Situation: Couple in mid-60s with no defined benefit work pensions worries they can’t afford to retire
Solution: A full assessment of their financial assets and rental income shows the worries are unfounded
In Alberta, a couple we’ll call Sam, who is 70, and Ethel, who is 64, are moving toward full retirement. Sam has already retired from his small auto parts business. Ethel, who advises clients about their diets and exercise, is winding down her business. Long ago, she made the decision to pay herself dividends rather than take salary that generates __canada Pension Plan benefits. Poor long ago, they are now affluent but don’t admit it. Their problem is to manage their $3,072,000 of financial assets and real estate to produce dependable income. There are no children and they have no debts. They worry that the financial ring fence they have built around their lives may not be strong enough.
“Do we have enough money to retire or must I keep working?” Ethel asks. “We could stay in Canada or move abroad where costs of living are lower. Will that be a choice or a necessity?”
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Family Finance asked Graeme Egan, head of CastleBay Wealth Management in Vancouver, to work with Sam and Ethel. In his view, they have choices, not a financial need to move out of Canada to a lower-cost country. “They are in much better shape than they think,” he explains. “Ethel can retire now. There is no need to sell their nearly $1 million house and leave Canada.”
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Income choices
On the surface, Sam and Ethel are just getting by. They have total net income of $3,540 a month composed of Sam’s $580 work pension income, $516 of his Canada Pension Plan benefits, $578 of his Old Age Security income, Ethel’s $1,250 of business income, and $616 of rental income. That matches their spending. They do not include income on $1,382,000 of financial assets held in cash, business, personal and registered accounts. Income generated by these accounts is left in the accounts to compound. Their real estate is worth almost $1.7 million. Even without tapping their considerable cash and investment accounts, Sam and Ethel can take advantage of tax rules that allow splits of eligible pension income. They already split their rental income, which is in accord with their joint ownership of their $700,000 rental property, and when Ethel turns 65, she can split her Canada Pension Plan benefits with Sam as he can with her. Eventually, they can split income from their Registered Retirement Income Funds. Splitting is just a tax calculation that they or a tax pro can do in preparing returns, Egan explains.
Raising retirement income
There are several ways to increase their investment income. With her preference to pay herself dividends from her business, which do not qualify for Canada Pension Plan benefits, it makes little sense to raise her final payout just to add a year to salary, pay tax and obtain income for filling up her small RRSP space. They each have $5,500 of space for their Tax-Free Savings Accounts for 2017 and future years. They have $50,000 cash to fund those contributions.
They have other sources of investment income. Their $700,000 rental property, for which they paid $215,000 years ago, generates $7,392 a year in net income. That is just one per cent on current value but 3 per cent on cost. Either on cost or on present value, which is the more relevant measure, the rental property is a poor investment. Property prices in Alberta will eventually rebound and, when that happens, they can sell.
Based on a $700,000 sale price less the $215,000 they paid for the property, their gain would be $485,000 less selling costs. Half the gain would be taxable. They would wind up paying about $100,000 at their own tax rate, leaving them with about $600,000 less costs of 5 per cent or net $565,000. If they take five years to sell, that sum, generating 3 per cent after inflation for 26 years to Ethel’s age 95 would give them about $32,000 a year in pre-tax income. It is quite a jump over the $7,392 they now obtain from the property.
The conventional wisdom for investing retirement funds is to hold perhaps half in fixed income and half in equities. Government bonds are a traditional way of investing in fixed income, however, with interest rates likely to rise in Canada in the not too distant future and to continue rising in the U.S., forcing down the market value of old bonds with low interest, they could buy investment grade corporate issues with maturities of five to ten years.
Corporate bonds tend to provide a boost of 1 to 3 per cent over what government bonds pay. But corporate bonds are illiquid for small investors. However, bond exchange traded funds (ETFs) provide low management fees often just 25 basis points (that’s ¼ of one per cent) of net asset value and offer diversification and liquidity. Ethel and Sam could hold half their portfolio in these bonds and the other half in stocks. Overall, they could have 50 per cent corporate bonds, 20 per cent Canadian stocks, 20 per cent U.S. stocks and 10 per cent global issues, all purchased via low fee ETFs, Egan suggests.
Investment choices
We’ll assume that the couple does rotate out of mutual funds and into exchange traded funds. With all ETF fees included and a return of 2 per cent after inflation to allow for the modest returns of bonds, their $1,382,000 of financial assets including cash invested to pay out all income and capital in the 31 years to Ethel’s age 95 would generate about $60,000 per year. They now pay an average of 2 per cent of $1,332,000 invested in mutual funds – that does not count $50,000 cash which would be very liquid as ETF units. That is $26,640 a year. That’s about 44 per cent of the estimated annuitized return. If they use exchange traded funds with an average fee of ¼ of 1 per cent per year on $1,382,000, including their cash, they would pay about $3,450 a year. An advisor might need to be hired at a cost of perhaps 1 per cent per year of assets under management to help them manage their ETFs. This could be a transitory cost until they learn to manage their own money. Even so, Ethel and Sam would be ahead of the return they now get from their mutual funds.
Adding up various sources of income for the period beginning when Ethel retires next year, the couple would have $60,000 in potential annuitized return on their financial assets, $7,392 annual rental income prior to sale of the property, $6,192 of Sam’s CPP benefits, $6,936 of Sam’s Old Age Security benefits, $6,960 of Sam’s work pension, $1,800 of Ethel’s estimated CPP benefits, and $6,936 of her Old Age Security benefits starting next year. The total, $96,216 with splits of eligible pension income and tax at 15 per cent would leave them with $6,800 per month, far more than their current spending. Sale of the rental property in five years at $565,000 after costs and tax with investment at 2 per cent after inflation would generate a further $28,000 a year for 26 years to Ethel’s age 95. “Good living and good causes await,” Egan concludes.
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