Excess Financial Services Fees Cripple Couple's Portfolio

Andrew Allentuck

SITUATION Couple worries losses will cut future income

STRATEGY Cut fees, pare back excess insurance

SOLUTION Capital adequate for retirement, heirs and charity

A couple we'll call Louis, 57, and Maryanne, 56, live in Alberta. Their son, 22, attends a local university while a daughter, 27, lives on her own. They have a good life with a monthly aftertax income of $10,400, a $750,000 house, a $310,000 condo that they rent out for $12,500 a year, and financial assets of $1,163,040, mostly in pensions and registered accounts.

Their mutual fund investments have produced red ink. The funds reflect the market's underwhelming performance, but high management fees are a permanent drag on returns. Those fees, which average 2.4% per year, suck up most of the dividends their funds' stocks pay, leaving the portfolio with deficits to show for years of management.

"We feel that the fees we pay are not justifiable given the low returns we are getting," Louis says. "That the funds may do well in the long run does not mean much when we are a few years from retirement."

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B. C, to work with Louis and Maryanne. "The market's ups and downs can't be blamed on management, but the portfolio does suffer from high embedded fees and advisors who have a specialization in sales instead of risk management," he explains.

Finding A Balance

Depending on when they quit their jobs, they could have total annual retirement income of as much as $170,000 before taxes. They could have more, perhaps for gifts to their children or for donations to good causes. "They may also want to sell the small condo they are keeping for retirement for something larger. It's in the future, it's not certain and it's therefore not part of this analysis," Mr. Moran explains.

Their problem is that they have been oversold financial products, the planner says. They have $500,000 joint and last-to-die insurance coverage, $500,000 personal term insurance for Louis and $300,000 term insurance for Maryanne, a total of $1.3-million paid by salary deductions and premiums. Their premiums, $5,700 per year on their personally paid term life policies alone, are wasted in the sense that they do not need such large death benefits. Their mutual fund management fees add up to $15,000 or more per year. In all, their fees for financial services total $25,000 per year. That is a fifth of their annual after-tax income.

Improving Portfolio Returns

Louis and Maryanne need to rationalize their portfolios and to reduce the total management and advisory fees they are paying. The $310,000 rental condo to which they may retire one day returns just 1.7% per year after taxes, mortgage interest and expenses. That is not much for a leveraged investment and would be a reason to sell. However, given that they might use it for retirement after selling their Alberta house, the low return can be seen as a kind of carrying cost until they retire and use the condo themselves. Capital appreciation could add to their return. In any event, Louis and Maryanne can afford to carry this low-performance asset for a few more years.

The fees on their mutual funds are substantial and should be cut, perhaps by having a professional portfolio manager handle their accounts. A manager would likely charge between 1.0% and 1.5% of assets and could design a portfolio with a suitable balance of stocks and bonds, commodities and exchange-traded funds. The savings on fees could be between $7,000 and $11,000 per year, Mr. Moran estimates.

An important question is what level of fixed-income assets should be in the portfolio. The usual advice is to have a bond allocation equal to age. That implies that Louis and Maryanne should have about 55% to 60% bonds and reduce their stock allocation to 40% or 45%. But in their case, Louis' large defined-benefit pension reduces their need for the bulletproof returns of government and top-grade corporate bonds.

Bonds at perhaps half the usual allocation would likely be sufficient, Mr. Moran suggests. Government bonds currently pay little. Investment-grade corporate bonds, however, yield 4% to 5.5% to maturity. The couple should shop for a low-fee, actively managed bond fund with a strong long-term record, the planner suggests.

Retirement Income

If Louis retires at age 60, he will receive a pension of $81,333 a year from his employer; Maryanne $15,600 from hers. Their RRSPs, which currently total $467,251, and to which they add $2,400 a year, will have a value of $510,000 when the couple retires, assuming that assets grow at three percentage points over the rate of inflation. This capital could generate $27,083 a year for the 31 years from Maryanne's retirement to her age 90. Were the couple to keep working and saving to Louis' age 62, the fund would rise to $541,662, and produce income of $30,238 per year (in 2010 dollars), Mr. Moran estimates.

The couple's TFSAs, currently worth $21,500, can grow with $5,000 of annual contributions by each partner. In three years, with a 3% annual real rate of growth after inflation, the accounts could have total assets of $54,403.

In five years, they could amount to $78,016. If Louis and Maryanne were to sell their house and move into the condo, they would have $750,000 to invest. They could use the cash to pay off their $247,800 debt, leaving a balance of $502,200, minus transaction costs, on the house sale.

If the $502,200 and the TFSA money were invested at three percentage points over the rate of inflation and spent from retirement at 60 to Maryanne's age 90, they would have an additional $27,830 in annual cash flow. If they retire at Louis' age 62, the cash flow would be $30,238 per year. Money saved on financial services fees could add to returns, the planner notes.

Assuming they choose to retire in three years when Louis is 60, they would have $96,933 from their company pensions, $27,083 from RRSPs and $27,830 from their house capital and TFSAs, for a total of $151,846 per year. After age 65, they would add combined CPP benefits of $16,815. Their Old Age Security benefits would be subject to the clawback. Thus, the couple's annual pre-tax retirement income after age 65 would be approximately $169,000 (in 2010 dollars).

They could work another three to five years to add to their retirement income, Mr. Moran says. "In the long term, however, cutting excess insurance and management costs will raise their income as readily as more years of work," he concludes. "Giving to good causes could also be part of their planning."

Copyright 2010, The Financial Post, Used By Permission