Why this GIC-fuelled retirement plan just won’t cut it
In Toronto, a couple we’ll call Ernst, 64, and Elise, 56, have built a secure life with hard work and dedicated saving. Ernst came to Canada as a teenager and worked in factories until, at age 40, a back injury sidelined him. He receives $52,800 from disability payments. Elise still works on a production line, earning $55,000 a year before tax. They also have net rental income of $5,400 a year. Together, they bring home $11,465 per month after tax. Frugal from the days when they did not have much, they have been aggressive savers, putting $9,566 each month into RRSPs, TFSAs and ordinary savings accounts for the time Elise retires.
That day is coming soon. Ernst has retired and has received long-term disability for many years. That will stop at age 65. Elise hopes to stop work in April. They want a pre-tax retirement income of $50,000 a year. Their plan: tend to their garden and grandchildren and take an annual $6,000 cruise.
What is not certain is when Elise can quit work. She can do it in a few months or in a few years. The timing depends on how well they can finance their years of leisure.
ALL IN CASH AND GICS
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Ernst and Elise. “They have maxed out their Tax-Free Savings Accounts, evened out their RRSPs at $227,400 each, and balanced ownership of a rental property. What is not so good is that their approximately $1.94 million of financial assets are comprised of GICs and $80,000 is in low interest savings accounts. Their home, which they say is worth $350,000, is just 14 per cent of their $2,508,200 net worth. A $200,000 rental property generates $5,400 annual net rental income, which is 2.7 per cent of current estimated value or a 6.75 per cent return on the original cost of $80,000. It is a fair investment with risk from vacancy, tenant damage, neighbourhood change and compensating potential gains if the price of the property rises.
The problem now is that their financial assets earn less than the rate of inflation. They fear stocks and corporate bonds. At present, the return for the $1,938,200 of investments other than their rental property at an assumed rate of 2 per cent per year is just $38,764 before tax. Add in continuing net rent of $5,400, estimated Canada Pension Plan benefits of $7,000 when each is 65 and Old Age Security at $7,004 per year each and their total pre-tax income will be $72,172 before tax. We’ll assume that Elise does not take early CPP benefits nor postpone application for CPP and OAS when she reaches 65. If they apply age and pension income benefits — RRIF income qualifies as pension income — they would pay tax at a rate of about 10 per cent to allow for zero tax on TFSA cash flow and have $5,400 per month to spend. That is ahead of their target income, even with a yearly charge of $6,000 for a cruise.
There are two ways to look at the couple’s situation, Moran says. On the one hand, they’ve reached their retirement goal, but their investment returns are below the rate of inflation and are, in fact, negative after inflation and tax. It is inefficient. They would do better if they were to own dividend paying stocks whose prices tend to appreciate with rising corporate earnings and dividend payouts.
TAX GAINS FROM STOCKS
There is also a tax gain to be had using shares rather than GICs, Moran explains. Assuming partner each has $7,000 CPP benefits, $7,004 OAS benefits and $ 8,000 of RRIF payments, total $ 22,004, each could have $15,000 of dividend income which, given the dividend gross up and dividend tax credit, would work to eliminate federal tax. Because provincial tax is based on federal tax, they would pay no tax. That hefty tax saving would pay for a few bumps in the stock market, he explains.
The difference between on the one hand cash held in GICs and savings accounts with government insurance and no possible loss but guaranteed loss to inflation and investment with market risk and probable compensation for inflation and some growth as well is stark.
“I prefer to have inflation rather than risk losing money in the market,” Ernst says. “Our expenses are much less than our income now and much less than they will be even if our purchasing power goes down because of inflation. I could not sleep with the risk of losing money in stocks or bonds.”
ALTERNATIVE INVESTMENTS
There is another way for the couple to take on market risk. Index-linked GICs, sold by chartered banks, guarantee return of all money invested with zero return if their underlying investment indexes lose value and some return, usually about 60 per cent of index performance, if the defined market rises. For experienced investors, these index- linked products are inefficient and often undesirable, but for investors with no appetite for loss, they are a solution far easier than active portfolio management. The products offer a psychological cushion at the cost of investment inefficiency.
Alternatively, an insurance annuity for half their financial assets would provide more income through return of capital and investment gains. Assuming a 3 per cent return after inflation, an annuity purchased for $929,000 and running for 33 years to exhaust all capital and income would pay $44,700 per year. On top of rental income, CPP and OAS, it would create a risk-free base income of $77,712 before 10 per cent assumed tax or $5,828 per month after tax. That would exceed their goal, pay for the $ 6,000 annual cruise and still leave money to maintain their present way of life with no further RRSP, TFSA or other savings. Income from at-risk financial assets could enhance their spending and provide funds now or in future.
The balance of the retirement portfolio could be in dividend growth stocks. The combination would offer guaranteed income from half the couple’s capital and atrisk income from dividends and asset price growth to add to income and spending choices, Moran explains.