In Vancouver, a couple we’ll call Katie and Edgar are moving into retirement. With $1.13-million in assets, a $500,000 home free of debt and total monthly income of $8,000 after tax, their lives seem secure. Katie, 64, is a diligent saver.
As manager of family assets, she has put most of the family’s money into low-fee mutual funds, though she holds $200,000 in cash in her non-registered accounts. Edgar, 74, is a scientist and continues to work part-time for a technology company. They need to build a plan for the day when, as mortality odds predict, Katie becomes a widow.
“I want to have a portfolio I understand, that is easy to manage and that allows me to feel comfortable,” Katie says. “So what should our investments, our asset mix and our plan be, considering our ages?”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Katie and Edgar. His view is that the couple is worried about the wrong things and not focusing on the right ones.
The Short-term View
Although Katie has an accounting background, she feels lost in stocks and bonds. She and Edgar have cash equal to nearly 20% of total financial assets. Edgar will continue to work and the $2,666 the couple saves in RRSPs and TFSAs each month will add to the cash hoard. Katie’s income from non-registered accounts will also add to it. The couple must make some decisions on how they will deal with their growing pile of uninvested cash. It’s a job that can’t be put off much longer. They need to start planning immediately — a five-year horizon will get them started.
The Five-Year Plan
Year 1 (2011) The beginning of planning for Katie’s life alone requires the couple to balance return on assets with risk. They should study markets and review style diversification in their mutual funds. Among the things to consider: strategies like value and growth, the importance of geographic asset diversification, and why they should hold bonds for income and portfolio stabilization. They should reduce cash by 90% with half of new investments in fixed income such as bonds or bond funds, the other half in equities or equity funds. The goal is to reduce volatility and to produce steady income.
Edgar and Katie will have to work on raising the cash flow from their financial assets. They can shift to higher weightings of investment-grade corporate bonds that pay as much as 300 basis points or 3% per year more than government bonds. For guidance in buying corporate bonds and to get lower trading costs, they use low-fee managed corporate bond funds with good records or exchange traded corporate bond funds with suitable mandates.
Year 2 (2012) Katie will be 65. It’s time to apply for $11,210 annual Canada Pension Plan and $6,259 annual Old Age Security. Katie has to decide when she will quit work and accept living on pensions and investment income.
Split pension income with Edgar when filing tax returns for as long as possible to reduce tax.
Year 3 (2013) Edgar is now 77. Assuming he has quit his part-time job, the couple should be spending non-registered assets so that their RRSPs have the longest time to grow before Katie must convert her RRSPs to RRIFs. This is a long-term growth and tax-averaging plan.
Year 4 (2014) Katie is now 68. Assuming she no longer works for her company, she should evaluate whether she should also be ending her position as a director that pays $9,000 per year.
The couple is now almost completely dependent on pensions and savings. Managing return on assets is critical to their standard of living. Income that is not spent in a given year can be reinvested in fixed-income assets.
Year 5 (2015) Katie, now 69, and Edgar, now 79, no longer have earned income that can generate RRSP room. So all savings should first be directed to tax-free savings accounts using cashable GICs with terms of five years or less, government or investment-grade corporate bonds with terms of no more than 10 years or bond portfolios with these characteristics. Leftover cash can be invested in dividend-paying stocks or bonds. Cash left in bank accounts at low interest will cost the couple the difference between the long term return on corporate bonds, about 5% to 6%, and the 1% to 2% per year pittance savings accounts are likely to pay for the next five years.
The Longer Term
It is fair to assume that Edgar will predecease Katie, Mr. Moran says. That will create a financial problem. Although Edgar’s registered assets can flow to Katie without tax, she would lose his Old Age Security benefits and all of his Canada Pension Plan benefits. She would also lose all of his $31,644 annual defined benefit company pension. All remaining income would be taxed in her hands.
If she does survive Edgar, Katie would have $82,656 per year of pre-tax income, 80% of it from her registered and non-registered savings, Mr. Moran estimates. The clawback, which begins at $66,733 in 2010, would cut into income over that level. Assuming she pays tax at a 25% average rate including the clawback, her post-tax income would be $62,000. That will be sufficient if Katie can shrink her retirement budget.
It will take some belt tightening, but there are big savings to be had after Edgar’s passing. She could cut many of their monthly expenses in half: the travel budget, gym and sports budget, RRSP contributions, home maintenance and car budget. The savings leave adjusted expenses at $55,656 per year, well within her estimated annual after-tax income after Edgar has passed away.
Managing for Inflation
Katie has asked the often-heard question of whether she will have to dine on cat food. “I am terrified of being destitute,” she worries. Her concern, which is not germane for the early years of being without Edgar, would become urgent over time as inflation drives up prices. If prices rise at 3% per year, then by the time she is 92 in 2038, things would cost about twice what it did at the time Edgar left her. Katie’s spending will have risen to about $111,000 per year using the 3% average annual rate assumption. However, if Edgar and Katie can embed a 6% pre-inflation return in their portfolio, they could insure against Katie’s being driven into poverty by expected inflation.
“Late in life, Katie and Edgar have to deal with their 10-year age difference and ensure that Katie can live out her life with financial security,” Mr. Moran notes. “The five-year plan will get them started and the longer term issues can be adjusted as they arise. The good news is that there is still plenty of time to do it.”
(C) 2012 Financial Post, Used by Permission