In the wake of moves by several high-profile private funds to restrict redemptions, many investors have only recently discovered just how illiquid these products can be. For seniors who rely on their portfolios to fund basic living expenses and meet mandatory withdrawal requirements, this loss of access is especially dangerous.
If too much of their savings are in what are known as gated funds, they are exposed to cash-flow shortfalls, tax problems, and permanent impairment of their retirement plans. It is increasingly clear that stronger protections are needed to ensure older investors are not left bearing the brunt of these risks.
Why gated funds hit seniors harder
If too much of a senior’s nest egg is tied up in gated funds, the first risk is obvious: Unlike younger investors, they do not have decades to wait for liquidity to return. They often need access to their savings right away or in the short term to cover basic living expenses. That becomes a serious problem when their money is locked inside an illiquid vehicle.
The situation becomes more difficult when a locked-up fund sits inside a registered retirement income fund (RRIF), because RRIFs come with minimum annual withdrawal requirements. The good news is these withdrawals can be taken in-kind, allowing the holder to meet the requirement without actually getting access to their funds. The issue is that these withdrawals are taxable, and taxes must be paid in cash, raising the question of where that cash will come from.
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The problem can intensify at death. If RRIF assets cannot be transferred to a surviving spouse or other qualifying beneficiary, the account is treated as though the full balance were withdrawn in the year of death, generating a large tax bill for the estate. In portfolios heavily concentrated in illiquid positions, the tax liability could even exceed the liquid holdings, forcing the executor to sell other assets simply to pay taxes on investments the estate cannot access.
To help deal with the problem, seniors may want to donate the fund units, but doing so generally requires the fund manager’s consent. It may also burden the charity with a holding it cannot readily deploy. Worse still, the CRA expects in-kind donations to be reported at fair market value (FMV). For gated funds, net asset value (NAV) is unlikely to be a reasonable proxy for FMV, so even reporting the donation amount can become a thorny issue.
Meanwhile fees, minimum withdrawals and tax calculations are all based on that NAV. This means seniors end up paying taxes and management fees on a figure that overstates the true fair value of their investment, further eroding their genuine retirement savings.
How seniors can be better protected
Advisers play a central role in preventing these situations for seniors. As clients approach retirement, it is essential to ensure their portfolios are not too concentrated in illiquid assets, particularly in any single illiquid fund. This often means gradually reducing illiquid positions over time and stress-testing the portfolio for the impact of one or more gatings.
That said, there’s more that regulators can do too, starting by strengthening guidance around concentration and liquidity for seniors. To ensure accountability, regulators should also put in strong enforcement mechanisms to protect clients when suitability failures occur. Such a failure could mean purchasing a private fund for a client that cannot handle illiquidity, or letting a client’s portfolio become too concentrated in one or more such funds. One solution could even be requiring investment dealers to purchase gated units at NAV when a clear breach is identified.
Preferential treatment for RRIF holders is another avenue. Regulators could require that any cash generated by locked-up funds first be allocated to investors with RRIF obligations.
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Finally, fee structures deserve scrutiny. Regulators could require automatic fee waivers or deferrals when a fund suspends or limits redemptions, tying the fund manager’s compensation more closely to delivered liquidity and fair market value rather than accounting estimates.
These remedies may appear severe, and any implementation would need to reflect the nuances of each case. For instance, there is a difference between a fund partly gating with cash distributions and fully gating with in-kind distributions. Nevertheless, taking decisive action would strengthen supervisory incentives for investment dealers and help ensure that seniors do not bear the full cost of missold products.
Illiquidity is not inherently bad, but when older Canadians discover that a fund in their RRIF has gated redemptions, the consequences stretch from day‑to‑day cash flow to estate taxes. It’s essential that advisers, fund managers and regulators treat these risks with the seriousness they deserve if private markets are to remain a credible option for retirees.
Benjamin Sinclair is an investment adviser and associate portfolio manager at Designed Securities. His newsletter and podcast on private markets can be found at www.BeyondTheExchange.ca.