An Alberta couple we'll call Victor, 57, and Edna, 53, are heading into retirement with spending too high and investments too low to support their present way of life.
Victor, who writes advertising jingles for a small marketing companies he owns, generates $54,000 a year before tax. Edna, a hospital administrator, gets $90,000 a year before tax. When their $144,000 annual incomes end, they face a retirement in which their way of life, even with a few cuts in spending, will have to move downmarket.
But for this couple, building assets is not their only goal. Committed to their church, they donate 10% of gross income, or $14,400 a year. One day, they would like to give $10,000 to each of their three children as wedding gifts. All in their 20s, two of the children now live away from home while a third is at home finishing university studies.
"In our situation, what do we need to do to ensure that we have enough money to live comfortably?" Edna asks.
Victor's business provides no pension and Edna has worked for her employer for only six years. They have shunned investing in financial assets. Though they have $48,000 in cash and stocks in publicly traded companies, their investments are nearly all in real estate - a rental house that was once their principal residence, a modest rental unit in Hawaii that generates cash rent of $2,400 a year and shares in two strip malls in Alberta.
"We just did not like the idea of putting money into the stock market," Edna says. "It's just that we like to invest in things that we can see. Real things like buildings."
But Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., who we asked to work with the couple, says they have taken a risky strategy.
"There is more risk than financial return in the portfolio as it is currently constructed," he says.
The strip malls produce no current return but may produce income in several years. They have a sideline in pheasant ranching that merely pays its own way but produces no profit. Worse, the largest part of their investments is in essentially illiquid assets - roosting birds and three properties, two of which have cashlight yields.
The return on the rental house, $2,000 a month rent less mortgage and taxes of $1,800 a month, is $200 net cash rent. To that, they add $645 paid to loan principal each month for total monthly return of $845, or $10,140 a year. Their equity in the house is $80,000, so the return on equity is nearly 13%. That's a good return for a solid asset, Mr. Moran says.
The Hawaiian units are troublesome, Mr. Moran says. They are on leased land and the lease expires in four years. Lease cancellation is likely, so it would be best to try to sell the units as soon as possible lest they lose their entire investment.
The strip mall shares are structured to defer payments of returns of uncertain amounts in several years. The investment has a $47,000 estimated current value and produces no income. They expect a 7% return. That's not bad if, indeed, it is realized. For now, it is a speculative investment with no cash flow.
Estimating Retirement Income
Family income has to be restructured for retirement. The plan is complex, but it will produce a major addition to their current $4,000 RRSP balance in relatively short order.
The restructuring looks like this:
- Edna rolls $12,000 from her taxable investments, which have no gains, into a spousal RRSP for Victor and adds $10,000 from her TFSA. This transfer can be in kind - no cash is required. The $22,000 transfer will generate a tax refund of $7,040 in her 32% tax bracket.
- Edna takes $15,000 from Victor's TFSA and adds it to the spousal RRSP contribution. She gets the tax deduction, he gets the RRSP credit. They can keep the assets in kind or sell them and contribute cash. This move increases the contribution to $37,000 and adds $4,800 to the refund for a running total of $11,840.
- The RRSP balance is now $37,000+$11,840+$4,000, or $52,840. The couple has been contributing $10,000 a year to their TFSAs, which should now shift to RRSPs. By Edna's age 65, if they can use financial assets that grow at 3% over the rate of inflation, they could build $253,960 plus $3,200 a year of tax refunds that would add up to $38,400 by Edna's age 65. The RRSP could pay $14,584 a year to her age 90.
- In two years, when Victor stops paying $7,000 to his child's education, that money will be added to his RRSP. That would be eight years times $7,000, or $56,000 of savings. At 3% over the rate of inflation, it would grow to $62,276 in 2011 dollars by his age 67. That sum could pay $3,475 to Edna's age 90.
Edna will have a pension of what could be as much as $23,676 a year if she remains with her present employer. Victor and Edna could each get $11,520 from the Canada Pension Plan and, when each is 65, $6,456 each in Old Age Security benefits.
The total pension income available by the time Edna reaches 65 adds up to $77,687 in annual retirement income from the time Edna is 65 to her age 90. If they split pension incomes and each pays a 15% average tax on income, they would have $66,034 a year, or $5,503 a month, significantly less than they now spend.
Even if the couple were to cut 7% out of expenses when their kids no longer need education financing, cut out $100 a month for restaurants and reduce their tithe as their income drops - perhaps 17% in all - their income will be just 63% of the present level when they are both over 65.
Having roughly two-thirds of total pre-retirement income after one's working life is over is often thought of as normal, but when that fraction represents a significant cut from what is already a modest income, the reduction becomes more significant. Indeed, the income reduction does not even allow for replacing cars or home maintenance. It does not support a great deal of travel, as the couple would like, nor a great deal of financial generosity to children or grandchildren.
There is more to life than earning a fortune but when money is tight, it is not just about covering the basics and replacing worn-out cars, it is resilience and having cash reserves for unexpected expenses. In this case, the couple would have to spend precious capital and judge what that effect will be on future spending. They will truly be living close to the bone.
Were there more discretionary income, Victor and Edna could purchase long-term care insurance. They could purchase additional insurance coverage for medical, dental and drug costs. But that coverage could add $1,000 per person per year to their budget. That's money they do not have.
In the end, the couple has to live on what they have and be guided in the future by the principles by which they have lived.
"This is a case in which it will be hard to maintain the couple's present way of life in retirement," Mr. Moran says. "Even if the tithe they pay to their church declines along with gross income and they are able to retain money that now goes to their kids school bills, their way of life will have to be trimmed aggressively."
(C) 2012 The Financial Post, Used by Permission