Volatility a risk factor
SITUATION Highly variable income and lack of investment plan STRATEGY Stabilize retirement income with mid-risk investment plan SOLUTION Ample retirement income, money for kids’ education
In Alberta, a high-tech sales executive we’ll call Marc, 46, has to cope with an income that yo-yos from month to month. He and his partner, who we’ll call Helen, maintain a home for Marc’s children, ages 8 and 6, of whom he shares custody with his ex-wife. Marc’s problem: building his financial strength so he can finance post-secondary education for the kids and retire with the confidence he can maintain his way of life.
Marc cannot predict his income. In 2011, he had an average $13,535 monthly take-home income based on some months in which he earned $5,000 and others in which commissions drove his take-home income to nearly $65,000. Income variability creates budgeting problems. On top of all that, Marc’s investments, a scattered collection of mutual funds, stocks and a whack of cash sitting on the sidelines, are not focused on a goal.
“I need to know if I am on track to have the financial assets necessary to cover my share of the kids’ education and retire by age 60,” he explains.
Family Finance asked Adrian Mastracci, a portfolio manager and financial planner who heads KCM Wealth Management Inc. in Vancouver, to work with Marc.
“The problem is not only that his income is quite variable. The larger issue is that his investment knowledge is quite limited. He needs a strategy to get him through volatile markets and to protect his nest egg.”
In spite of the variability of Marc’s income, the basis for growth of his present $497,000 of financial assets is in place, Mr. Mastracci notes. He has the capacity to save $50,000 to as much as $80,000 a year, depending on commissions.
What Marc needs is financial security. Yet his present mix of stocks, mutual funds, a whopping $160,000 in cash and a $23,000 RESP is a scrapbook of ideas good and bad. His portfolios have defunct shares in the bankrupt Nortel Networks as well as solid investments in Canadian chartered banks. There is no plan, no method of monitoring assets, no balance of growth and income goals, and no meaningful horizon for retirement.
Balancing risk, return
Marc wants a pre-tax income of $80,000 to $100,000 a year in 2012 dollars when he begins retirement at age 60. If he accepts a good deal of market volatility, he can weight his portfolio heavily with stocks and achieve his pre-tax goal of $1,260,000 to $1,660,000 of financial assets, Mr. Mastracci estimates. That’s a 5% to 7% annual return. On the other hand, if Marc insists on keeping volatility down, he will need as much as $2,590,000 in financial assets that
[Marc] needs a strategy to get him through volatile markets and to protect his nest egg
would be 80% or more weighted with a mix of steady dividend stocks and corporate bonds that return an average 3% to 4% per year.
Bonds have the ability to deliver returns in precisely known amounts at precisely known dates. That certainty costs a lot in return, however, for in exchange for security, they pay less than stocks, whose returns are far more difficult to predict.
Marc has 14 years to go to retirement, so he ought to be able to handle a portfolio that has a high stock content. The benefit of choosing volatility over security is that the capital needed to produce his return will be about half of the requirement for the high-bond-weight portfolio needed to generate $100,000 a year before tax, Mr. Mastracci says.
If Marc takes a middle course and aims for a portfolio with a 5% annual return based on dividends and capital growth, he will be able to achieve a $100,000 mid-range investment income at age 60 with $2-million of financial assets, Mr. Mastracci says.
After tax at an average 30% rate, he would have $70,000 a year, or $5,833 a month, to spend. It would cover his present monthly expenses of just $3,086 net of $10,449 a month of mortgage cost, line-ofcredit payments, RRSP and other savings, and child-support payments. The excess of income over expenses would allow for travel, help for his children or support good causes. At 65, he could add CPP benefits of $ 11,840 a year, which, after tax, would add $691 a month to his investment income.
reaching the goal
If Marc adds $4,110 a month, or $49,320 a year, to his existing financial assets of $497,000, and does this steadily for 14 years with a monthly 5% return, at age 60 he would have his $ 2- million, Mr. Mastracci estimates.
The first move should be to cut debts. Marc has two outstanding liabilities — a $125,000 mortgage with a 3.95% interest rate and a $45,000 line of credit with a 4% interest rate. He has $160,000 of cash in a moneymarket mutual fund. The interest on debts that Marc has to pay comes out of after-tax dollars.
Marc should write a couple of cheques on his pile of cash to pay off most of his debts. That will save almost $1,300 a month, or $15,600 a year. Some $5,000 a year of those savings can go to building up educational savings for his children in the family’s registered educational savings plan, for which he at present saves only half the amount required to get the full Canada Education Savings Grant. It will add the lesser of $500 per child or 20% of contributions each year. In this case, the CESG will add $1,000 a year to the family plan. Next Marc should use his maximum limit for RRSPS, $22,970 in 2012. Tax savings at about $9,200 a year will add to total retirement savings. He should ensure that he makes full use of taxfree savings accounts as well.
“This plan can help Marc to build up his savings in spite of his highly variable income,” Mr. Mastracci says.