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By Andrew Allentuck
The Globe And Mail
Report on Business
Saturday, January 6, 2007
At the age of 64, a retired executive we'll call Herman lives in Vancouver doing a small amount of consulting. He has $130,000 of annual income from pensions and investments. He wants to spend $1-million out of his $2.89-million in total assets on a house. He is concerned about plunging into the Vancouver property market because his former employer, a company that pays a large part of his pension out of earnings, could be unable to maintain the flow of $60,000 a year in payments to him.
Adrian Mastracci, fee-only portfolio manager at KCM Wealth Management in Vancouver, says, "Managing investments during his retirement years is the biggest challenge. There are several factors that could derail his retirement: inflation, health costs, low returns and large losses."
"There is some risk that the company could fail," Herman explains. "Conservatively, allowing for the possibility of that failure, how should I have my money invested and how much can I spend per month?"
What our expert says
Facelift asked Adrian Mastracci, a financial planner and portfolio manager who heads KCM Wealth Management Inc. in Vancouver, to speak with Herman in order to devise an investment plan that can add security to his retirement cash flow.
"Managing investments during his retirement years is the biggest challenge," Mr. Mastracci explains. "There are several factors that could derail his retirement: inflation, health costs, low returns and large losses."
Herman is divorced and his children are in their thirties with independent lives. He is a sophisticated investor.
The key risk in Herman's plan is, as he recognizes, the continuity of a large component of his pension income. Sometimes called a top-hat plan, it's a commitment from his former employer to provide $5,000 a month for his life. It comes from an unfunded account, that is, it's a pay-as-you-go plan based on the company's fortunes. Created as a form of deferred compensation, it is really a variable, postponed wage that could tumble to zero.
Regardless of that business risk, Herman will have Canada Pension Plan payments. After a separation agreement which transferred some credits to his former partner, his CPP will be about $4,800 (in 2006 dollars) a year beginning when he turns 65. He could wait to age 70 to begin payments. He is in good health and, if he does postpone benefits, they will rise at a rate of 0.5 per cent for every month after age 65 that he defers the benefits. At age 70, he would therefore receive $6,240 a year in 2006 dollars. Benefits are indexed to increases in the consumer price index and should rise at an estimated rate of 2 per cent a year, Mr. Mastracci suggests.
Herman will also receive $5,800 in 2006 dollars of Old Age Security payments each year beginning when he is 65. The payments will be indexed at 2 per cent a year but will be entirely clawed back. The clawback begins when net income exceeds $62,144. It recovers all OAS benefits when net income hits $100,944. Herman's income should exceed that upper limit next year, the planner notes.
Herman could suffer a major reduction in his income from failure of the top-hat pension or an investment loss. But he could cope, for his annual expenses are $63,000, about half of his gross income.
There is little Herman can do to convert the top-hat pension from its present structure as a conditional promise into a guaranteed income flow, Mr. Mastracci says. He could, of course, buy a life annuity that would pay more than government bonds. But there is a cost in locking up money for what could be decades. In any case, an annuity is an investment and not really a replacement for the top-hat pension. He could also sell short its publicly traded common stock, a move that would generate a profit if the company's health were to suffer.
But such a move would actually add risk to his finances, for any short position can produce huge losses if the stock rises and obliges the investor to buy shares to cover those he has already sold, the planner notes.
Herman plans to spread his risks. If he buys the house, he will be taking money out of financial assets and putting it into property. He plans to finance the house mostly with cash from his income assets, a blend of short bonds and short deposits that earn relatively low but secure income. Yet the shift from low return investments to real estate will produce its own risks.
Buying in Vancouver's hot real estate market could be chancy. Over the long term, however, buying a house should turn out well. It is likely that it could be sold with capital gains in the future, even if the steamy B.C. real estate market corrects in the near term. Herman should ensure that the house is his principal residence so that there would be no capital gain on its proceeds, Mr. Mastracci adds.
Assuming that Herman does buy the house for $1-million, his financial assets would decline to $1.89-million. If he were to use only his portfolio of bonds, short-term deposits and cash for the purchase, he would still have $229,000 in cash equivalents such as treasury bills plus accrued interest and stocks and various assets in registered plans that total $1,661,000. After buying the house and assuming that the top-hat pension plan remains intact, he could spend $175,000 a year to age 90. At that time, his funds would be exhausted, though he would still have his public pensions and a major asset in the house, which would be likely to have appreciated, Mr. Mastracci says.
Herman is a very healthy 64 year old. He has good prospects for living for another few decades. As Mr. Mastracci sees it, his risks are broader than just the continuity of his corporate pension. Given his promising outlook for a long life, he needs to keep up with inflation and generate growth, while protecting against the possibility that the Canadian equity market in which he has focused his investments could suffer a drastic decline.
As a defence, the planner recommends that Herman's portfolio have an allocation of 60-per-cent growth stocks and 40-per-cent fixed income such as bonds. The stocks should be held in a taxable account to take advantage of preferential tax rates on capital gains. The bonds can be held in registered plans to defer taxes on the fully taxed income that they produce.
Investing a portion of the equity allocation outside of North America would produce desirable diversification in countries whose business cycles vary from those in Canada and the United States, he notes. Mr. Mastracci suggests that Herman have 35-per-cent Canadian stocks, 15-per-cent U.S. stocks, 10-per-cent other global stocks, 25-per-cent bonds and 15-per-cent securities that pay reliable and growing dividends.
In the end, there is little Herman can do to eliminate the risk that his former employer may one day have to reduce or eliminate his pension. He would not have his relatively modest lifestyle curtailed even if the corporate pension were to fail. Over time, Herman would be able to replace the lost income of the top-hat plan. He's fortunate to be able to do that, the planner notes.
"My analysis shows that while Herman would understandably lament the loss of his top-hat pension, he could accommodate the loss without any change of lifestyle," Mr. Mastracci says. "He has worked hard and built several life preservers for his future."
"I have to accept the risk that the top-hat pension could fail," Herman says.
"It turned out this way because my pay at the company was linked to my performance and, in consequence, my pension was linked to a performance component. The irony now is that it is the company's performance that determines what I get."
Client situation
Herman, 64, is a retired executive living in Vancouver.
Net monthly income: $6,500.
Assets: Index funds, $1,321,000; short-term deposits, $1,229,000; RRSPs, $335,000; car, $8,000.
Monthly expenses: Rent, $1,500; utilities, $200; apartment insurance, $150; food, restaurant, $600; travel, $900; charity, $100; entertainment, $200; clothing, $100; gifts, $100; auto insurance and gas, $200; miscellaneous, $1,200; savings, $1,250.
Total: $6,500.
Liabilities: Visa bills, $3,000; tax instalment $25,000.
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