Wealth Comes With Issues in Complex Investments

Andrew Allentuck


Wealthy couple risks loss from complex portfolio


Restructure investments, create plan for inheritance


Secure portfolio and lower taxes

In Saskatchewan, a couple we’ll call Morris and Valerie, both 58, are retired. Valerie draws $60,000 per year from a commercial property she owns. With Morris, she also has two rental condos that produce net income of $10,200 per year. Morris supplements their income by drawing $20,000 per year from $175,000 in a savings account to produce $90,200 annual pre-tax cash flow. After tax, their income is $6,000 per month.

Morris and Valerie have achieved the Canadian dream, “Freedom 55,” as one life insurance company styles it. Their financial assets add up to $2,825,000, which they manage themselves. The money is invested in a collection of funds, commercial property, bank accounts and stocks that have produced an average annual compound return of just a few per cent per year. It is very little for a substantial portfolio, Morris laments.
“I have made mistakes in picking stocks and I have not timed my trades very well,” Morris says. “I realize I am on my own. I manage the portfolio, but it is a lonely job.” It is work that does not forgive mistakes, he adds.

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Morris and Valerie to improve investment returns and to make his income more secure.
“The problems are really about the complexity and diversity of their income,” he says. “There are too many investment accounts without evident structure. One the one hand, this gives them protection against the failure of any single stock or the underperformance of any mutual fund or even group of funds. On the other hand, the number of funds, preferred stocks, common stocks, bonds and American shares would make management hard even for a professional portfolio manager.”

Structuring Income

Valerie draws cash out of her commercial property, leaving $15,000 of rental income in the management company as retained earnings. They also have two condos they rent out, which provide a few thousand dollars a year net rental income.

At age 60, each can draw reduced Canada Pension Plan benefits, but they can afford to wait until 65 and should do so, Mr. Moran says. At that time, Morris will receive the twothirds of maximum credits and earn $7,432 per year. Valerie will receive 44% of maximum credits she has earned, or $4,832, for total annual benefits of $5,432 per year.

Each will receive Old Age Security benefits at age 65. Those benefits, now $6,222 per year, are likely to be subject to the clawback, which begins at $66,733.

Assuming a conservative return of 3% over inflation, their potential retirement income based on their assets should be at least $132,500 per year until their age 90. Putting it all together, their maximum sustainable retirement income should be $157,208 per year, subject to what might be a loss to each of about $2,000 per year to the OAS clawback, leaving gross income after clawback but before income tax of $153,208. After tax at an average rate of 25%, they would have disposable income of $114,906 per year, a sum far in excess of their present spending requirements.

Tax Planning for Inheritance

Morris has a backup. He expects to receive an inheritance of $1-million from his father who is 88. Dad is quite competent and can do estate planning. Dad should rewrite his will to make the money to be inherited by Morris go into a testamentary trust with Morris as beneficiary rather than to Morris directly. The trust will file its own tax return at graduated rates. The trust will cost at least a few hundred dollars to set up, could involve probate fees of as much as $13,000, and may involve some fees for annual tax accounting, but the tax savings could be quite substantial, Mr. Moran says. Moreover, the money taxed in the hands of the trust will not further boost Morris’ income and further impair his ability to retain OAS benefits.

It is important for Dad not to gift capital now for several reasons. If transferred now, it cannot be part of the testamentary trust. And if Dad needs long-term care, he might not have the cash to pay for it. A bill of $50,000 in a care facility, paid with after-tax dollars, is possible. Moreover, deductibility of health-care costs can be quite limited if not paid by the patient. A few years of such care would significantly erode Dad’s estate, the planner says.

Morris and Valerie will be able to watch their capital grow as they age. They can add stability by moving assets from stocks and real estate to bonds or bond funds over time, aiming for a bond exposure as a fraction of their financial assets roughly equal to their ages. If they remain modest in their spending, they will be able to convey a substantial estate of their own to their children and charities.

Professional Management

Their legacy will be simpler and the management problems they leave to the kids will be less difficult if there is a single entity to manage their stocks, bonds and funds. A registered portfolio manager could be hired for a fee of 1.0% to 1.5% per year of investments under management. The manager would be a single entity, a far simpler arrangement than watching a gaggle of assets. The manager’s first job would be to rebuild their portfolio to make it more controllable, more focused and more profitable.

Investors are protected from financial manager crooks if all money is sent to a major trust company acting as custodian for the manager. The trust company also issues cheques to the client, leaving the manager the single job of asset management.

There is a final question of exposure to U.S. succession duties, a.k.a. death taxes.
Unlike Canada, which only taxes accrued but unrealized gains on designated assets at death, the United States taxes the full market value of U.S. property. U.S. property includes real estate in America and American stocks, which the couple holds. High net worth Canadians can find themselves obligated to prepare a U.S. succession tax return, though under tax law, non-residents of the United States can apply tax credits to wipe out or reduce their liability up to present limits that would eliminate the couple’s U.S. tax due. Morris and Valerie should acquaint themselves with this area of U.S. tax law, track its changes and then make a prudent decision about retention or sale of American stocks in their portfolio.

“Morris and Valerie have achieved a degree of financial independence that would make them the envy of many people,” Mr. Moran says. “The challenge of wealth is to steward it well. Advice and information are everywhere. Wisdom, however, is rare. That said, they are now the sole managers of their fortune. They need to find a management solution that will be permanent and cost efficient

The Financial Post, Used by Permission