How getting out of GICs could ensure the success of this couple’s retirement
In Alberta, a couple we’ll call Mike and Teresa, 60 and 57, respectively, are warily approaching retirement. They are concerned that their savings may not be sufficient to let them maintain their way of life after they stop working. For now, they spend $5,500 a month out of their combined take-home income of $5,584 a month. Some expenses are not essential, but they are close to the edge where what comes in equals what goes out.
While neither has a company pension, they have accumulated a very respectable net worth of nearly $1.9-million which is where most of their retirement income will come from. They owe nothing other than a few current credit card bills.
Mike, a foreman in a manufacturing company, brings home $3,744 a month, down from income twice as high several years ago. Downsizing from his higher-paying job came with layoff packages that he rolled into his RRSPs. Teresa is an administrative assistant in a private company. Their children are in their mid-20s and independent.
Quitting work, which they plan to do in two years, will open a void in their budget. There will be three and six critical years, respectively, from being able to take Old Age Security benefits and, in Teresa’s case, a year away from even reduced Canada Pension Plan benefits.
“I am concerned that our after-tax income will not be able to support a lifestyle similar to what we have now including a few trips a year,” Mike says. “We typically spend around $5,000 on each trip for hotel, airfare and time on tennis courts. There is also my hobby of restoring old sailboats. I spend about $6,000 a year on that. Can we do all that on our retirement income?”
Family Finance asked Graeme Egan, a financial planner and portfolio manager with KCM Wealth Management Inc., in Vancouver, to work with Mike and Teresa, to take a close look at their spending and savings and make recommendations on what kind retirement they can afford.
“The issue is how to ensure their investment capital can generate sufficient income for years until the time OAS and CPP kick in to help maintain the way of life they have in mind. That leads to the next question: how to structure their RRSP investments for retirement. They will be dependent more than most couples on what they have saved and invested. For at least a few years until their government pensions — OAS and CPP — start, they are going to be completely on their own.”
The solution, he says, will be to raise returns until their government pensions start and then to sustain those higher returns through their retirement. The method — add a critical few per cent to returns by shifting from GICs and resource stocks to stocks which pay substantial dividends which tend to rise with inflation.
That can add about 1.5% to pre-tax returns. It may not seem much, but the results of this boost, which would be a third more income each year, are the difference between getting by and having choices. If they don’t boost returns to at least keep pace with inflation, in the three decades from retirement to their mid-’90s the purchasing power of their savings will fall to half — or even less if inflation rises to mid-single digits. Portfolio restructuring is vital.
PORTFOLIO MANAGEMENT
The current investments in their registered accounts, which are the bulk of their assets, are relatively heavily allocated to energy companies and lightly allocated to financial services. Cutting back on energy producers, which tend to pay modest dividends, and adding banks, selected utilities and telcos, which tend to pay 4% to 5%, will increase total portfolio income by 1% to 2%. Their GICs add up to $415,000. That’s a large commitment to a low yield asset class which is illiquid until each GIC matures.
As they mature, the GICs should be switched to ladders of investment-grade corporate bonds with maturities of five or ten years. These ladders are sold as exchange traded funds in various packages by sev- eral companies. Bond l adders automatically switch maturing bonds into new issues at what are likely to be higher interest rates, thus reducing the erosion of higher rates on the interest rates of existing bonds. The switch should add 1.0% to 1.5% to their fixed income.
Mike and Teresa juggle contributions to their TFSAs and RRSPs each year, however, if they save $11,400 a year in their respective registered plans — Mike to his RRSP and Teresa, who has lower income, to her TFSA, then their present assets, $1,296,000, if invested to return 4% after inflation, will become $1,426,000 in two years. At a 2.5% return after inflation, they would have $1,385,000 in two years. Savings can be paid out beginning in 2016 on an annuity model, which corresponds to the way Registered Retirement Income Funds deplete capital at rising rates.
Beginning in two years at Mike’s retirement, the payouts, structured so that, when Teresa is 95, all capital will have been paid out, will sustain a draw of $72,520 with a return of 4% over inflation or $59,000 a year with a return of 2.5% over the rate of inflation before tax.
STRUCTURING FOR RETIREMENT
At 65, Mike can add $12,460 a year from CPP and $6,619 in annual OAS benefits for total pre-tax income of $91,600 a year, assuming the 4% return rate. Three years later, Teresa can add her $9,600 annual CPP benefit and $6,619 annual OAS for total income of $107,820. They would have gross income of $94,298 and, at the same tax rate, after tax income of $7,368. At the 2.5% rate of growth and return, they would have a monthly income of $6,443. That, too, would cover present allocations. But their margin of safety would be reduced by $925 a month. Small differences in rates of growth of assets wind up making a big impact on retirement income.
“Mike and Teresa can live in retirement much as they do now, travel more, and do more for their children if they boost their returns of their portfolio,” Mr. Egan says. “They must get out of GICs, which have guarantees against default as well as a guarantee to lose value to inflation.”