LESS HOUSE, MORE INCOME KEY TO HER RETIREMENT
A British Columbia management consultant we’ll call Lydia, 64, is considering retiring. Like other residents of the Lower Mainland, her assets are overweighted with property. Her home, a 4,000- square- foot two- storey house on a mountainside has a $3 million price tag. It was a home for her four children and late husband. Now she is single and the house is 83 per cent of her total wealth ( excluding her car) of $ 3,618,000. Her monthly income of $ 7,810 after tax, however, including a $ 103 monthly CPP survivor benefit due to end soon, leaves her far from a millionaire’s lifestyle. Her problem: when to retire? Her goal is $ 5,500 monthly income after tax starting at age 65
“To downsize or not?” Lydia asks. “I have a rental suite that brings in $ 1,000 a month. I can sell, reduce my household expenses, and give up $ 12,000 a year in revenue. On the other hand, I would free up a great deal of capital? Do I need to do that?”
Family Finance asked Benoit Poliquin, a financial planner and portfolio manager who is chief investment officer of Exponent Investment Management in Ottawa.
“Yes, Lydia, downsize you should, as you will see,” Poliqu in recommends. “There are other ways, but the challenge is to sort out the alternatives. The core question is whether you need a $3 million house when you live alone. It ties up an awful lot of capital.”
THE ALLOCATION PROBLEM
The money bundled in the inflated price of the house produces no income and the house itself requires almost $ 1,000 a month of maintenance and property tax. The rental suite covers that, yet there is no financial return after the bills are paid. The house could appreciate to $ 4 million or more, but no market rises forever.
The alternative is to cash in some value and invest it. That can be done by sale and downsizing or borrowing against the currently mortgage- free house. The first way has only the opportunity risk that the house could rise in price one day. The second choice has the risk that interest rates will rise one day and make any conservative fixedincome investment with money taken out of the house less profitable and, perhaps, even a losing proposition, Poliquin says.
Lydia has three choices and can make any one or blend them. First, downsize the house to capture perhaps $1 million of its inflated value. Second, raise investment returns. Third, work longer. To sort out which choice is best, we need to do some math. At 65, Lydia will have CPP benefits of $ 13,370 a year and full Old Age Security benefits of $ 6,942 a year. These government benefits add up to $ 20,312 a year before tax. If her present $ 618,000 of financial assets were annuitized to pay out all capital and income in the 30 years from 65 to her 95th birthday, they would generate $ 31,530 a year. The sum of these cash flows is $ 51,842 before tax. There is no way this sum would satisfy her $ 5,500 monthly after- tax income target.
LIVING SMALLER
If Lydia were to downsize to a $2 million house and, after selling and moving costs, commissions and so on, liberate $1 million, the fresh cash, annuitized on the same basis for the 30 years to her age 95 would generate $51,000 a year. Her total income would be $ 102,842 a year. After a $ 4,500 income reduction courtesy of the OAS clawback, which starts at $72,809, and 23 per cent average income tax and she would have $75,700 a year to spend with no dependence on suite rental in her new home. That’s about $ 6,300 a month, well over her $5,500 target.
The boost over her income target, $ 9,600 a year, could be spent on dream-ofa-lifetime travel or saved for a new car as needed, gifts for her children or donations to MIKE FAILLE / NATIONAL POST good causes. Lydia would in effect be trading space she does not need and cashing in on the B.C. property market. It’s a sensible and low- risk solution. Moreover, the gain on Lydia’s $ 3 million principal residence would not be subject to tax. There are alternatives to downsizing the house. If she keeps it and uses rental income to pay her taxes and upkeep, she would need to make her $ 618,000 in financial assets generate a 10 per cent return before tax. It is doable, but the portfolio would have to hold small to mid- cap stocks with nosebleed dividend yields and junk bonds far below investment grade. It is unsuitable for a retirement portfolio.
WORKING LONGER
Lydia could work longer and defer starting CPP and OAS. For each year of deferral after 65, CPP adds an 8.4 per cent bonus, OAS a 7.2 per cent bonus. If she works to 70, her annual CPP would rise to $ 18,876, her annual OAS to $ 9,441. That would make her adjusted pre- tax income based on $ 51,000 investment income about $ 79,300 a year and her income after 15 per cent average income tax and the clawback about $5,500 a month.
Her present high rate of saving could be translated into investments, adding to retirement income. Delaying retirement another year to age 69 would narrow the $ 400 monthly gap and chances are that living in a home worth two- thirds of her present home would allow sufficient reductions of property tax and maintenance to make her plan work. Even allowing her present assets to gain value over inflation in the years of deferral of retirement would give her the spending power she wants, Poliquin explains.
Which solution is best? Downsizing and using an annuity payout model for what would then be $ 1,618,000 of financial assets is easy. If Lydia makes it to 95, she would still have the $ 2 million house, which may have appreciated and could eventually be part of a legacy for her children who would then be in late middle age. Working longer is a tougher call, for Lydia might not be up to it and may not find the idea of adding three or four years attractive.
Keeping the house and reaching for a 10 per cent investment return is a doubtful plan. The odds of large investment losses are high. “A retirement plan is not a casino,” Poliquin concludes.