Living Six-Figure Lifestyle on Five-Figure Income, Contract Workers Struggle After $20,000 Investing Loss
Investment losses and uncertain job prospects threaten couple’s retirement plans
Calculate retirement finances, reduce investment risk and work toward defined goals
Near Toronto, a couple we’ll call Terrence and Sally, both 41, are raising their 7-year old child on take home income of $7,300 a month.
That’s a lot in most parts of Canada, but in their neighbourhood, where seven-figure homes are common, it’s not a great deal. They are living a six-figure lifestyle on five figures of annual take-home income and a wounded portfolio.
They also have unemployment risk. Both work on contracts and are unsure that their jobs will ever be permanent. Terrence, an engineer, and Sally, a research administrator, moved to Toronto from B.C. in 2012, buying a new house with money from the sale of their former home. The purpose of the move was to earn more money, but a bad investment and weather related misfortunes wrecked the plan.
They had a bad basement flood, then damage to the house from the ice storm last December. They have tried to compensate by being frugal, seeking out sales for what they need and building up their RRSPs and RESPs, but they remain at the mercy of the job market.
“We experienced a series of financial hits in the past year,” Terrence says. “Our insurance did not pay for all the weather-related damage. We took a big loss on one small cap investment. I don’t have a permanent job yet and Sally is on contract. Naturally, we are anxious about our future.”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with the couple. “They see the risks ahead — unemployment perhaps, maybe more investment losses — and they are worried. But their zeal to do well and their practice of saving a fifth of their income each month suggest that they will come out just fine.”
For now, they have both income and investment issues. Sally, who has an extensive science background, makes $2,400 a month. After tax and other deductions, she contributes $1,950 to monthly family income. Terrence makes $8,334 a month, which allows him to contribute $5,350 to monthly after-tax family income.
They have an RESP for their child with a balance of $37,000. If they continue to add $2,500 a year, get the $500 annual Canada Education Savings Grant and obtain a 3% return over the rate of inflation for the 10 years to the time that the child is ready for university the fund would have $85,150 in 2014 dollars. It would cover tuition and books and perhaps some away from home living costs at many universities in Canada for a four-year degree.
Their RRSP, which currently has assets of $186,350, suffered a $20,000 loss when small cap mining company was unable to maintain funding for a project. The value of the couple’s shares in the company fell to zero. That deflated their portfolio by about 20%.
They both have defined benefit pension plans. Sally worked for a government department in Alberta and built up pension value of $152,400. She can take that as a pension at age 55 of $757 a month or $9,084 per year plus a $230 bridge to age 65. Or she can take a taxable payment of $28,766 and transfer $109,126 to a locked in RRSP and give up the pension and potential fringe benefits that go with the pension.
Which is the better choice? To match her pension benefit, Sally would have to live to 85 and obtain an investment return on the $109,126 and the after-tax value of the $28,766 (let’s say it’s $22,437 after 22% tax) and grow the sum at one per cent over the rate of inflation. If those conditions are fulfilled, the capital would grow to the theoretical $201,600 required at age 55 to match the defined benefit promised.
If Sally can beat this rate of return, she could take the cash and invest it. The money would be hers. On the other hand, the defined benefit pension is a life annuity and, if she lives beyond age 85, the pension may beat the investment. The issue does not end there. The pension has no investment risk. Considering that capital markets convulse every decade or so, sometimes more often, the guaranteed return is valuable, the planner says. We’ll assume she takes the $9,084.
Terrence has a defined benefit pension which will pay him 2% per year for his years of service times the average of the last five years of his employment. If he puts in 25 years with the present employer at his present salary, $100,000 a year in 2014 dollars, then he would have a $50,000 annual pension.
Their present mortgage should be paid in full at the present rate of $2,000 a month in 5 1/2 years. That will leave them with $24,000 a year to invest. Their ability to use RRSPs is limited by company contributions to Terrence’s present defined benefit pension and Sally’s income.
Their combined RRSPs have a current value of $186,350. If they continue to add $391 a month to Terrence’s RRSP or a spousal plan for Sally and if the contributions grow at 3% a year over the rate of inflation, they would have $545,200 in 24 years at their age 65 in 2014 dollars. If that money continues to grow at 3% over the rate of inflation and is paid out so that all capital is exhausted at their age 90, it would generate $30,400 a year before tax.
They have TFSA accounts with a present balance of $25,000. If they add, as they are doing, $11,000 a year to the accounts for the next 24 years and obtain a 3% return after inflation, they would have $440,900. That capital could produce a flow of $24,600 a year at the same rate of return with all capital paid out at age 90.
Most of their savings will go to taxable accounts. Assuming that they invest $1,000 a month at 3% over the rate of inflation in taxable accounts and allowing for 33% tax on annual returns — a blend of interest, dividends and capital gains, it would grow to $372,363 in 2014 dollars by their age 65. That capital, still generating net 2% over the rate of inflation, would produce taxable income of $7,447 a year in 2014 dollars indefinitely to allow for retention of gains and income or use of the cash flow to purchase a retirement home.
At 65, Sally could get $7,475 a year CPP based on her work history. Terrence would qualify for full Canada Pension Plan benefits of $12,460 a year. At age 67, each would receive Old Age Security at $6,619 2014 dollars.
Adding up all these sources of retirement income, they would have about $154,700 before tax in 2014 dollars at age 67. With splits of eligible pension income and a small income reduction caused by the OAS clawback, which is triggered when individual taxable income exceeds $71,592, they would have about $9,900 to spend a month after 22% average tax. Their present expenses net of mortgage interest, which is likely to be terminated by 2020, child care costs, education and retirement savings would be more than covered.
“Terrence and Sally have taken lumps which will be lessons that pay off handsomely,” Mr. Moran says. “They will not make a fast fortune, but they will probably achieve the retirement income this analysis forecasts.”
(C) 2014 The Financial Post, Used by Permission