Redeeming Mutual Funds￼￼
Mutual funds provide liquidity for investors. Mutual funds can be redeemed easily and investors can receive their money quickly.
On an annual basis, the fund manager must provide investors with the requirements to redeem fund units. This information is set out in the prospectus and outlines the criteria for redemption requests to be considered in “good order”. Some of the items needed for a good order redemption request include:
- Order received before the time stipulated in the prospectus.
- Order placed by the rightful owner of the units or shares to be redeemed.
The fund manager must also provide information to investors on how often the fund is valued and how the redemption price is calculated.
A single withdrawal can generally consist of any lump-sum amount, subject to the funds being available in the mutual fund.
Purchases and redemptions are based on the valuation date following the receipt by the fund of a purchase or redemption request, and settlement of most funds is the trade date plus three business days (T+3). For money market funds, settlement is usually the next business day (or sooner, if chequing privileges are available).
On Friday, July 16, Bernard makes a redemption order at 6 pm Eastern Time for units of his Precious Metals Fund. The valuation day for his trade will be Monday, July 19 since his order came after 4 pm. The funds must settle in his account by the close of business Thursday, July 22, although he may receive them sooner.
Systematic Withdrawal Plans
Systematic withdrawal plans (SWPs) are redemption programs that allow investors to receive a regular cash flow from their holdings. These plans provide investors with three advantages:
- Withdrawals can be tailored to the client’s specific cash flow needs, providing assets are sufficient to support the payout level.
- Investments remaining in the fund continue to generate returns.
- Depending on the type of funds held, income may be eligible for preferential income tax treatment.
A fund that offers systematic withdrawal plans must describe them in its prospectus. As well, the prospectus must specify if there is a minimum level of holdings, such as $50,000 or $100,000, before investors can take advantage of these plans.
SWPs provide clients with flexible payment options. They can be set up to pay out at regular intervals such as monthly, quarterly, or annually. Clients can also choose to redeem:
- a ratio or percentage of holdings
- a fixed dollar amount
Ratio Withdrawal Plan
In this type of plan, the investor receives a cash flow based on a percentage of his or her portfolio’s value, such as 8% or 12%.
The amount paid is calculated as a fixed percentage of the average daily NAVPU during the previous payment period, or the value of the account on the last day of the previous payment period.
The withdrawal ratio is flexible, which is ideal for the investor who has immediate cash needs but whose income needs may change in the future.
If an investor’s withdrawals are less than the growth of the portfolio, the investments continue to grow and the investor can withdraw more in later years without depleting the investment.
However, if an investor’s withdrawals exceed the fund’s return or the investor excessively increases the withdrawal percentage, then the portfolio’s growth is adversely affected and begins to deplete the capital.
Fixed-dollar Withdrawal Plans
With this type of plan, the investor chooses to receive a fixed amount at specified intervals, such as monthly or quarterly. Investors who have financial commitments that are relatively stable may choose this type of plan.
The fund sells enough units, depending on the price, to produce the payment. Since the price may vary for each payment, it is therefore possible to experience the same risk mitigation effect for de-investing as dollar-cost averaging produces when investing. In other words, as prices fall, more units are redeemed and when prices rise, fewer units are redeemed.
Taxation on Lump Sum or Systematic Withdrawal Plans
With a systematic withdrawal plan (SWP) or lump sum withdrawal, all distributions are taxed in the year received.
The prospectus must disclose the tax consequences from mutual fund dispositions. In most cases, the fund company provides tax reporting to the investor that includes:
- the average cost of units held
- the number of units redeemed during the year
- the total dollar value of payments made during the year
It is required by law to withhold tax on redemptions made from tax-sheltered registered plans (for example, RRSPs). The tax rates depend on the total dollar amount of the redemption.
In compliance with the Canada Revenue Agency, the appropriate withholding tax rate is applied on the basis of the full or aggregate amount (minus fees and charges). The rate is based on the total amount of the transactions per request in an account, not on the individual transactions.
Many fund managers have launched series of mutual funds that may be used as alternatives to SWPs. These series are usually known as Series T, where T stands for Tax. The name of the series indicates the payout percentage. Thus, Series T6 pays an annual payout of 6% of the fund’s year-end net asset value per unit (NAVPU), Series T8 an annual payout of 8%, etc.
With Series T, it is not necessary to redeem units in order to provide the required cash flow. Instead, the required cash flow is provided by means of capital, which is not taxable.
NOTE: Series T distributions do not always have a return of capital. For instance, if a fund is a T4 and the portfolio earns 4%, there will be no return of capital.
A distribution is characterized as return of capital when the amount of the distribution exceeds the taxable income of the fund. The taxable income of a mutual fund consists of Canadian dividends, foreign dividends, interest income and net realized gains. Any distribution that does not fall in one of these categories is treated as a return of capital for tax purposes.
Sustainability of Payout
In order to be sustainable, the payout rate should approximate the average long-term return of the fund, taking into account its asset allocation and investment objectives. For example, a mutual fund with 80% equity normally has a higher average long-term return than a fund with 40% equity. The key word here is long-term. Over any given period, it is quite possible that either fund would outperform the other.
If distributions consistently exceed the fund’s long-term return, the fund will eventually be depleted. This is the same result as with SWPs.
Over the long-term, there will be some years with positive returns and other years with negative returns. In addition to the average long-term return, the sequence of the returns also matters. For a given average return, it is preferable for the positive returns to occur early in retirement and for the negative returns to occur later. This is because the portfolio is usually largest at the beginning of retirement. The portfolio decreases over time as withdrawals are made over the investor’s retirement years. It is preferable for the positive returns to benefit the portfolio when it is large and the negative returns to hit the portfolio when it is small, rather than the other way around.
It is possible for an investor to change the payout rate by switching from one series to another. For example, by switching from Series T8 to Series T6, the investor reduces the annual payout rate from 8% to 6%. The switch constitutes a redemption of the Series T8 units and will trigger a taxable capital gain or allowable taxable loss.
However, some Series T funds have been established under the umbrella of a mutual fund corporation instead of a mutual fund trust. It is possible to switch from one class of shares to another within a mutual fund corporation without immediately triggering a taxable capital gain.
Mutual fund corporations will be examined in greater detail later in the course.
|Most fund companies allow you to sell units in one mutual fund to purchase units in another mutual fund among its own offerings. This transaction is called switching.|
A fund’s prospectus outlines whether this service is available and whether a switch fee can be charged. If your client purchased a mutual fund with a deferred sales charge, there are no redemption fees charged if the client switches to another fund. In general, your client maintains the same deferred sales charge schedule as if he or she had not made the transaction.
As well, if your client had purchased the mutual fund with a front-end load, there is no sales charge applicable at the time of the switch.
However, there may be an early redemption charge for redemptions or switches made within a certain time period, often the first 90 days after purchase. If your client purchased a mutual fund with an early redemption fee and decided to switch to another fund within the early redemption period, he or she would be subject to that early redemption charge.
Additionally, the dealer may charge a commission of up to 2% for executing a switch transaction, regardless of whether the original units were purchased with a sales charge or a deferred sales charge.
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