PROPERTY BUY RISKS MOM’S ROSY RETIREMENT
In a small town in northern Ontario, a woman we’ll call Bonnie, 38, is raising her 19-year-old child as a single parent. An account services manager for a large company, she takes home $6,265 a month. She has a $390,000 house, supported by a mortgage with an outstanding balance of $249,700, and a plan to retire at 60. Bonnie’s life appears to be financially secure. However, she is taking on additional risk, as she is buying another, newer home with a $490,000 price tag. She has put down $10,000 on the yet-to-be-built condo and will borrow the rest next year. The plan: to keep the present home as a rental property, maintain savings at an impressive 40 per cent of take home income and retire with her present gross income, $90,000 a year, with all debts paid.
Family Finance asked Benoit Poliquin, chief investment officer of Exponent Investment Management Inc. in Ottawa, to work with Bonnie.
“She is frugal and she is focused on retirement savings,” he says. “But carrying two homes — one a residence, one a rental — is going to make her house rich and cash poor. Her budget is going to be predicated on keeping rents flowing all of the time. It’s a lot of risk.”
LIVING ECONOMICALLY
Bonnie spends only half of her take-home pay on food and living costs, putting the balance into her mortgage and investments. Her TFSA is topped up to a balance, with growth, of $46,000. She has $143,300 in RRSPs, $48,000 in an RESP for her child and she has $117,000 in her non-registered accounts.
Bonnie has a cushion for retirement, a company pension likely to be $21,100 a year before tax at age 60. It’s not indexed, but it will be a floor under the income her financial assets and perhaps her rental property will provide.
At retirement in 22 years, Bonnie’s present RRSP balance — growing at three per cent over the rate of inflation plus $7,200 in annual contributions — should be $501,600. Her TFSA, with additions of $10,000 a year and the same rate of growth, should appreciate to $402,700; if the TFSA contribution limit is rolled back to the previous limit of $5,500, Bonnie can expect the same returns by contributing $5,500 to her TFSA annually and putting the balance, $4,500, into non-registered investments such as low or zero dividend stocks that generate no tax bills until sold at a profit equivalent to three per cent annual growth after tax. Her taxable investments should have grown with $5,600 annual contributions to $400,300. Thus, at age 60, she will have financial assets of $1,304,600 in 2015 dollars. Her rental property should at least cover its carrying costs. We can’t project a return for it.
RETIREMENT BUDGETING
If Bonnie pays out her financial savings at 60 on an annuity basis so that all capital is exhausted at age 90, the return over 30 years would be $64,600 with the assumption of payment at the start of each year. With the company pension she would have total pre-tax income of $85,700 — arguably close enough to her $90,000 target to make her plan work.
Bonnie expects full Canada Pension Plan benefits of $12,780 a year at age 65. She could take her CPP at age 60 with a 36 per cent reduction for net pre-tax payment of $8,179. That would close her gap but it would be a high price to pay. She should wait to 65. At 67, she would receive Old Age Security at a 2015 yearly rate of $6,839 for total annual pre-tax income of about $105,300. The OAS clawback, beginning when net income rises over a 2015 rate of $72,809 and taking 15 per cent of OAS above that level, would leave her with pre-tax income of about $100,420 a year.
If single (no income-splitting), Bonnie would pay 25-per-cent income tax, reducing disposable income to $6,300 a month. That’s what she spends now but, with no further RRSP savings, and little or no mortgage payments, she would have more money for travel and other pleasures, Poliquin says.
RAISING RETURNS, REDUCING RISKS
The risk to Bonnie’s plan is the new home, Poliquin says. If she stays in her present home, her mortgage will be paid off by age 52. If she moves to a new home, her mortgage would be paid off by the time she is 60 if there have not been cost overruns or rental problems.
However, the move from owning a home to renting is complex with issues of management — will she do it or hire someone for a fee of five to 10 per cent of rents, accounting and contingencies like vacancy and tenant damage. Bonnie should ask herself if she wants this trouble.
On a financial basis, Bonnie can offset the financial risks of a rental property by raising her returns on financial assets. At present, she has a portfolio of financial assets focused on Canada with about 25 per cent in cash and bonds and the balance in Canadian stocks. Her mutual funds, mostly no-load products sold by her bank, have average management fees of two per cent. That’s below the 2.7 per cent mutual fund industry average, but she could easily cut costs and add to her returns by switching to exchange-traded funds with management fees of 7/10ths of one per cent or less.
If Bonnie hires an investment manager, she could pay annual fees of one per cent to 1.5 per cent of assets under management, narrowing the advantage of switching out of mutual funds, but she would have stocks and bonds assembled for her needs. A custom-made portfolio would consider Bonnie’s time horizon, age and risk tolerance. Migration to individual account management will be sensible for her needs and effective at her level of assets.
At her age and with her good health, she could buy $500,000 coverage in a 20-year term policy for as little as $380 a year. The rate would rise in 20 years when she is 58, but her child would be independent, her mortgages mostly or completely paid, and her level of assets much higher, Poliquin notes. She could reduce coverage then or cancel it.
“Bonnie is ready for retirement,” Poliquin says. “She should focus on risk management and her investment costs, but the foundation for a secure retirement is in place.”