A little bit of equity risk would go a long way for couple’s retirement plans
Acouple we’ll call Henry and Marcy, both 55, live in Ontario. Henry is a self-employed management consultant who brings home $6,900 per month. Marcy is an administrator for a large company and brings home $3,200 per month out of her $5,000 pre-tax and benefits salary. Henry would like to retire in 2019. Marcy will continue work to age 65, then receive a $20,000 yearly pension. They want to replace their century-old house, but worry the cost of the upgrade could so deplete their $1,418,500 in financial assets that they will be unable to maintain their way of life.
“We could sell the house for $680,000 and build elsewhere, but if we do that and add a minimum of $175,000 to the proceeds, what would that do to our future spending?” Henry asks. “Would we end up with a nice house we can’t afford?”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Henry and Marcy. “Their present house is only 32 per cent of their net worth. Expenses are sustainable, even if they build a new house,” Moran says. “But the issue is not so much house cost as their inefficient investments.”
ASSET ALLOCATION
Most of their money is locked up in low-interest GICS in personal and company accounts because they fear the undeniable volatility of the stock market. We’ll assume they continue to invest in GICS with a one per cent return after two per cent current inflation and before tax.
Under such a scenario, the $482,000 remaining in their personal taxable accounts after buying the newer house would generate $4,820 per year.
That, Moran says, would be enough to cover their expenses in retirement. But their ability to outpace inflation will depend on how their money is invested.
Their return could be increased to $14,460 if the money was invested in a balanced stock and bond portfolio yielding three per cent after inflation. The enhanced return would more than make up for income lost to diversion of $175,000 to a house move up.
INVESTMENT MANAGEMENT
Currently, Marcy’s TFSA contains just $500. Cash from current income and maturing GICS could top that up to the lifetime contribution limit, which stands at $63,500 as of 2019. Henry’s TFSA has a $63,000 balance which includes gains over its $57,500 cost base. They should add $6,000 to his account for 2019 and $63,000 to Marcy’s, Moran suggests, for total contributions of $69,000. That would bring their TFSA totals to $132,500.
If the $132,500 balance of their TFSAS grows with two $6,000 contributions for ten years at one per cent above inflation, it would become $271,900 in 2019 dollars. If that money were to grow at that rate and be spent over the following 25 years to the couple’s age 90, it would support annual payouts of $12,200.
The couple has $657,000 in taxable personal savings. If they take out $175,000 for building a new house on top of present value, less $69,000 for TFSAS, they would have $413,000 for investment. Invested at one per cent after inflation in GICS, it would produce $13,900 per year for 35 years to their age 95.
The couple’s RRSPS total $371,000. Marcy has an indexed defined benefit pension. However, the pension adjustment rule limits total RRSP contributions to about 18 per cent of earned income and thus severely limits her RRSP contributions. If Henry retires this year, his RRSP contributions will end. He has filled his space. Assuming no further RRSP contributions and asset growth at one per cent over the rate of inflation for ten years, it would become $409,800 and support annual payouts of $18,425 for the next 25 years when the account would be empty.
We will assume that Henry takes dividends of $32,700 net out of his company’s $327,000 idle cash every year for 10 years to a zero balance to the time that Marcy retires at 65. No payouts from TFSAS and RRSPS begin until the couple is 65.
From Henry’s retirement this year to their age 65, they would have Marcy’s $60,000 annual salary, $13,900 income from taxable savings and $32,700 taken out from his company for a total of $106,600. With eligible income split, after 13 per cent average tax, they would have about $7,700 per month to spend.
After Marcy retires in 10 years, they would have her $20,000 annual pension, $18,425 of RRSP income, $12,200 of TFSA income, $13,900 in proceeds of taxable personal savings, two CPP benefits totalling $27,710 and two OAS benefits totalling $14,434 for total income of $106,669. With no tax on TFSA income and the remainder split and taxed at an average rate of 13 per cent, they would have $7,850 to spend each month.
Before Marcy’s job pension starts at 65 and after the start of the pension, they would have more than enough cash to pay present monthly expenses with no further RRSP contributions, now $1,500 per month, nor other savings at $4,804 per month. Monthly costs would decline to $3,796, perhaps a little less if their new house has higher property taxes and utility bills. But they would have ample money for spending or perhaps donations to good causes.
RISK AND RETURN
The couple loathes equity risk. They save $6,304 per month in cash and RRSP accounts but are content with GICS that barely keep up with inflation and which, after inflation and tax, lose value. Conceptually, they could put $1,028,000 of taxable and RRSP holdings into assets that return an average three per cent after inflation and maintain the position for 35 years. Compound interest would increase the sum to $2,892,700. At one per cent annual growth, that same capital would grow to just $1,456,300. That is the price of shunning equity risk for the certainty of inflation erosion of asset value.
“Restructuring investments to 60 per cent dividend-paying stocks with the remainder in bonds or GICS would maintain purchasing power to the mid-21st century,” Moran concludes.