PENSION-POOR, HOUSE-RICH COUPLE EYE FUTURE WARILY
Not far from the canyons of Bay Street, a couple we’ ll call Norbert and Ellen, both 62, are migrating their lives toward retirement. They have two children in their late 20s, one financially independent, the other almost independent. Their financial lives are secure: They have a $ 750,000 townhouse, about $ 700,000 of financial assets and no debt. But they worry that when Norbert, who retired from a job in software applications, and Ellen, who still does document management, will one day not have sufficient income to maintain their way of life. It is an understandable concern — about half their net worth is their house, which takes $ 7,200 a year of maintenance but pays no income.
“We are not sure that we have enough money to live comfortably in retirement using the returns and capital of our investments,” Norbert says. “We’d like to know how much more we might have available to spend above and beyond the basics for travel and perhaps to assist our children.”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Norbert and Ellen. “Their core question comes down to whether Ellen, who is still working, should stay on the job to build up their savings and Norbert perhaps return to full time work. We’ll do the numbers to get the answer.”
ESTIMATING RETIREMENT INCOME
Their base retirement income is made up of Canada Pension Plan and Old Age Security benefits. Neither has a company pension. Each elected to take CPP at 60, accepting a penalty that amounts to 36 per cent of age 65 benefits. The penalty, which is 7.2 per cent per year, persists until each dies.
Taking CPP early is sensible if one’s life expectancy is short, but the long term consequences are quite negative, Moran notes. Their present combined CPP is $ 1,426 per month or $ 17,112 per year. Had they waited to 70 to take CPP, they would have received a 42 per cent bonus plus the indexation that goes with a rising base.
For now, they generate a four per cent average annual return through their mutual funds, less management fees that average two per cent per year. The gross return for their approximately $ 700,000 of investments is about $ 28,000 a year. Their net annual investment return after fees is $14,040.
Ellen has a gross salary of $ 37,200 per year. That gives them present pre-tax annual income of $ 68,352. After zero tax on Norbert’s CPP income and 10 per cent average income tax on Ellen’s income, they have an average tax rate of six per cent, giving them annual after-tax income of $64,250, or $5,355 a month, which easily covers their $4,319 expenses.
When they are 65, Norbert and Ellen will be able to receive OAS, currently $ 6,846 per person annually. That would push their income to $ 82,044 a year if Ellen is still working. Their monthly income after 10 per cent average i ncome tax, which recognizes age and pension income credits, would be $6,153.
If Ellen retires at 65, f amily i ncome would be $ 44,844 a year before 10 per cent average tax. They would have $ 3,363 a month to spend.
Present expenses would not be covered.
INVESTMENT EXPENSES
They can get more out of their savings by annuitizing their approximately $ 700,000 of savings. If Ellen retires now and if they obtain a three per cent return after inflation and fees and take all their income and capital over t he 33 years to their age 90, they would have $ 33,805 a year plus CPP and, at 65, OAS for total annual retirement income of $ 64,609. With splits of eligible income and 10 per cent average tax, they would have $ 4,845 a month to spend. Their present expenses would be covered with a $ 6,300 annual surplus for travel or occasional purchase of a new or newer car.
They could have even more i ncome by shifting their portfolio f rom one bank’s over-the-counter mutual funds to professional portfolio management with an average annual fee of one per cent plus minor trading costs. They would pick up $7,000 or more per year and would have a portfolio that is tailored and traded for their needs. A bespoke portfolio constructed for one client has many advantages, Moran says.
A custom portfolio would have a targeted bond to stock ratio. Bonds would be selected for both sensitivity to interest rate changes and credit risk. The funds Norbert and Ellen hold are weighted to dividend paying stocks, which amounts to reducing interest rate sensitivity in exchange for stock market growth. The manager of the fund may be right in setting this balance, but the name for their fund, “monthly income”, is a misnomer.
A review of its assets suggests i t should be called “growth with some dividends.” With $ 700,000 of stocks and bonds, Norbert and Ellen should be able to do better, Moran says.
Their RRSPs and TFSAs are already well funded and they have no great sums of cash with which to buy new i nvestments. What t hey need is a strategic restructuring of their portfolio with a view to cutting costs and adjusting risks.
“This couple has planned well,” Moran says. “Their portfolio management costs will be modest if they can cut fees on their investments. That will make up for taking CPP early and buy a lot of security. If they resist the temptation to overspend, there will also be a legacy for their children.”
COSTS WILL BE MODEST IF THEY CAN CUT FEES ON THEIR INVESTMENTS.