NEW BABY UPSTAGES PLANS
Acouple we’ll call Jorge and Rita live in B.C.’s Lower Mainland where the scenery is gorgeous and the cost of living is high.
Jorge, 40, works for a large shipping company. Rita, 37, works for a small marketing concern, but she has put her career on hold for the recent arrival of their first child. She has given up job income of $3,500 a month pre-tax, and receives $1,500 a month Employment Insurance benefits instead for the next 50 weeks. That has reduced their take-home monthly income from $7,990 to about $6,500.
Their dilemma — how to rearrange their finances in order to raise their child and to have a comfortable retirement in a couple of decades. They are up against high accommodation costs, little present equity in their home, family income interrupted by parenthood, and what are likely to be rising interest costs that will shift family income to their creditors. Part of the problem is that they have made a late start on having a family. Part is their present burden of debt. The combination of debt service and retirement savings takes 52% of their income. Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Jorge and Rita. “We can provide the balance of current spending and retirement saving that they need,” he says. “For now, they are behind their age peers in building net worth and paying off their $417,000 mortgage with 24 years to amortize.”
On a balance sheet basis, with $728,300 of assets and $446,000 of liabilities — that’s including their $29,000 car loan — they have net worth of just $282,300 — not a lot for their ages but substantial nevertheless given that Jorge will have a defined benefit pension.
They can bridge the income reduction until Rita returns to her job by stopping RRSP contributions of $1,800 a month she has recently made to fill available RRSP space. That’s essential in any event, for with no job income, Rita will not generate qualifying RRSP space. The cut will bring their new budget down to $6,100 a month and leave $400 a month for initial child-care expenses.
What they really need, however, is focus on debt reduction, for with their $417,000 mortgage, any large increase in interest rates could devastate their family budget. Debt reduction will be achieved by restructuring their savings and investments. Retirement plans will include a strategy to minimize taxes on income after Jorge quits his job.
BUILDING NET WORTH
Jorge and Rita have $140,300 in their RRSPs and $19,000 cash on hand. Best move — keep $5,000 in an emergency fund and use $14,000 from cash to pay down the mortgage. That will reduce the present 24-year amortization by 13 months and save $13,766 of interest if present low interest rates persist, or more interest if they rise, Mr. Moran estimates.
Jorge will have solid employment pension. Relying on that, the couple can redirect the $1,800 a month they have been putting into their RRSPs. They will pay another $600 in income taxes without RRSP contributions and the refunds they generate, but they will have $1,000 for accelerated mortgage payments at $1,000 a month, and $208 for a Registered Education Savings Plan for their new baby. The result is that their mortgage amortization will be cut to 15 years and four months.
If they put $208 a month into the RESP, they will accumulate $2,500 a year and qualify for the $500 annual Canada Education Savings Grant. If they do this to the child’s 18th birthday, and attain 3% over the rate of inflation, the fund would have about $77,500 in 2014 dollars, enough for tuition and living expenses at most Canadian universities.
When their car is paid for in 2018, another $600 a month will be liberated. That money can be added to the mortgage payment, cutting the amortization down to 13 years and saving a further $13,096 of interest.
RETIREMENT PLANS
Jorge’s DB pension plan works on the common formula of 2% of the average of the best five-year salary average times years of employment. He will have been employed for 30 years at age 59, so his pension, based on current salary, $81,600, will be $48,960 a year.
Assuming that $1,800 monthly contributions to RRSPs end to allow money after tax to go to mortgage paydown, RESPs and child costs, then, if the present portfolio of $140,300 grows at 3% over the rate of inflation for 19 years with no further contributions, it will have $246,000 at Jorge’s age 59. The couple could use this money as a supplement to Jorge’s company pension. That would allow them to wait to age 65 to take their Canada Pension Plan benefits. If they use this approach, then they could draw $30,700 in the years from Jorge’s retirement at 59 to Rita’s age 65 and add $48,960 from Jorge’s company pension for total income of $79,660. If this income is split, they would have $5,775 a month to spend after they pay average tax of 13%. Their budget with their mortgage and car paid and RESP contributions ended would be $5,300 a month.
This strategy would mean that Jorge would start to draw CPP benefits at age 68, gaining 8.4% each year, or a 25.2% bonus over the age 65 CPP benefit. His CPP payout would be $15,600 and Rita’s $9,345 at an estimated 75% of the age 65 maximum, $12,460. Jorge’s Old Age Security would have started at 67 at $6,704 a year and Rita’s OAS at her age 67 at the same amount, making final income Jorge’s pension at full value, $48,960, his enhanced CPP of $15,600, Rita’s CPP of $9,345, and two OAS benefits of $6,704 for total income of $87,300. Their tax rate would still be 13% based on the pension income credit and various age credits, thus making their permanent retirement income $6,300 a month in 2014 dollars. They would have almost $1,000 a month more discretionary income than they have now.
Is this plan realistic? Chances are that Jorge and Rita will have part-time jobs in retirement. Perhaps Jorge will extend his work life and Rita return to full-time work relatively soon, boosting her potential RRSP contributions and eventual RRSP payouts.
“This analysis is a baseline case,” Mr. Moran says. “It is the most modest retirement income scenario we can expect. The odds are that Jorge will work beyond age 59 and that Rita will return to her career. But with no solid numbers on those two timing events, I think our plan is reasonable.”