Selling rentals will give Alberta couple’s retirement a boost
In Alberta, a couple we’ll call Chuck, 63, and Ellie, 64, worry their retirement income won’t support their way of life. Planning to retire from his work as a marketing manager for a large company, Chuck accepted an offer of six months’ salary beginning in February. After withholding, he will net about $38,000 after tax. Ellie retired two years ago from her work as an administrative assistant on contract for a large company, which did not provide a pension for temporary workers.
Their present monthly income is composed of Ellie’s $420 CPP, Chuck’s present income of $9,150, $800 in rental income from two properties and Chuck’s $735-a-month pension from a former job. It adds up to $11,105 a month before tax, about $9,000 after tax on Chuck’s income and none on Ellie’s.
That income is more than sufficient for present spending of $4,755 a month net of savings, but when Chuck retires he’ll have just six months’ salary as a retirement package — and then nothing more. Their standard of living is in jeopardy.
“Can we enjoy the lifestyle we desire — doing volunteer work internationally with Habitat for Humanity for six months at a stretch?” Chuck asks. “Do I need to work part- time and how do we make provisions for our son if a problem he has with his stomach worsens?”
Family Finance asked Graeme Egan, a financial planner and portfolio manager who heads CastleBay Wealth Management Inc. in Vancouver, to work with Chuck and Ellie.
THE BALANCE SHEET
The couple’s net worth is about $ 1.22 million. Real estate makes up 70 per cent of their assets and has provided, via mortgages, a good leveraged return on equity. The liabilities add up to $677,671 — $536,349 of that is mortgages on rental properties, the interest on which is tax deductible. For now, their financial assets ($ 577,152) include $ 129,723 of cash, the result of a sale of a U. S. vacation property. The sum includes a $ 50,000 down payment for their son’s condo.
In preparation for retirement, the rental properties need to be reviewed, Egan says. Their combined equity is $ 331,000 and Chuck and Ellie owe $ 536,349 on them. Their mortgages have low interest rates averaging 2.5 per cent. The properties and their leveraged returns have been profitable. But times change and it is time to reduce leverage and the risks, such as vacancy, that go with owning rental property.
The couple are considering selling one property in order to raise cash to pay off their own home mortgage. If sold, it would net its estimated price of $ 408,500, less the $ 216,916 mortgage. After perhaps $ 20,000 in selling expenses, they would have $ 171,584, which could be used to discharge the $ 141,322 home mortgage. There would be a capital gain on the net sale price, less the $ 330,000 they paid. If they do get a $ 50,000 profit, they would have tax of perhaps $ 10,000 to pay, Egan estimates. That would leave $ 20,262 to be added to financial assets, bringing the total up to about $ 597,500, not counting equity in their son’s home.
BUILDING UP FINANCIAL ASSETS
Their other property returns $ 4,800 a year, 3.7 per cent with no inflation adjustment. The return provides income and growth of the owner’s equity: The property has a present estimated value of $449,000 and a mortgage of $319,433, for net equity of $129,567. In the Alberta housing market, prices are under pressure. The property has provided a good return and security, but it is time to consider sale, Egan says.
Were they to sell it and realize perhaps $ 110,000 after selling expenses, they could add that sum to financial assets, bringing the total to about $707,500. If that sum is annuitized on the same basis — that is, expended in full in 26 years — and the three-percent return after inflation maintained, they would have investment income of $39,600 a year, or about $ 3,300 a month before tax. The annuity- payout method, which is only a calculation and not a suggestion to buy an annuity from an insurance company, would reduce the estate they leave for their son. They could retain capital just by limiting spending and use TFSAs or other envelopes to conserve his inheritance, Egan notes.
PENSION PROJECTIONS
Their monthly income at Chuck’s retirement at his age 64 would then be: Ellie’s $ 420 in CPP and $ 570 Old Age Security benefit; Chuck’s CPP of $947 (a 7.2 per cent reduction from what he would have collected at 65) and his $ 735 defined- benefit monthly pension from a former job; and investment income of $3,300 a month if both rental properties are sold. Chuck would also have $ 9,135 income as his sixmonth termination package from his employer. The total would be about $ 15,107 a month before tax or $ 12,085 a month after 20 per cent average income tax, Egan estimates.
When Chuck is 65, he would lose the $ 9,135 payments but gain $570 in monthly OAS income, making the couple’s total pretax income $ 6,542. With splits of qualified pension income and payment of nine per cent average tax, the couple would have $5,953 a month to spend.
The couple’s current $ 9,000 monthly allocations would have to be trimmed. Just terminating RRSP and TFSA would reduce allocations to $5,855, which would be within their budget.
INVESTMENTS
At present, Chuck and Ellie have a handful of mutual funds. They have good records, but they also have management expense ratios of 1.6 per cent to 2.6 per cent with fixed income at the low end of the range and equity funds at the top.
We have used a conservative return assumption of three per cent after inflation, but a return of one or two per cent more would be feasible just by cutting the management fees of the mutual funds they own. On $ 600,000 invested in financial assets, a two- per- cent fee cut would put an additional $ 12,000 in their pockets. A professional portfolio manager could do the job for perhaps one per cent of funds under management, reducing the gain to $ 6,000. But it would add up. In 10 years, another $60,000 could be a bequest to their son, Egan notes.
In the end, rebalancing the couple’s assets will leave them with about 20 per cent of their wealth in their home and 80 per cent in financial assets. If they move to a total allocation of their enhanced financial assets in two- thirds stocks and one- third bonds, they will have a well- diversified portfolio and, should they wish to return to leveraged property investing, liquid assets to cash for future down payments. They still have the option of returning to what has been a profitable investment.
“It’s time to reap the rewards of the mortgagebased investments and capture the relatively high return ( that) leveraged investing in real estate provided,” Egan says.
IT’S TIME TO REAP THE REWARDS OF THE MORTGAGE-BASED INVESTMENTS AND CAPTURE THE RELATIVELY HIGH RETURN (THAT) LEVERAGED INVESTING IN REAL ESTATE PROVIDED. — VANCOUVER FINANCIAL PLANNER GRAEME EGAN