T Series Funds: The Tax Efficiency Myth and Structural Risk

By Dan Hallett, CFP, CFA

Investors would rather invest in something that distributes a regular amount of cash than sell their shares to generate cash flow.  This psychological phenomenon seems to hold no matter what the source of cash distributions.  Add perceived tax-friendliness and it’s no wonder that T series mutual fund units are so popular.  But the mirage of T series funds’ yield and tax efficiency comes with unique challenges.

T series’ mythical tax advantage

The ‘T’ in T series is short for ‘Tax’– so called because of its perceived tax advantage. The appeal of a T series fund lies in its relatively high and level cash distribution.  The tax moniker is given because the majority of the monthly cash payout is not taxable when received.  Instead, it’s classified as “return of capital” for tax purposes.

To illustrate, compare Fidelity Canadian Balanced Series A with Fidelity Canadian Balanced Series T8.  The A and T8 labels denote separate series of units of the same fund (i.e. identical legal entity).  The A units’ quarterly, uneven distribution is made up only of a sufficient amount of net taxable income to avoid tax at the mutual fund trust level – nothing more, nothing less.

The T8 units pay out an even amount of monthly cash, currently $0.07 per unit.  (The number eight in T8 denotes an approximate distribution rate of eight percent.)  The table below summarizes the sources of total return for series A and series T8 units of Fidelity Canadian Balanced fund.

FIDELITY CANADIAN BALANCED:  A vs. T8 series(Year ended June 30, 2009)
  A series T8 series
Distributions (% of NAVPS)
     Dividends 1.8% 1.8%
     Other income 0.2% 0.2%
     Cap Gains 0.0% 0.0%
     Return of Cap 0.0% 7.7%
     TOTAL DISTRIBUTIONS (a) 2.1% 9.7%
% change in NAVPS (b) -14.3% -22.1%
Total Return (a + b) -12.2% -12.2%

Sources:  fund annual report and MRFP for year ending June 30, 2009
Totals may not add up exactly due to rounding.

Series A and series T8 are two parts of the same body, so to speak.  It should come as no surprise, then, that the taxable portion of distributions is virtually identical for each series (2.1% of NAVPS).  The total return for each series is virtually identical (-12.2% of NAVPS).  The only difference is the cash paid out in excess of the taxable income, which is classified as return of capital (RoC).

Series A units paid no RoC because its mandate is simply to pay out the fund’s taxable income.  Series T8 units paid out an equivalent of 7.7% in pure RoC distributions.  Accordingly, its unit price (or NAVPS) fell much more (by about 7.7% more) since paying out more cash reduced the fund’s net assets.  A-series investors could have replicated this cash flow stream if they’d simply sold units equal to 7.7%.  Had they done so, they’d have the same amount of jingle in their jeans – and they’d have been left with a capital loss to carry back or forward (because NAVPS fell over the period).

The issue is whether advisors and investors are more comfortable with a falling asset value or a falling unit balance – both involve taking cash out of the portfolio.  One is very explicit (selling units to generate cash) and another is a bit hidden (RoC distributions).  But they place the investor in the identical economic position at the end of the day, both pre- and post- tax.

The one tax advantage never mentioned

There is one instance where a T-series fund can provides real tax benefits.  Suppose you have a big accrued gain in a fund’s A-series units.  If the same fund also offers T-series units, investor can re-designate (i.e. switch) his units from A to T series without triggering a gain because you’ve stayed in the same legal entity.  Then you can take distributions of the T-series fund without selling units to trigger a gain on each sale.

But with a big paper gain, the adjusted cost base (ACB) per unit is low so it won’t take as long for return of capital distributions to reduce the ACB to zero, after which all subsequent distributions are taxed as capital gains.  So this is a tax deferral strategy that will only last a few years and that is only available to investors with large accrued gains.

Distribution mechanics & structural risk

Interest from bonds, dividends from stocks, trust distributions and capital gains from the profitable selling of securities combine to make up a fund’s taxable income. These are the most obvious sources of a mutual fund’s cash flow.

Where a fund pays out in cash an amount that exceeds its taxable income, there are four possible sources of this extra cash.

1. A fund that brings in more money from new and existing investors than it pays out to selling unitholders will be able to use some of the ‘net inflows’ to cover monthly distributions.

2. In the absence of ‘net inflows’, a fund may hold elevated cash reserves to fund monthly cash payouts.

3. A fully invested fund that has no significant ‘net inflows’ can instead sell some of its investments to fund monthly cash distributions (thereby triggering capital gains or losses).

4. Finally, a fund’s last resort source of cash is a line of credit that can be tapped to keep the cash flowing to investors.

In the case of the Fidelity Canadian Balanced fund, both A and T8 series units were in net redemptions for the year ending June 30, 2009 – but series O and B units pushed the overall fund into net sales for the year.  Some of the $562 million in net sales could have been used to fund cash distributions.  T series (T5 and T8 units) account for the vast majority of cash distributions.

For instance, A-series investors of this fund took just 2% of total distributions in cash (i.e. 98% was reinvested into the fund).  Investors in the T8-series units took a full 73% of their distributions in cash.

To the extent that the overall fund falls into net redemptions, the fund will have to resort to options 2 (hold more cash), 3 (sells investments) or 4 (borrow) above to continue paying out cash to investors.  But each of these options has either an associated direct or opportunity cost.  And over time, it could raise costs not just for T-series investors but those in all other series of units.

Advice

With no real tax benefits (save for one rare exception), potential additional costs and the ability to recreate the same cash flow stream using systematic withdrawals, we fail to see any real financial benefits of T-series funds.

We have a record of identifying T-series funds that are at risk of cutting distributions.  Most notable was our December 2001 prediction that IA Clarington Canadian Income-T8 would be forced to cut its distribution.  We were proven right.  When so many investors use the cash for living expenses, advisors must set the right expectations at the outset.  Doing so will make your clients much happier than if you have to explain to them why the cash they’ve been spending cannot continue.

Related:

Putting monthly distributions to the test (Jan 2011)

Monthly income funds’ payout sustainability – the sequel (May 2011)

Distribution rate does not equal yield (Jun 2011)

   
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7 comments to T Series Funds: The Tax Efficiency Myth and Structural Risk

  • [...] nearly a dozen years, putting their distributions to the test and highlighting such funds’ mythical tax advantages.   Over the past two years, I’ve been particularly critical of the BMO Monthly Income [...]

  • SS

    Other advantages that were over looked:
    (1) T-6 will give almost 17 years of Tax Deferral.
    (2) Less tax paid up front means an interest free loan from CRA, therefore more money at work to grow your assets.
    (3) Possible reduction in the OAS Clawback.
    (4) Ability to switch back into Corporate Class for more years of tax deferral.
    (4) NPV (Net Present Value) is greater with ROC.

    The issue is not the income stream, but what that income stream consists of, and the Tax, and the Time Value of Money.

  • Thanks for your note SS. I would say that I did not overlook these points but I don’t see them as justification for using a T-series type of fund. In my view, a systematic withdrawal plan is nearly as efficient and is available on all mutual funds – not just those that offer unsustainably high cash payouts. To your specific points…

    1. T-6′s 17-year tax deferral. I have never seen justification of this. Look at my table at the top of this blog post for starters. Both the T-8 series and the series A versions of Fidelity Canadian Balanced result in the same amounts of taxable income. There is no deferral.

    And as this older article by Jamie Golombek illustrates, the tax impact of running an old-fashioned systematic withdrawal plan is minimal in early years and only rises when a T-series fund may well be driven to an ACB of zero – thereby resulting in all payouts classified as capital gains. In other words, not a meaningful difference.

    2. Tax deferral = tax free CRA loan. I agree with this generally but it does not apply uniquely to T-series funds. A SWP plan will accomplish much the same thing with complete customization.

    3. OAS clawback. Again, based on my comments in #1 and #2 above, this would not apply uniquely to T-series. To clarify, I’m not disputing that T-series distributions trigger a lot of taxes. I’m just saying that payout out lots of cash doesn’t make fund level interest, dividends and capital gains disappear. It’s still there. That a fund pays out a lot more than is taxable isn’t magical – but it may be brilliant marketing.

    4. Tax deferral via switch to corporate class. I assume you’re referring to a scenario whereby an investor has accumulated wealth in a corporate class, switches to a T-series within the same corporation (not a taxable sale) and then back to the regular corporate class fund (still not a taxable sale if money never leaves the corporation).

    However, if you have a mutual fund trust that pays out a monthly cash distribution and you switch from that trust to a corporate class fund, that is a taxable sale (i.e. capital gain or loss will be triggered).

    5. RoC = higher NPV. I don’t think this would be meaningful based on my comments above (in particular in points #1 and 2).

    I’m happy to look at any evidence you would like to share that supports the claim of materially lower tax-impact vs. a standard SWP plan. Otherwise, we’ll have to agree to disagree.

  • I would add that the level of income is absolutely relevant. When I first started looking at this issue with the old Clarington Canadian Income fund, a full 40% of unitholders were taking the distribution in cash. Based on how I saw that fund – and others like it – used by advisors it’s safe to assume that many of those taking cash payouts were using the cash to pay monthly living expenses.

    One advisor I know used to call one such fund her “widows’ fund” referring to how it was recommended to all widow and other elderly single female clients to generate cash flow.

    Every fund I’ve taken to task for unsustainably high payouts has cut or fully eliminated cash payouts. I think it matters a lot for clients relying on these cash payouts to support parts of their lifestyle when the cash flow stream disappears. I’m guessing it matters a lot to clients of IA Clarington Strategic Income Y (formerly Clarington Canadian Income), Mackenzie Sentinel Income A (formerly the Industrial Income fund), and others that have cut distributions.

    Look at the Clarington fund as a perfect illustration of this. Just 12.5 years ago I looked at this and stated that the payout was not sustainable. Eight months later (summer of 2002) the payout was cut by 25%. It continued falling until payouts were cut altogether (except what’s required to avoid tax at the fund level).

    So many people bought the fund and started receiving cash payments with the idea that it would support their lifestyle. And now these clients’ cash flow has disappeared while their fund unit price is half of what it was a dozen years ago. Are you saying that this is irrelevant? It’s not a direct tax issue but when these products are sold as reliable sources of tax efficient cash flow, I think it’s highly relevant.

  • As a wealth management expert, our purpose in life is to create on an overall strategy to better our clients’ positions with respect to their long term standard of living, ensure and protect their financial well-being, and provide options for them in the future.

    There are many advantages to using T-series funds that have not been fully considered here. For instance, I am able to adjust the regular distributions of income for my clients in such a way as to allow them a “tap” to turn on and off their cash flow as required without triggering capital gains. I am also able to utilize fixed income inside of a t-series fund and have that interest income treated the same as a capital gain or dividend. The effect here is to allow my clients to draw an income from a lower risk portfolio while still being taxed as if they had an equity portfolio.

    There are a myriad of other advantages to using t-series portfolios that I won’t take the time to get into here, such as how to use them inside of a holdings company to the benefit of my clients’ heirs. When considered purely as a tax play they represent a considerable advantage. In my humble opinion, the advantages are far more substantial than what I believe you are leading your readers to believe. (Perhaps I should tell my client that I didn’t think they really wanted approximately $700 per month OAS income they’ve worked all their lives to deserve?).

    Life is about options, and my mission in life is to provide options for my clients. As a footnote, I have never engaged a client with any payout greater than 5%, and usually I recommend a 4% distribution. I would not consider any greater than 5% as a sustainable amount of distribution over a long period of time (say 25 years) and I would NEVER sign off on a client doing so, unless they were at a late stage of life and wanted or needed the income distribution for various reasons.

    That may be the poignant issue to cover off here – The distribution rates you are quoting are not sustainable, but nor would they be with a standard SWP in my opinion. Back-testing will show that 5% distributions in “growth and income” or “growth” T-series portfolios have historically seen clients with net growth in capital over the long haul.

    With all due respect, considering the author is clearly more qualified than I am, at least on paper, and while I believe that T-series should never be “sold” to a client as a pseudo-annuity type of product (the concept of a “widow” fund makes me want to ring the broker’s neck!), I do believe it would have been much more valuable to the readers to have a more comprehensive look at the use of T-series portfolios as part of a larger overall strategy.

  • Thanks for your comment George. Note that I broke up your text to put it into paragraphs so that it’s easier to read but otherwise your comments are unchanged. You touch on many points so I will pull out each one and given that you have taken the time to write a detailed comment.

    You wrote…

    I am able to adjust the regular distributions of income for my clients in such a way as to allow them a “tap” to turn on and off their cash flow as required without triggering capital gains.

    I’m aware of one or two companies (i.e. Manulife and/or Invesco) that allow you to specify the amount of T-series distribution by account but otherwise, I was unaware that this could be customized.

    But the same can be done with regular (or systematic) withdrawal plans – or SWPs. And the tax consequences are minimal as noted above in my blog post and in Jamie Golombek’s article.

    I am also able to utilize fixed income inside of a t-series fund and have that interest income treated the same as a capital gain or dividend. The effect here is to allow my clients to draw an income from a lower risk portfolio while still being taxed as if they had an equity portfolio.

    While some synthetic fixed income funds (which I wrote about a few years ago) used to be a good way to accomplish what you say the Federal Minister of Finance eliminated this strategy. There is one corporate class bond fund that I know of that isn’t synthetic.

    And there is NexGen Financial which has a tax-driven structure which can accomplish what you say but it’s a costly structure. When I last looked at it a few years ago, the fees made it uncompetitive with other options in my assessment. But I haven’t looked at it recently.

    (Perhaps I should tell my client that I didn’t think they really wanted approximately $700 per month OAS income they’ve worked all their lives to deserve?).

    I assume that you’re saying that your tax-friendly strategies help clients avoid OAS clawback. Income has to be relatively high for this to be an issue but as my original Fidelity example illustrates, the amount of taxable income is the same for series T as for any other series of the same fund.

    Life is about options, and my mission in life is to provide options for my clients. As a footnote, I have never engaged a client with any payout greater than 5%, and usually I recommend a 4% distribution.

    This sounds like you take the right approach with respect to sustainability. But even 5% is no slam dunk (as is illustrated in this recent Global & Mail article).

    The distribution rates you are quoting are not sustainable, but nor would they be with a standard SWP in my opinion.

    Correct because I’m writing about “unsustainable” distributions so that’s my focus. At one time, virtually ever monthly income fund sported such high payouts. It’s only after I’d written about this topic for a few years and some funds (previously-thought to be infallible) had to cut payouts that distribution rates started to come down and companies started adjusting payouts annually.

    Now more sustainable payouts are common but the biggest sellers are those with fat unsustainable payouts. And a big reason is that these are mis-understood and/or mis-sold.

    While I may have given the impression that I’ve taken only a surface look at this topic, I’ve spent a great deal of time on such products over the past 13 years. Aside from some disagreements on the pure tax benefits it sounds to me like your views are more responsible than those of your peers.

    Thanks again for your comments George.

  • […] 09-Feb-2010:  T-series Funds:  the tax efficiency myth & structural risks […]

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