May-September Pair Builds a Future

Andrew Allentuck

In Alberta, a couple we'll call Ernie, 62, an environmental consultant, and Philippa, 38, a corporate middle manager, bring home a total of $10,767 per month. That's a good income, but they are tired of the rat race. They want to quit work--Ernie in a couple of years, Philippa by the time she is 60, and migrate to more interesting pastures, perhaps Ontario, British Columbia or even the United States.

Calling it quits has its risks, however. Their assets total $1,033,700, including a house with an estimated value of $360,000. But they also have debts that add up to $197,000. Their net worth, $836,700, is a good nest egg for a new life in another place, but their plans are complicated by the difference in their ages.

"We want to retire and to spend time travelling while my husband is still active," Philippa says. "I could live another three decades after he dies. If he retires in two years and puts $3,500 per month into the pot for our expenses and I work to age 60, we would want our investment income to be $7,000 per month before tax in current dollars. Can we achieve this?"

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Ernie and Philippa. "If they move after Ernie retires, Philippa's income would be unknown. Their budget would depend on CPP and, eventually, OAS, plus investment returns. The problem is to add predictability to their finances," Mr. Moran says.

Mortgage Management

Ernie and Philippa can afford to eliminate their mortgage, if they wish, by using some of their $216,650 of nonregistered assets. They should compare their present returns from nonregistered investments with the 5.5% mortgage interest rate. If their portfolio does not produce at least 5.5% plus an adjustment for tax, say 7.7%, there is a case for using some of the money to eliminate the mortgage. They could replace investments they sell by borrowing what they have spent. Interest they pay to earn investment income would be tax-deductible, Mr. Moran says.

As a matter of mortgage strategy, they could either pay the debt gradually or all at once. Paying off the mortgage could be done gradually. The couple's mortgage, with a present balance of $163,000, allows for payment of up to 20% of the original $175,000 balance each year without penalty. That's $35,000. Added to the $16,020 they pay annually, that would amount to $51,020 per annum for three years and two months. At that time, the mortgage balance would be reduced to zero, Mr. Moran says.

Alternatively, the couple may decide to pay off the mortgage all at once. The present mortgage is up for renewal in November 2011. Ernie and Philippa could decide to pay it off before they are hit with what are likely to be higher interest rates. As the rollover date approaches, they can weigh the cost of penalties, usually three months interest, and compare that with the additional cost of carrying the mortgage a few more years, Mr. Moran suggests.

Retirement Management

The quarter-century difference in the couple's ages creates complexity in funding their retirements. Ernie will receive CPP at the maximum rate of $11,210 per year, and OAS at $6,204 per year, for a total of $17,414 per year or $1,451 per month. Ernie would like to contribute $3,500 per month to the retirement budget. He would therefore need an additional $2,049 per month. If he can generate a 3% real return from invested assets, he will require a lump sum of $439,770 in 2010 dollars to fund his contribution for the 25 years. He already has $309,100 in his RRSP and $216,650 in his non-registered account, so he has exceeded his estimated capital requirement already by almost $86,000, Mr. Moran says.

Philippa should receive CPP and OAS in amounts similar to those Ernie will get. But those two pensions will not be enough for her to put $3,500 per month into their retirement budget. To make up the difference, she will need as much as $815,900. She will outlive Ernie by perhaps 25 years, so her capital requirement is clearly greater.

Philippa currently has $93,950 in her RRSP. She puts in 6% of her $120,000 annual salary or $7,200 per year and her employer matches half of it for total contributions of $10,800 per year. If she continues to contribute $10,800 per year, she can build up a total of $287,224 in her RRSP account, Mr. Moran estimates. That will be far from the capital she will need to generate $3,500 per month for 25 years, but the gap can be closed in three stages.

First, at her age 50, when she may want to move to part-time work, Ernie will have an $85,550 surplus over his own retirement funding goal. That money will effectively close part of the gap, leaving a required capital balance of $439,400 after allowing for continuing RRSP contributions.

Second, she can use an expected payout from life insurance with a present value of $262,000 at Ernie's death. Unfortunately, permanent or whole life insurance policies like Ernie's generally do not pace inflation, so it is not possible to say in advance what the purchasing power of the payout will be.

Third, she can maximize savings by contributing all monthly cash savings, $475, and maybe transferring some of her household spending, such as $425 per month on clothing and $380 per month on cosmetics and grooming, to add perhaps $7,200 per year to savings. In 22 years, assuming a 3% annual real return, Philippa would have an additional $219,900 that would close the retirement funding gap, the planner estimates.

Investment Management

These cash-flow estimates come with a good deal of uncertainty, Mr. Moran admits. Ernie and Philippa have been proficient with their investments and have built up a portfolio of blue-chip stocks. But Philippa's RRSP is invested entirely in successful but relatively aggressive mutual funds. They have $51,000 in bonds and an additional $9,050 in a bond fund. Their mutual fund fees average 2.4% on equity portfolios. They need to add stability and to cut fees, Mr. Moran says.

They can cut fees by moving money out of high-fee mutual funds into exchange-traded funds, with charges that are likely to be one-fifth to a quarter of the annual fees they currently pay.

They also need to push bond content up from the current level of 10% to about 35% to 40% of financial assets. Adding bonds, perhaps a blend of government and corporate issues, with maturities in a range of three to seven years, would boost cash flow to an average 4.4% to 5.5%, from their present dividend level of about 2.5%. Fee savings would add to cash retention.

"Philippa might achieve her retirement goal," Mr. Moran says, but the couple must be vigilant. "She and Ernie will have to do everything right -- maintain returns at 3% or better after inflation, cut management fees, maximize her RRSP contributions, add bonds and chop frills from their current budget."

SITUATION Couple with 25 years age difference planning retirement

STRATEGY Pay off mortgage, build capital

SOLUTION Cash to maintain way of life for decades