SIX-FIGURE LIFESTYLE FACES NEW REALITY
Restructure spending with major cuts, open RESPs for kids and make investment income more secure
An Ontario-based businessman we’ll call Mark, 49, is struggling to come to terms with the decline of his business. From 1998 to 2013 it provided a mid-six-figure income. But his company, which distributes recreational products, has had to face increased regulation and devastating competition. The business has declined drastically, yet Mark has tried to maintain his family’s former way of life on an income a fraction of what he used to earn.
Mark makes his home with his wife, whom we’ll call Eleanor, 36, and their three children ages 11, seven and five. The family’s pretax annual income is $182,800: $75,000 from Mark’s business, $40,000 from Eleanor’s job in a hobby craft company and $67,800 from a mortgage fund.
There is no immediate risk that the family will go hungry. They have $2.2 million in financial assets and a house with an estimated value of $2.3 million. Yet they are running a $6,027 monthly deficit of expenses in excess of income and Mark’s employment and business prospects are uncertain.
“I am living on deeply reduced income and savings, but we can only do that for a certain period of time,” Mark says. “I am afraid we’ll eventually run out of money.”
Family Finance asked Graeme Egan, an independent financial planner in Vancouver, to work with Mark. “The immediate problem is that the couple’s total after-tax income from all investment and employment sources, about $11,223 a month, is less than their $17,250 monthly spending,” he says.
Mark and Eleanor have not contributed to their RRSPs for several years. They have no tax-free savings accounts and the children have no registered education savings plans.
PAYING FOR THE KIDS’ EDUCATION
Funding the children’s RESPs is urgent. The eldest, 11, is only six years away from starting post-secondary education. An annual $2,500 contribution attracts a $500, or 20 per cent, grant from the federal government, in effect an instantaneous profit. If Mark and Eleanor contribute $7,500 a year and get $1,500 of Canada Education Savings Grant contributions, they will amass six years at $3,000 a year for the eldest; 10 years for the middle child, age seven, or $30,000 in contributions; and 12 years for the youngest, or $36,000. On that basis, using a three per cent projected return after inflation, the parents could balance benefits so each child would have about $33,000 for university.
First step: Cash in $25,000 of low-yield, taxable Canada Savings Bonds to fund three children’s RESPs, $2,500 each per year, for a total of $7,500 plus a catch-up contribution year of $7,500. That uses up $15,000 of the $25,000. Next, put $10,000 ($5,000 each) into TFSAs for Mark and Eleanor.
BUDGET MANAGEMENT
The couple has $147,000 in cash. They can reserve this sum to fund their monthly deficit until their employment prospects are clarified. The sooner that happens, the more money they will have for contributions to their RRSPs and TFSAs.
For additional ongoing savings, they should cut their $20,000 travel budget by 75 per cent to save $1,250 a month, reduce dining out to $163 a month and trim entertainment to $300 a month — for savings of $1,187 a month. Clothing and grooming could be cut in half for a $500 monthly savings. Mark also expects the child support he pays to his first wife to drop in November — to $1,500 from the $4,000 he currently pays — pushing potential savings to $5,437 a month. Their spending would be $11,813 a month, only $590 more than present after-tax income.
Those savings could partially fund two TFSA annual contributions of $10,000 each toward the current maximum $41,000 limit and the RESP for $7,500 a year. RRSP contributions should remain suspended until Mark’s tax rate is higher and, thus, contributions have a greater impact on tax payable.
Mark and Eleanor have RRSPs filled with mainly large cap Canadian stocks. Outside of the RRSPs, there is an $800,000 investment in a mortgage investment corporation. It’s been a good investment, but it amounts to almost 38 per cent of Mark’s financial assets. The mortgages are mostly large commercial loans. They are secured, but in a meltdown, the fund could have losses.
At present, the MICC produces a $5,650 pretax monthly return. That works out to an 8.5 per cent yield. Prudent risk-management implies reducing the portfolio weight of the MICC by 75 per cent to just 10 per cent, but it would be a costly move. With a strategic rebalancing of the portfolios, a gradual reduction of the MICC position could be achieved with only modest cost, Egan suggests. The gain would be safety.
For the future, Mark has to weigh his present way of life with his current income. His $2.3-million house has a shelter cost of $3,638 a month or $43,656 a year. That works out to 32 per cent of after tax income — a lot for a family that has to see its costs drastically reduced.
If Mark and Eleanor are not able to raise their income, they should consider a 50 per cent downsizing of their house. A house with a price tag of $1.15 million would still be a handsome home. The $1.1 million liberated after selling costs would pay off their $684,000 non-amortizing home-equity line of credit and leave $416,000 for investments. Invested at three per cent over inflation, that could add $12,500 to their annual family income, Egan estimates.
PAYING FOR RETIREMENT
For retirement, Mark and Eleanor want $10,000 a month after tax for their living expenses. That implies $145,000 before tax with splits of eligible pension income. Their present savings of $1,135,000 in non-registered investments, $752,000 in RRSPs and potential income from TFSAs — say, a total of $2 million at retirement — could generate $83,400 a year with a three per cent return after inflation for the 43 years from Mark’s age 65 to Eleanor’s ago 95.
Add in $12,500 annual income from capital released by downsizing their home and full Canada Pension Plan benefits of $12,780 for Mark, they would have $108,680 a year before tax from Mark’s age 65 to his age 67. Then Mark’s $6,765 annual OAS benefit would start, resulting in $115,445 total income to Eleanor’s age 65 when her CPP of an assumed $6,390 would start. Then at age 67, her OAS of $6,765 would start for final income of $128,600 a year. With splits of eligible pension income and pension credits, they would have about $8,575 a month to spend after 20 per cent average income tax.
“That income would not support the way of life they had on a mid-six-figure pre-tax income nor hit their $10,000 after tax goal, but it would be comfortable and secure,” Egan concludes.