, had he instead invested his $70 in a GIC, the numbers wouldn’t look nearly as good, although perhaps still acceptable. Assuming his $70 GIC portfolio grew by only 50% prior to death due to the increased tax drag, he’d still have slightly more than $100 at death, which would be the only year when taxed in the highest tax bracket.

What is the tax hit from selling some of your non-registered portfolio? Although you won’t pay as much tax per dollar on capital gains vs. RRIF withdrawals, if you’re up big in your non-registered portfolio, you might be better off letting those investments continue to flourish, depending on some of the other factors in this list. Of course, don’t let tax considerations block out investment considerations – if the signs suggest that it’s time to sell a stock despite its past performance or it represents too large a share of your portfolio, don’t be afraid to pull the trigger despite the resulting tax hit.

How much is flexibility worth to you? Slowly pulling out RRIF funds over time to build up a non-registered war chest to provide more wiggle room for larger expenses later or to allow more gifting during your lifetime may eventually be worth your while even if there are no immediate benefits, other than perhaps a bit more peace of mind.

What would you do with extra RRIF withdrawals? What is the after-tax return or savings if using the cash to pay down or avoid incurring debt, buying life insurance that grows and pays out for free or helping future generations? If planning to reinvest in your own name, early withdrawals to purchase GICs is far less appealing than paying down high interest credit card debt.

How much longer do you expect to remain above ground? The shorter your remaining lifespan, the smaller the opportunity cost of triggering taxes ahead of schedule, particularly for RRIF withdrawals that will ultimately be fully taxable at death.

When looking to sell non-registered winners, don’t forget to also harvest losers as well to negate all or some of the taxable gain. Moreover, if triggering a large gain will push you into the OAS clawback zone or a really uncomfortable tax bracket, consider selling in stages over multiple tax years to reduce the tax pain if there isn’t a compelling investment reason to sell the entire investment now. If approaching the end of the year, selling some in December and more in early January might make a big difference to your bottom line in some circumstances.

Conclusion

There are myriad moving parts to take into account when strategizing how to draw down income during retirement and, as is so common, one size does not fit all. Knowing your options, how the tax system works and using somewhat pessimistic assumptions that are fact-checked regularly can go a long way to making the most of your retirement assets and improving the quality of your sleep.

I will have more to say on these matters in future articles, particularly for those you who also have corporate savings to draw upon during your golden years.

Apr 10

Making the Right Call: The Ins and Outs & Ups and Down of Covered Call Funds

As I’ve said many times before, few things in the investment world make me happier than receiving nice fat deposits into my investment accounts on a regular basis. I may have never been to Mississippi, but I strongly suspect that I’d have a strong affinity to the Show Me State.

I get even more excited when I know that I won’t have to share too large a portion of those juicy payments with the government come tax time. As I have been known to repeat ad nauseum, it’s not what you make, but what you keep after fees and taxes that really matters. Inside registered accounts, all distributions are treated the same. Accordingly, it’s irrelevant how you make your money in such accounts, so long as it’s an appropriate investment for your temperament and circumstances. On the other hand, how you get paid inside a non-registered account, whether in your personal or a corporate account can matter a heck of a lot. That’s where covered call mutual funds or etfs (I’ll use “funds” to describe both hereafter) might really shine.

Background

Put in simplest terms, a fund that “writes” or sells covered calls trades some of the potential upside from the stocks they are selling call options on in exchange for an upfront payment called an “option premium.” Using an example, if you own a stock worth $100, you might sell someone the right or option to purchase that same stock from you for $103 any time over the next month in exchange for an extra $.50 right now. If the stock never hits this value, the option will expire as worthless and the person purchasing the call will be out $.50 with nothing to show for it. You, on the other hand, will get to keep the stock, any dividend income paid on it, plus the up-front $.50 option premium payment. And, if you’re so inclined, you can start from scratch and sell another call option the next month.

Conversely, if the stock soars to $105 prior to the option expiring, you will be required to sell at $103 (or buy back the option) and miss out on that extra $2 of profit. So, although you are stuck selling a stock worth $105 for $2 less than market value, you still realized a $3 on the increase of value, any dividends issued, plus the $.50 option premium. Accordingly, although you didn’t do as well as if you hadn’t sold a call option or the person who purchased it who and made a 300% profit, you still have a lot to smile about. And, if you’d been collecting options premiums on that same stock for several months before it was “called away,” (forced to sell your stock at the price stipulated or “strike price”), you still might still be ahead of the game compared to simply buying and holding that stock.

Finally, if the stock goes down over the call period, although you’re probably not too happy about this, at least you’re $.50 better off from receiving the call premium than the guy down the street that owed the same stock but didn’t write a call. And, if you were a retiree on tight budget, the extra $.50 in call premium per share may mean not having to sell as many shares during a setback to pay for groceries. In summary, covered call funds usually underperform typical funds in a rising stock market but the higher income they generate vs. owing a similar basket of individual shares might be very attractive to more risk-adverse or income-hungry investors more interested in monthly payments than growth.

Option Pricing Basics

In the example I provided, I arbitrarily pulled numbers out of the air in order to explain the general concept. The value of any call option is highly variable and is affected by the following:

The prospects and volatility of the underlying stock: A stock that goes up and down like gymnast on speed generates a higher premium than a staid blue chip special, as the upside if the riskier stock catches fire during the option period is that much higher and, thus, enticing.

General Market Volatility: As you might expect, not only does a specific stock’s volatility affect what you can charge for an option premium, but so does that of the stock market as a whole. For example, options premiums will be a lot higher during an event like a global pandemic than when all is sunbeams and moonshine.

The Length of the Option Period: If you write an option that lasts 3 months, you should be entitled to a higher option premium than writing one that lasts a single month, since whoever purchases the option has three times as long to strike it rich and for a hot stock to keep on climbing.

The Difference Between Strike Price and the Stock’s Current Value. In my example, the “strike price” of the option was $103 for a stock currently trading at $100. If the strike price was only $102, the option premium will be higher since there is that much better price of the option eventually “being in the money” and rewarding the buyer. Likewise, as you’re agreeing to surrender more of the upside if pricing the strike price close to the current value, it only makes sense if you’re paid more in exchange. Finally, the increase in the option premium as the difference between the strike price and market price decreases can increase significantly as buyer risk goes down and seller opportunity cost rises. Accordingly, if the seller in my original example was selling a call option for $101 or even one that is already “in the money” such as a $100 call option, they should expect to get significantly more than the $.50 option premium from my example.

Advanced Lessons

As you might expect, things are not quite as simple as the example I’ve described above when looking at this strategy inside a fund versus on a single stock basis. Different companies have different strategies, so it’s important to understand how the various funds differ from each other before deciding on what does (or doesn’t work) best for you. Here are a few of the things to consider:

Do you believe in that market sector? In basic terms, if you don’t like the sector, don’t chase the income stream on the related covered call funds, or at least limit your exposure. And, even if you like the sector, beware of too much of a good thing in case your hunch doesn’t pan out. Consider a basket of different covered calls funds with different holdings or look into funds that do this for you rather than merely buying sector specific funds.

On what percentage of the fund are they writing calls? Most covered call funds don’t write calls on the entire fund. Accordingly, the more shares that aren’t optioned, the more potential upside in a rising market vs. a fund that has written calls on a higher percentage of its holdings. When comparing funds, take this into account rather than merely focusing on yield. The higher portion of a fund’s shares that aren’t optioned, the better the upside in a rising market.

What is the maximum percentage of a fund that can be optioned? Many funds target a set yield and will write just enough options each month so that the combined dividend and covered call premium yield generates the desired yield. Accordingly, in more volatile times, a fund may not need to write as many call options to hit their yield targets if each call option pays a higher option premium than during a quieter market. That said, funds may also restrict the maximum percentage of shares optioned at any one time. One way or the other, it’s good to know both what’s going on right now and the limits on how much can ultimately be optioned away if circumstances change.

What is the fund’s typical spread between the market value of the shares optioned and the strike price of the options and how variable is this? As explained earlier, the tighter the spread, the higher the option premium. In fact, some funds have recently started selling call options that are “in the money” or where price for exercising the option equals the market value of the share. I’ve seen funds like this generate income of the mid-teens but it’s important to remember that you will be giving up the entire upside on all optioned shares in that scenario, which may sting in a rising market. Conversely, when the market hits the skids, these funds should outperform similar options-free funds. Returning to the previous bullet, it’s also vital to know what percentage of the underlying stocks are optioned, as the non-optioned portion of the fund can still appreciate during a rising market. Accordingly, unless the market has gone gangbusters, to use a technical term, such funds may still hold their own when the market enjoys modest but not monumental gains.

Do the funds use leverage? There are several covered call funds out that borrow to purchase perhaps 25% more of the underlying shares, using the extra dividend yield from the extra shares and covered call premiums to cover the borrowing costs. This might allow the funds to more fully participate in rising markets if it means less of the underlying shares are optioned but are more likely to take it on the chin when the market falls. I would also expect that as interest rates decrease and the fund’s borrowing costs decline that such funds would not need to write as many options to generate the target distribution, further increasing their performance against their covered call peers in a rising market.

How long has the fund been around and what’s its track record? The new breed of covered call funds that issue “in the money” options has captured a lot of interest but it’s really hard to gauge their performance against both other covered call funds that employ less aggressive option writing strategies and against more traditional funds that don’t employ options at all. The high yield is amazing and may be answer enough for some, but it’s hard to make an accurate basis of comparison without the necessary historical data. The study I discuss later in this article raises some concerns regarding traditional covered calls. Although a juicy yield is a wonderful thing, keep an eye on the fund’s overall performance. Even better, look at its long term track record if one exists.

Fees! What does any fund charge compared to its peers?

How is the fund’s target distribution typically taxed? In a non-registered account, the distribution from a covered call fund is likely a mix of things. The options premium portion is taxed as capital gains. Depending on the underlying assets in the funds, some of the income may also be eligible dividends, interest income, foreign income or tax-deferred return of capital. Although interest income is usually the least desirable, a lot depends on your tax bracket, as eligible dividends may be disastrous for investors relying on the GIS, nirvana for those with slightly higher tax brackets and not nearly as good as capital gains for investors making the really big bucks. While an investment’s raw yield usually grabs the headlines, knowing what you’ll ultimately get to keep after taxes can help you make a more informed choice. That said, it’s a dangerous thing to make investment choices solely by focusing on taxation.

Additional Thoughts and Arguments Against

There are concerns in some quarters that the chase for option income can actually reduce total returns, such as identified in Larry Swedroe of Alpha Architect’s November 24, 2023 article (A big thanks to Moneysaver reader Dave Reid for sending this along!) That article compares the performance of some covered call funds vs. similar funds that don’t use this strategy and cited another study that concluded that over the study period (1999-2023) that a Nasdaq-focused covered call etf didn’t do nearly as well as a standard, cheaper etf tracking the same index. It also pointed out that a standard etf may be more tax efficient since more of its return translates to deferred capital gains. Finally, it also concluded that the smaller the spread between the option strike price and the stock’s trading price at issue, the worse the fund’s overall performance. In other words, the income from the call options didn’t fully compensate investors for surrendering upside.

This article raises many good points, although I would have loved to have seen a Canadian-based example. In an example where the underlying Nasdaq stocks averaged over 16% annual growth, it is no surprise that the covered call version drastically underperformed.

In defense of covered calls, I think that merely focusing on the total return can also lead to “sequence of return problems” for investors dependent on their portfolios to pay for their daily bread. As I’ve written about previously when discussing the “sequence of returns,” or when an investment has its good vs. bad years rather than its overall performance, having to liquidate stocks during a correction to pay the internet bill can have a disastrous impact a portfolio’s long-term performance, as it forces investors to “sell low.” Such investors may not have the luxury to wait until the stock market cooperates and might instead appreciate a higher income along the way, particularly if they don’t need to shoot the lights out to stay on track for their ideal retirement.

Conclusion

Ultimately, like in so many areas of life, there are pros and cons to every decision. Although wealthier clients with a long time horizon, higher risk appetite and no need to generate extra income may do better with more traditional funds, more income-dependent or conservative investors may look at their investment options very differently. And, if you are one of them and are considering covered calls to help ensure that you have enough to fund your monthly premium peanut butter habit or to sleep soundly at night, I hope this article has helped in your investigation.