National Post (National Edition)
Couple has built solid asset base, but inflation threatens to erode cash savings
IF THEY RAISE RETURNS TO THE RATE OF INFLATION, THEY WILL HAVE A SECURE RETIREMENT FOR THREE OR MORE DECADES. IF THEIR RETURNS FROM THEIR FINANCIAL ASSETS LAG INFLATION, THEIR INCOMES WILL WITHER. — ROD TYLER, HEAD OF TYLER FINANCIAL GROUP Take a long run view, evaluate low volatility stocks, patiently shift cash to stocks
In Saskatchewan, a couple we’ll call Betsy and Horace, both 56, have takehome income of about $12,750 a month, including $1,500 in monthly rent from farm land they own. Horace works for a small financial institution and Betsy is a civil servant. Their goal is annual after-tax retirement income of $70,000 in six years, when they are 62. They have substantial financial assets and pensions, but they fear investing more than a quarter of a million dollars they hold in cash in RRSPs and in non-registered accounts.
“We have concerns regarding exposure of our RRSPs to the stock market,” Horace explains. “Our returns have not been adequate, so we have opted for a conservative plan of saving. What we are really seeking is peace of mind.”
The problem they express is understandable. Capital markets are not stable or even predictable in the short run. Family Finance asked Rod Tyler, a financial planner who heads the Tyler Financial Group in Regina to work with Betsy and Horace. His conclusion is that, to preserve their retirement income from inflation, they will have to take on more market risk.
Their initial retirement income at 62 will have four components: First, Betsy’s $30,900 pre-tax defined benefit pension; second, their $60,000 annual income at three per cent after inflation from approximately $761,000 of present financial assets, including $240,000 of cash, plus additional savings of $82,200 a year growing at a blended rate of 2.4 per cent a year and annuitized for 33 years to age 95; third, $18,000 income from renting out farm land; and, fourth, two Canada Pension Plan benefits, reduced by 7.2 per cent for each year before 65 at which they retire. The adjusted CPP pensions will total $19,836 a year, giving them total pre-tax income of $128,736. After 23 per cent income tax, based on splits of eligible income, they will have $99,125, which works out to $8,260 a month to spend. That will be enough — when stop putting away $6,850 in RRSP and other savings each month, their allocations drop to $5,900 each month.
That surplus gives them the option to postpone starting CPP until age 65 — when combined annual benefits would total $26,925 — or as late as age 70, when combined benefits would total $38,233, a 42 per cent increase over the age 65 value (an effective bonus of 8.4 per cent a year). The cost of starting CPP at 62 rather than age 65 is $7,089 a year. Not waiting until age 70 costs them a whopping $18,397 per year, before tax.
When Betsy is 65, her pension will lose its bridge and drop to $25,200 a year, but they will receive two Old Age Security benefits of $6,846 each. Their incomes, mostly split, would be below the OAS clawback trigger point, currently $72,809 a year. Their combined income would be $136,730 and, with the same tax rate based on age and pension credits as well as higher income, they would have $8,780 a month to spend.
INFLATION
Keeping up with inflation will be a growing problem. The couple’s expected return on their invested assets will be 2.3 per cent a year, less than the three per cent assumed for annual inflation, which is within the Bank of Canada’s target range. If they continue to hold a third of their additional annual savings in cash, compounding will not cover up the underlying problem that their invested assets are losing purchasing power.
Betsy’s pension is not indexed. If it loses purchasing power at an assumed inflation rate of three per cent a year, then in 20 years, when they are 76, it will have purchasing power of $19,600, a sharp drop from its $25,200 value at Betsy’s age 65. Their financial assets are losing purchasing power at almost one per cent a year. Some of the loss would be compensated by indexed benefits from CPP and OAS, with more dollars generated by CPP indexation if they start benefits at 65 or 70, but given the ratio of private income from investments, a company pension and farm land, most of their income will have inadequate growth.
Horace and Betsy can make their financial assets more productive. Were they to transfer assets to lowcost managed funds or to exchangetraded funds, which they could select with professional advice, they could save one per cent or more of present management fees of as much as 2.5 per cent each year, Tyler adds. That alone adds one per cent to returns.
DIVERSIFICATION
There is no single solution to ensuring that a portfolio holds or gains value. Diversification of assets into stocks, bonds and other asset classes is the method least likely to fail. There is no consistent leadership by sectors or by type of asset, so spreading savings widely makes sense.
Rather than try to find the winners, it is often useful to exclude the losers. The asset mostly likely to lose in the long run is cash. With Canadian inflation likely to rise if the soft loonie continues to make imported food and other goods more costly, Horace and Betsy’s income is sure to lose purchasing power.
The choice of assets to protect their purchasing power over the long-term comes down to picking and combining stocks, bonds and cash. In the period from 1946 to 2012, U.S. and Canadian stocks had a real annual return of six per cent a year, bonds a real return of two per cent a year and short government bonds and savings accounts of 0.4 per cent a year. For holding periods of five years in the period from 1871 to 2012, stocks beat bonds 69 per cent of the time and for holding periods of 10 years, stocks beat bonds 96 per cent of the time. The implication — cut cash and add equity — is obvious.
The difference in returns between holding a third of assets in cash, assuming that future savings go to cash in the same ratio as at present, is about $6,000 a year before tax. Over the 33 years of their retirement from age 62 to 95, that would add up to about $198,000. There are several ways to do this calculation — for example, with or without compounding — but holding a fortune in cash when there is a surplus over spending is costly.
“If they raise returns to the rate of inflation, they will have a secure retirement for three or more decades” Tyler says. “If their returns from their financial assets lag inflation, their incomes will wither.”