COUPLE NEEDS TO ADJUST SPENDING
In Ontario, a couple we’ll call Betsy, 61, and Jim, 62, want to be fully retired by age 65. Jim works fulltime at his own company; Betsy, an administrative assistant in a local health-care products business, earns $60,000 a year before tax. Their disposable income, including withdrawals of money from their savings, works out to $5,000 a month. Unfortunately, they are spending $7,445 a month, drawing down their savings.
They can afford the erosion for now, but they are overspending by $29,340 a year. In two decades, their deficit would eat nearly $600,000 of capital. It would curtail their wealth in late old age and perhaps limit what they might need for long-term care or just enjoying life. Not only should they raise their retirement income, they should also adjust their spending.
Jim and Betsy want to stay in their $425,000 home for as long as they can maintain it, keep a beloved 39-foot cabin cruiser until they can no longer enjoy it, and give their wealth as a bequest when they pass on. The boat, their largest non-financial asset after their house, eats $12,000 a year in fuel, upkeep and insurance.
“Can we maintain our proposed way of life for 25 years or longer?” Betsy asks. “We have no company pensions, just our savings. Will it work?”
Family Finance asked Guil Perreault, a financial planner with the Foster Agency in Winnipeg, to work with Betsy and Jim. He’s optimistic that their plans will work, but says the viability test is in their numbers.
PROJECTING RETIREMENT INCOME
Jim and Betsy are well prepared for retirement. Their present $1,099,114 of financial assets growing, at three per cent a year after inflation for three years to Jim’s anticipated retirement at 65, will generate $1.2 million. Then, if harvested at three per cent a year, that capital will produce $36,000 a year indefinitely. The capital base will be a legacy for their grown children.
When both partners are 65, they will have total government benefits of $39,912 consisting of two CPP benefits, each with a full value of $13,110 at 2016 rates, and two Old Age Security benefits, at $6,846 each. Their total annual, pre-tax income of benefits and investment income will be $75,912. After pension income, age credits and splits of eligible pension income, they could pay tax at an average rate of 10 per cent and have $5,700 a month to spend indefinitely.
Alternatively, they could annuitize their financial assets, starting at Jim’s age 65, for 31 years to return all capital by Betsy’s age 95 and harvest $58,300 a year. They could buy an annuity from an insurance company and use the tax benefit of a documented return of capital, which is not subject to tax, to generate a reserve for a substantial inheritance for their children. The insurance-based annuity could have a minimum number of payments that would include the children if the parents were to pass away before expiration of a straight life annuity. They would shift investment risk to the insurance company, but lose control of money put into the annuity. There is no need to use an annuity if they trim expenses to live within their income, Perreault says.
Some of their present spending of $7,445 a year will be curtailed when their $755 a month car loan ends when Jim is 65. That will bring spending down to $6,690 a month. They could also cut house maintenance in half, saving $500 a month; trim clothing expenses by half, saving $225 a month; and perhaps cruise a little less in their boat, saving perhaps $500 a month in fuel and related costs. These potential savings would further cut expenses to $5,465, well within their future after-tax income based on the simple three per cent of capital return, Perreault estimates.
INVESTMENT MANAGEMENT
The couple can raise their income. Their equity investments, which are all in mutual funds, have fees as high as 2.5 per cent a year. There’s also $74,300 in non-registered savings accounts earning almost nothing. They have been reluctant to accept short-term market ups and downs that are part of longterm investment plans.
Jim and Betsy are concerned by market volatility. Their present portfolio allocation is 70 per cent stock mutual funds, 20 per cent fixed-income in bond funds and 10 per cent cash. Raising the fixed-income portion could reduce portfolio volatility. There is risk in bonds too, as bond prices will fall when interest rates begin to rise and make existing bonds less attractive. Allocation between asset types will be a delicate balance that will need to be reviewed at least annually, perhaps with the help of a financial adviser.
They can create a buffer against losses in stocks or bonds by cutting the costs of their investments. Most index-type exchange-traded funds have annual management expenses below 0.5 per cent a year, a fifth of the fees they now pay for managed funds. Cost savings of two per cent or more a year would add to their returns and mitigate any future losses, Perreault notes. If Jim and Betsy choose low volatility ETFs, they can have dividend income and relatively steady short-term price moves in their stock portfolio.
Jim and Betsy have underutilized their Tax-Free Savings Account space. Betsy has $36,500 in her TFSA and Jim has nothing. He could take some of the abundant cash he has in his non-registered accounts to invest in TFSAs and fill his $46,500 available space, Perreault suggests.
RAISING INVESTMENT AWARENESS
There is a larger issue — management and understanding of investments. Jim and Betsy have entrusted all their investments with their adviser at a major securities firm. They have almost no knowledge of how their life’s financial work is invested, which mutual funds they hold, nor what the erosion cost of fees is on returns. A 2.5 per cent annual management fee for a fund, which is typical of many of the couple’s mutual fund positions, may seem innocuous, but in 20 years, it’s 50 per cent of the fund’s initial price. Earnings and asset growth may offset the cost, but the principle is clear. The couple’s adviser also charges a few hundred dollars in annual fees for holding the accounts.
Jim and Betsy are not alone in being innocent of understanding of their investments. It is in the couple’s interests to read their monthly accounts from their investment dealer, to read the funds’ reports of holdings in print or online, to check on fees and to study financial markets. The goal is not necessarily to be able to pick assets more wisely than their adviser, but to know how to evaluate what they own and perhaps to question the financial advice they are given, Perreault suggests.
Odds are that things will work out fairly well for the couple, Perreault says. Investment returns and government pensions and a few spending cuts will be sufficient to maintain their way of life. A lifetime of hard work is on their side.