Affording retirement means taking portfolio off the sidelines
Acouple we’ll call Sal, 64, and Eleanor, 62, live in British Columbia. With two adult children at home and seeking jobs, they have a solid life with almost a million dollars in financial assets, a $ 1- million house, and a $ 6,825 monthly after- tax income made up of Eleanor’s salary and Sal’s employment and government pensions. Sal has been retired for five years. For now, there is no financial problem, for the couple’s monthly income is more than their $ 5,590 monthly spending, net of RRSPs and other savings. It is the future that worries them. “I am concerned that we may not be prepared for what is coming in 20 years,” Sal says.
Sal and Eleanor are refugees from the capital markets. Sal, who has an engineering background, had put his faith in mutual funds. He got poor performance for his efforts, so he moved to the sidelines in money market funds which pay 1% a year. They can’t keep up with inflation or get the money they need if they stay in what is essentially cash. Three years from now, Eleanor, an administrator in a transport company, will turn in her company identity card.
Family Finance asked Graeme Egan, a financial planner and portfolio manager with KCM Wealth Inc. in Vancouver, to work with Sal and Eleanor.
Sal and Eleanor will get a breather when their children move out. Then their $ 5,590 in monthly living costs, particularly the $ 1,000 a month they spend on food and the $ 1,100 a month they spend on fuel and repairs for their three cars, should drop.
The budget for the time when the kids are gone and no longer eating or driving on the parents’ tab, could, however, be a good deal higher if their travel budget, now $ 700 a month, rises to the spending they will need for trips they anticipate to South America, Europe and Asia. They want to be global travellers. But they will have to do serious financial planning to be able to afford it.
GROWING ASSETS
Before she retires in 2017, Eleanor can contribute, as she is now doing, $ 5,400 a year to her RRSP. Assuming she gets a 3% annual return after inflation, the couple’s total RRSP portfolio, $ 292,840 at present, would grow to $ 337,000. That would provide gross annual income of $ 10,100 a year if capital is not infringed or $ 18,800 if they were to pay out all income and capital by her age 90.
At work, Eleanor will contribute to her company’s defined contribution plan with a current balance of $ 400,000 for three years and get company matching contributions of $ 3,300 a year. Her contributions come off her monthly pay. The DC plan would then grow to $ 458,100.
Assuming the same returns, this capital would provide income of $ 13,750 a year without encroaching on capital or about $ 26,000 a year if all capital is paid out and exhausted by her age 90. Their investment account of $ 250,000 could grow to $ 273,200 at 3% a year in three years with no further contributions. It could provide annual income of $ 8,200 without cutting into capital or $ 15,230 a year with the annuity payout model to Eleanor’s age 90.
Their Tax- Free Savings Account with a $ 43,050 balance can be kept as is as a cash reserve with no further contributions and no tax on withdrawals.
TIMING RETIREMENT INCOME
When Sal reaches 65, his present pension income, $ 1,805 a month composed of $ 705 from the Canada Pension Plan and $ 1,100 from previous employment, will decline by $ 776 when the company pension bridge ends. His total income will be $ 324 from a job pension and his $ 705 CPP benefit. He will start receiving Old Age Security benefits of $ 552 a month for total pension income of $ 1,581 a month.
When Eleanor reaches 65, she will get OAS at $ 552 a month and CPP at an estimated $ 953 a month. Using the annuity payout choice, the combined annual payout from the couple’s RRSPs, Eleanor’s defined contribution company pension and non- registered investments would be $ 60,030.
She would have an age 65 CPP benefit of $ 11,436 a year and OAS of $ 6,618 a year. Her total pre- tax income would be $ 78,084. Added to Sal’s age 65 job pension and government pension income, $ 18,972 a year, the couple would have total pretax income of $ 96,876.
After splitting of qualified pensions and payment of tax at an average 15% rate, they would have $ 6,860 a month to spend in 2014 dollars, a little more than present after- tax income and more than their present spending, $ 5,590 a month.
Moreover, that income will be more than the reduced money they would spend after elimination of $ 450 a month savings for RRSPs and some saving on food and car fuel and maintenance.
They can have a surplus of more than $ 1,000 a month with those expenses reduced. If they do not use the capital payout model and instead use returns of 3% a year on taxable accounts and RRSPs, their annual income would be cut by $ 27,980 or $ 2,330 a month. After tax at an average rate of 15%, they would have $ 4,880 a month to spend.
INCREASING RETURNS
Attaining their nearly six- figure retirement income depends on the couple remodelling their investments. To get more out of their financial assets, they have to return to capital markets rather than hiding out from them. If they invest to attain and maintain a 3% return after inflation, these income predictions will be in the ballpark.
If they stay on the sidelines in money market funds and low interest bank accounts, their assets would barely generate $ 10,000 a year. To meet the 3% post- inflation return, Mr. Egan recommends 60% equity and 40% fixed income. They can aim for a 7% total return from blue chip Canadian, American and global stocks and 4.5% from investment grade corporate bonds with terms of no more than five years.
This allocation would provide an average 6% annual return before tax or inflation adjustments.
Next problem — getting those returns. Equity mutual funds have management fees averaging 2.5%. That would mean they would need stocks in their funds with a pre- fee return of 9.5%. Bond funds have average fees of 1.6%. That means their bonds would have to return 6.1%. These returns are far above the historical average for their classes. Meeting the return targets would require gambling on small cap stocks and accepting their high volatility and loading up on funds of risky junk bonds. Neither is appropriate to a retired couple.
The better bet is to control fees by shifting cash to exchange- traded funds with fees often a tenth of those of mutual funds. That would make the target returns attainable.
“This plan works if the couple gets back into capital markets to achieve the target returns,” Mr. Egan says. “If they don’t do that, they will not be able to afford the retirement they want.”