OIL CRASH FORCES FAST FIX FOR COUPLE
In Alberta, a couple we’ll call Gary, 60, and Wendy, 67, made their home and grew prosperous with Gary’s decades of work in the oilpatch. A petrochemical engineer, he earned as much as $200,000 a year doing consulting, spending $890,000 on rental properties and piling up about $595,000 of financial assets. Wendy worked as an administrative assistant earning $24,000 a year before she retired in 1990.
The consulting income is history, a casualty of collapsed oil prices and the energy industry’s slump. Wendy draws $1,110 a month of combined Canada Pension Plan and Old Age Security benefits. Gary gets $475 a month from CPP. Add in some rental income that brings in $590 from their two rental properties and their total income, $2,175 a month, is $3,240 less than their expenses. They need a fix and it has to be fast.
“I am not sure what the future will bring,” Gary says. “We need to know if we can survive.”
Family Finance asked Guil Perreault, a financial planner with the Foster Agency in Winnipeg, to review the couple’s finances. His recommendation — get rid of a money losing rental property, cut expenses and reallocate assets to cut investment costs. “They have the ability to fix their finances and, if they get started, odds are they will succeed,” Perrault says.
The largest problem is that the couple’s income properties, which make up 60 per cent of their invested assets, produce little cash flow.
One unit is rented to the couple’s son and its $1,150 monthly rent is below market rates. Their mortgage alone is $673 per month and has 21 years remaining. Property tax and insurance raise their total cost to $992 per month. Gary and Wendy have no plan to raise the rent, even though the return on the property is $158 a month before any reserves for repairs or depreciation. Its return on equity is less than one per cent.
Their other rental property generates $1,300 a month before expenses: $787 for the mortgage and $285 for taxes and insurance. The mortgage will be paid off in six years. When their tenant’s lease is up for renewal, which is within a year, they should negotiate a new rent sufficient to cover total costs, Perreault recommends. However, even if the rent rises by half to cover their costs of $1,072 a month or $12,864 a year and provide a margin for depreciation and vacancy risk, the asset would have a net return of approximately zero until the $787 monthly mortgage costs ends in 2021.
They would be better off selling and investing the estimated market price of the property, $430,000, less the mortgage, $58,000, for a net value of $372,000. Allow $20,000 for preparation and selling costs and they could have $352,000 to invest in an exchange-traded fund of stocks that have paid dependable and rising dividends for many decades, Perreault says.
If they obtain growth of three per cent after inflation, they would have pre-tax income of $10,560 year. If they annuitize these funds so that all capital is paid out over 30 years to the time Gary is 90, they would have $18,427 a year before tax.
The couple’s investment portfolio has $596,238 in financial assets, including a U.S. 401K retirement account worth $250,000 in Canadian funds. Almost 90 per cent of their financial assets are in mutual funds, with average fees of 2.5 per cent, and the balance is in cash in various accounts earning one per cent at most. Their management fees are about $8,000 a year.
They could save perhaps twothirds of those fees by using ETFs bought through an online discount broker. If their financial assets were then to generate 2.7 per cent after inflation, they would provide $16,100 a year before tax. If annuitized to pay out all capital over 30 years, they would have investment cash flow of $29,500 a year.
Neither Gary nor Wendy has a company pension. However, they have CPP and OAS.
Wendy already receives $565 a month or $6,778 a year from OAS. Her CPP benefits provide $545 a month, or $6,540 a year. Gary receives $475 a month, or $5,700 a year, from CPP and will receive $6,778 from OAS when he is 65. Their government pensions add up to $25,796 a year. Added to potential investment income of $47,927 a year, they would have total, pre-tax income of $73,723. With splits of pension income and application of age and pension income credits, they would pay tax at a 13 per cent average rate and have $5,345 a month to spend.
INCOME AND SPENDING
At their present level of spending, $5,415 a month, their present income of about $1,971 a month ($1,585 of government pensions and their nominal $386 net rental income) leaves them with a $3,444 monthly deficit. With restructuring as recommended, their monthly deficit would shrink 90 per cent to $315 a month.
They can turn that into a surplus by eliminating one of their two cars, at a potential saving of $150 a month in operating costs, licence, etc. Other things that can be cut include $100 of entertainment and $400 of food. Their total savings would be $650 a month and leave spending at $4,765 a month. They would have a nominal surplus of $580 a month that could be used for travel, on which they now spend nothing, or banked for eventual replacement of their one remaining car.
There is more to do. Their portfolio is poorly invested: Fixed income assets are in taxable accounts, which pay annual interest of as little as 0.5 per cent, and almost a third of their assets are fully taxable GICs and bank accounts.
They should be sheltered in RRSPs or TFSAs to preserve what little interest they pay. The couple has $47,000 of room for TFSA contributions. It is only paperwork to transfer the taxable cash to fill the TFSAs.
The couple has been generous to financial advisers: $172,000 of their money is in high-cost mutual funds in registered plans on which they pay management fees of as much as 2.5 per cent each year.
By migrating money within the plans to ETFs with fees of no more than 0.5 per cent a year, they would raise total returns by almost $3,500 a year. Moreover, data show that index funds within ETFs beat managed funds over the long run.
“This is a case of a couple whose financial foundation — the Alberta oil business — has crumbled,” Perreault says. “When Gary generated an income of $200,000 a year or more, they could afford to ignore investments, rent properties below market value and spend freely.
“That has changed. If they reduce spending and boost investment returns, they can have financial security in retirement and maintain the way of life they know.”