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TFSA Investors: How to Construct a Passive-Income Stream More Powerful Than Your OAS or CPP Pension

Can you rely on just your CPP and OAS pensions with zero in savings?

The answer ultimately depends on your standard of living and at what age you opt to receive pension payments. For most, relying solely on one’s pension(s) is not sufficient enough to finance a retirement lifestyle that’s anything close to being comfortable.

As such, it’s vital for Canadians, especially millennials, given we’re not sure how much thinner pension payments can get in the distant future, to build a nest egg as soon as possible to ensure the greatest degree of financial freedom in retirement. Fortunately, with the Tax-Free Savings Account (TFSA), one can build a dividend-paying portfolio that’s completely free from taxation for those who follow the rules to keep the Canada Revenue Agency (CRA) from knocking.

In a prior piece, I outlined the true power that making regular annual contributions to a TFSA can have over the long run. Indeed, it’s difficult to fathom the profound wealth-creating power of tax-free compounding that’s made possible by the TFSA. And while systematically investing every year’s contribution (it’s $6,000 as of 2020) may not seem like a big difference over the intermediate term, it could mean the difference between a nest egg that’s able to pay dividends far larger than a pension, and one that merely supplements one’s already thin monthly pension payments.

The key is to save enough principal to maximize your tax-free passive-income stream down the road. And when it comes time to retire, you have the freedom to raise the bar on your income stream’s yield as you deem fit.

How much would you like your nest egg to yield?

You can stick with “the 4% rule” to get a good blend of growth and upfront income, or you can stretch the yield a bit further to 6% or even 8%.

While stretching a yield to 8% may seem like a recipe for an imminent dividend (or distribution) cut, there are securities out there with sustainable payouts. In such cases, the higher yield comes at the trade-off of growth, not necessarily the safety of a distribution.

If you’re looking to stretch your yield to the higher end of the spectrum, you may want to consider looking at REITs, royalty companies, and specialty income ETFs, like those incorporating “covered call” strategies to boost income. Unlike common shares, such instruments implement a capital return structure that allows for higher yields without a higher degree of risk.

The more you pay shareholders with distributions, though, the less money is in the pockets of the companies to pursue growth initiatives.

Consider Pizza Pizza Royalty (TSX:PZA), a Canadian pizza titan that’s catered to aggressive income investors. Shares of the name yield an astonishing 8.7% at the time of writing, thanks to the income-focused capital return structure and a substantial amount of capital depreciation over the last three years.

While a royalty company’s distribution yield is likely to be richer than the dividend yield of your average common stock, Pizza Pizza’s near-9% yield is not by design. Pizza Pizza’s historical yield has averaged around 6% over the years, and the only reason the yield has swelled up is due to significant competitive pressures that have taken their toll.

An overly generous capital return structure can be both a blessing and a curse. And in Pizza Pizza’s case, it’s been a curse, since it’s become much tougher to keep up with tech-leveraging competitors with limited capital to reinvest in the business.

Domino’s Pizza, a top competitor in the pizza industry, is now known as “a tech company that just sells pizza.” Or at least that’s what the CEO wants investors to think. Given the incredible innovations, including Pizza Tracker, it’s hard to argue with the tech case. Moreover, as technology and digital ordering experiences become more vital to the success of fast-food firms, firms that don’t have the capital to reinvest could be left behind.

While Pizza Pizza has done a decent job of keeping up with tech-driven trends given the financial constraints, I ultimately believe that the return structure does not bode well over the extremely long haul. That said, Pizza Pizza shares have already been damaged such that there’s value to be had for those looking to tilt their diversified passive-income stream’s yield slightly towards the higher end.

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Fool contributor Joey Frenette has no position in any of the stocks mentioned. The Motley Fool owns shares of PIZZA PIZZA ROYALTY CORP.

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