Souring investment forces once-comfortable retired couple to cut back expenses
Use annuity payout structure and cut expenses to ensure continuity of financially secure retirement
In Ontario, a couple we’ll call Sid, 65, and Roberta, 61, are retired. Sid worked for a large insurance business and receives pension income while Roberta, who held a variety of jobs in business management, has no company pension and remains an investor. One of her investments, a small restaurant in the U.S., has accounting issues and no longer provides dependable income of US$40,000 a year.
A fire destroyed their home in 2012. They rebuilt for $1.2 million, more than the insurance company offered, and drained $250,000 of their savings.
Their issue now is determining if the U.S. business problem — which is wrapped up in a lawsuit in which Roberta and other owners have challenged the restaurant’s accounts — and the money they spent rebuilding their home over what the insurer paid, will cripple their retirement. They have two children, both in their 30s, who are financially independent and have children of their own.
“We want to be able to stay in our home as long as possible and to travel, but our ability to do so is in doubt,” Sid says. “Given our negative cash flow, we need to figure out where to get money. It’s a tangle of problems.”
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Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Sid and Roberta. “These people understand their finances, but there are bumps in the road with the American restaurant, which is 15 per cent of their invested capital. That is what has to be resolved — it’s in a lawsuit with other partners of the business lined up against the management. Without the restaurant income, their expenses may eventually drain their assets or force premature sale of the house.”
The current budget
Their house is 50 per cent of their total assets. It’s likely to appreciate in the roaring Ontario market, but it is a financial dead weight that produces no income, Moran says.
What’s left to generate income at present are RRSPs, TFSAs and cash that add up to $1,065,652. That’s a good deal of money, but the yield in today’s market at, say, three per cent after inflation, is about $32,000 a year.
Without RRSP and TFSA income and without the restaurant, their core pension income is about $25,804 a year, including Sid’s $5,370 annual company pension, his $6,778 annual Old Age Security benefit and their combined Canada Pension Plan benefits of $13,656 they started when each turned 60. To support their annual expenses of $95,724 they withdraw $69,920 from their non-registered savings.
Continuing this practice will wipe them out in five years.
If the restaurant shuts its doors for good and provides no more income, their $1,065,652 of financial assets could be annuitized so that all capital and income are paid out for 29 years to Roberta’s age 90. Assuming a three per cent yield after inflation, that capital would generate pre-tax income of about $54,000 each year. The annuity pays out all capital and income by that date, much as RRIF tables do.
The sum of pension income and the annuity, plus the $6,778 OAS benefit Roberta will receive at 65, would give them total annual income of $86,582 before tax. Assuming splits of eligible pension income, they would pay tax at an average rate of 15 per cent based on age and pension credits, leaving them with disposable income of $6,130 a month. That would not cover their nearly $8,000 a month of present expenses. However, if the restaurant lawsuit succeeds and its income is restored, they would have an additional $2,833, after 15 per cent average tax, to spend each month. That would make their after-tax monthly income $8,963 — enough to cover all present expenses.
Preparing for a bad outcome
The problem, clearly, is what happens if the U.S. lawsuit flops, the restaurant produces no income and Sid and Roberta remain in deficit of spending beyond income. Some budget trimming will have to be done. The first candidate is their largest non-essential expense, travel, at $1,400 a month. It could be cut to $400, saving $1,000 a month. Restaurants could be cut to $100 a month, saving $300. If they sold one car and cut car fuel and expense in half, they would save $175 a month and save perhaps another $100 on car insurance. More cuts could include the $500 a month they lavish on grandchildren. They could take $300 a month out and still have $2,400 a year for the kids. With those cuts, their total monthly spending would be reduced by $1,875 and their present expenses, $7,977 a month, would be down to $6,100. Their expenses would be covered.
The U.S. restaurant has been a terrific investment. Roberta originally invested US$40,000 and she has been paid that much income for each year for the last two decades. The value of the restaurant is US$150,000, but if Roberta walks away with nothing from the lawsuit and future income from the restaurant, she will have gained US$800,000 before tax over the years.
Weighing a troublesome
investment
If the restaurant case turns out favourably, Roberta could sell her stake for its estimated Canadian value of $197,368. There might be some selling costs, perhaps commissions, lawyers, etc., but if she walked away with $150,000, she could add $4,500 a year before tax to income with a three per cent return after inflation. It would also save on accounting bills: The money earned in the U.S. creates a U.S. tax liability and the need for costly U.S. returns, as well as adjustments and documentation and forms for Roberta’s Canadian tax return.
Keeping the restaurant investment could nevertheless be worth the trouble. Sid and Roberta travel to Florida in the winter. The restaurant pays for holidays in the U.S. and leaves a surplus. They have no need to buy American dollars at the stiff premiums banks charge over the official exchange rate. Even if the American property is troublesome, its US$45,000 gross annual return is about 10 times what they could get from ordinary dividend stocks. It’s worth the hassle, Moran says.
The structure of the couple’s income is mostly indexed government pensions, the indexed company pension Sid gets and investment income indexed by the return calculated after inflation.
When they get to their 80s, they may revisit the value of keeping their home. If the cost is too much and they choose to downsize, perhaps moving to a condo or an assisted living situation, they could liberate several hundred thousand dollars that could be used for fees for care.
They have the alternative of doing that now and buying long-term care insurance or critical illness coverage, but the cost of that is high and they might need neither.
“The problem with the U.S. restaurant is just a bump in the road,” Moran says. “If the restaurant case goes their way, then their problems are mostly solved. Just for caution, they can reduce expenses now and add to their cash reserve. In spite of that issue and spending a lot on their new house, years of hard work and saving has given them a lot of financial security.”