B.C. couple hopes to transform paper wealth
Acouple we’ll call Rex, 69, and Frances, 65, live in B.C. Retired for many years, they worry their $850,000 of financial assets, almost all of which is in RRSPs, will not be sufficient for lives that could be longer than they expected. They are both in very good health.
“We hope our savings will last 30 years before the money runs out,” Rex says. “Our only liability is a $100,000 home equity line of credit that we took out to help our grown kids buy homes of their own. Should we use an annuity to raise RRSP income or should we try to invest outside the RRSPs to increase income?”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Rex and Frances. With an estimated market price of $1.75 million and their C$250,000 U.S. vacation home, the couple has $2 million of their $2.89-million net worth tied up in two properties. So while they are wealthy on paper, they have little extra money to spend each month. They need a budget and to limit spending.
AMPLE CAPITAL, INADEQUATE RETURNS
Rex and Frances’ monthly income consists of $5,000 RRSP withdrawals plus $3,360 of combined OAS and CPP. After splits and tax, they have $7,205 monthly and spend all of it. As their RRSP drawdowns eventually increase, as the rules for Registered Retirement Income Funds require, their tax brackets are likely to rise.
Rex and Frances have ample savings, though $360,000 of their $800,000 of RRSPs is in guaranteed income certificates that earn less than 2 per cent a year. Some $2 million of their assets are in two houses that produce no income. Another $50,000 is in cash earning approximately nothing. Put together, they have $2.4 million dollars earning little or no cash return, though the homes have an implicit return in the form of accommodation that they would have to rent with after-tax income if they did not own them. They defer property taxes on their Canadian home via a B.C. program for seniors, which stipulates that taxes need to be payed when the home is sold.
The problem now is to raise cash flow and to cut costs, Moran says.
First, the costs. The couple’s $100,000 line of credit costs them 3.5 per cent or about $292 per month. Their best move is to use $40,000 of $50,000 cash held outside of the RRSPs to pay down the line of credit, saving them a few thousand dollars a year. The adjustment adds no risk to their portfolio and, in fact, reduces their exposure to rising interest rates.
Next is to deal with the cash hoard in the RRSPs. The average return on their GICs is 1.72 per cent per year. They could double that return in a mix of bank shares, some telco stocks, perhaps some utilities. These sectors tend to have heavy ratios of debt to equity, so share values may weaken as interest rates rise. But over time, rising earnings tend to make up for moderately higher borrowing costs and, of course, the companies tend to raise dividends. In any case, doubling income with modest downside price risk is not a bad deal, Moran says.
THE COST OF SECURITY
As an alternative to a move from low yielding cash in RRSPs to higher paying stocks, the couple could buy annuities.
Annuities can be thought of as life insurance running in reverse, that is, a sum of capital pays a monthly benefit until all the money in the kitty runs out. Insurance companies price life annuities on the basis of their costs to generate money and the risk that the annuitant they pay will live more than a certain number of years. For a plain life annuity with no minimum number of payments, mortality risk is a big gamble for the person buying the policy. Most people prefer annuities with some minimum number of payouts.
Rex and Frances could each buy a life annuity. For Rex, $100,000 would generate $633 per month in benefits with no minimum number of payments. With 10 years of payments guaranteed, it would pay $504 per month. That’s 7.6 per cent in the first case and 6 per cent in the second. It looks good, but a lot of that is return of capital. Frances’ terms would be better due to gender and lower age. Annuities provide guarantees and remove market risk. But there is no inflation protection except for additional costs that lessen annuities’ appeal.
It would be possible to buy an annuity for $50,000 for each partner as a kind of security blanket and then to invest the remainder of their cash in stocks that have strong and rising dividend income. Moran says. They could also ladder annuities, buying one every few years to follow rising interest rates. But the problem that they give up a lot of money to earn a little would remain.
BUDGET MANAGEMENT
The better move is to open and then fill up TFSAs. To fill them, Rex and Frances could put their life insurance, for which they pay $108 per month, on premium holiday. The policy would then live on its own cash value and internally generated income. They would save $1,296 a year. It’s worth discussing with their insurance agent, Moran says. They could also tighten up spending by cutting back on $417 per month for hobbies and golf, $350 for restaurants and perhaps reduce house cleaning at $333 per month.
When Rex and Frances convert RRSPs to Registered Retirement Income Funds, their payouts will be eligible for the pension tax credit worth $2,000 per person per year.