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By Andrew Allentuck
The Globe and Mail
Report on Business
Saturday, May 26, 2007
In Vancouver, a couple we'll call Max and Suzy are moving into what they would like to be a comfortable retirement. Max, 61, a retired engineer, has already ended his career. Suzy, 60, a civil servant, expects to be retired within a year or two. Max has built up a portfolio of quality stocks and solid bonds, but, he fears, it may not be enough to sustain their retirement.
Adrian Mastracci, fee-only portfolio manager at KCM Wealth Management in Vancouver, says, "They deserve recognition for doing so many things right. They have no mortgage on their home and they have accumulated a substantial RRSP. They have also built up several pensions."
Their goals are modest. Suzy is eager to expand her garden, which would involve buying land at B.C.'s inflated prices. Max, engaged in his own hobbies, would also like a larger house in which to putter. They have two grown children and have no plans to leave significant amounts of money to them. Max and Suzy are on their own and wondering whether they should take on a $200,000 mortgage that would be needed to buy a larger house and lot. They also want to increase their travel and, within a few years, buy a moderately upscale car.
"We want to know if we can afford a larger house on our retirement income," Max explains. "We don't want to buy a larger house that would be a millstone around our necks."
Facelift asked Adrian Mastracci, a registered financial planner and portfolio manager, to work with Max and Suzy in order to test the feasibility of their plans.
"They deserve recognition for doing so many things right," he says. "They have no mortgage on their home and they have accumulated a substantial RRSP. They have also built up several pensions."
The main financial challenge will be to expand their real estate holdings for Suzy's gardening, the planner notes. Their total assets are $1.06-million, virtually all in their $450,000 house, $557,000 of RRSPs and $50,000 of personal property. They have no liabilities apart from credit card bills that they pay in full each month. Their present incomes total $96,600, of which $72,800 is Suzy's employment income that will end when she retires. For now, they can easily cover their annual $50,000 household and travel budget, not counting savings. However, when Suzy retires, and if the couple chooses to buy a bigger house and lot, family finances will grow tighter.
Their goal of moving up to a $650,000 house will be difficult to attain, Mr. Mastracci says. The couple has almost no cash savings, so they would have to borrow $200,000. A 25-year amortization would cost $1,200 per month to finance. In 15 years, they expect to receive a $200,000 inheritance that could be used to eliminate remaining debt, they suggest.
By cutting some expenses, the $1,200 monthly mortgage would be affordable, but it is still not a good idea, the planner says. It is not prudent to rely on an inheritance far in the future. Nor is it sensible to take on debt that would eliminate their ability to add to their almost zero cash reserves for emergencies. If the payments were to come from RRSP withdrawals, they could be running retirement savings down too quickly. Finally, at their ages, it is not wise to carry large amounts of non-deductible debt, Mr. Mastracci insists.
Their retirement cash flow will be used up just sustaining their present way of life, Mr. Mastracci notes. Max currently receives $5,200 annually in Canada Pension Plan income. Suzy will receive $5,000 per year in CPP income at age 65. The couple will receive slightly reduced Old Age Security payments that will total $8,200 at age 65. Mr. Mastracci assumes that OAS and CPP will each rise at 1.5 per cent per year, which is less than the projected 2.5 per cent rate of inflation.
Suzy's government pension is indexed and will begin at age 62 at $24,700 per year. Of that, $5,000 will be a bridge that will end at age 65 when her CPP begins. The couple has other pensions from foreign employment that will total $11,800 at 65.
Assuming that Max lives another 25 years and Suzy another 30 and that their investments earn 6 per cent per year, then their pension base will need $475,000 of RRSP assets on top of other pension income to fund a $60,000 annual gross income in 2007 dollars. The $475,000 base will sustain an RRSP drawdown of $30,100 per year until Suzy is 65, Mr. Mastracci says. Then, when she is 65, Suzy and Max can take another $10,700 per year from their RRSPs every year.
Proposed pension splitting rules will enable the couple to divide their $60,000 income to $30,000 each. That will leave each with $25,000 net income. They will meet their retirement goal in after-tax dollars, but with no cash to spare.
The couple needs to save more during the few remaining years that Suzy will work, Mr. Mastracci says. They should be able to find $10,000 a year in spare cash. They can find that amount, $833 per month, by trimming some of the $130 they spend each month for dining out, the $125 they spend on the services of a home cleaner, $250 per month for gifts, and their $800 per month allocation for travel. They can put that money into their RRSPs. Suzy has $13,000 of RRSP room.
Max has been managing the couple's RRSPs. Currently, Mr. Mastracci notes, the registered investments are 34 per cent stocks, 38 per cent bonds and 28 per cent income trusts. The stocks include major financial services companies with histories of raising their dividends, good global stocks, some U.S. health care mega-caps, and several good income trusts. His bonds include government issues and investment grade corporate issues. Given the couple's low risk tolerance, it would be useful to rebalance to achieve a ratio of half stocks and half bonds and fixed income, the planner says.
There may be costs in reducing income trusts, which are stocks in all but name, and adding bonds. The yield on income trusts tends to exceed that on bonds. However, income trusts are designed to be tax-efficient, usually at the expense of earnings retention and growth of the underlying business. Bonds are far safer than income trust payouts. Moreover, investment grade bonds, when held to maturity, present little risk of default. Raising bond content is necessary for this couple, for they have relatively few assets with which to recover were any of their income trusts to lose significant value or to suspend or lower their distributions, Mr. Mastracci notes.
This case is about balancing risk and opportunity. CPP and OAS payments may be indexed to increase at higher rates than those which the planner has assumed. As well, the couple's registered assets may appreciate faster than the assumed rate of 6 per cent per year. But Max and Suzy have virtually no cash savings and no financial cushion except their RRSPs. If pressed for cash, they would have to sell their house or refinance it. They have placed themselves in a position of substantial risk and need to reduce it, the planner says.
"Max and Suzy have to make some long range plans in order to make their lives more secure over the next 25 years," Mr. Mastracci says. "If they buy a bigger house, then, if interest rates rise, they could find themselves unable to pay the mortgage without making many tradeoffs. This is not something that retired people seeking security should have to do. The safest course for Max and Suzy is to stay in their present house. If they want that bigger house, then Max would have to consider going back to work and Suzy would have to postpone her retirement for another five years."
"We are prepared to take the risk," Max says. "We have made less conservative assumptions and we see that our plan to buy a larger house is feasible. If interest rates rise too much, we could sell the larger house and take a capital gain."
*****
Client situation
Max, 61, and Suzy, 60, live in Vancouver.
Net monthly income: $5,150
Assets: House $450,000; RRSPs: Max $384,000, Suzy $160,000; non-registered: zero; cash $3,000.
Monthly expenses: Property taxes $208; house repair $200; utilities, phone $167; cleaner $125; food $700; car: gas, repair $290; garden $140; cable, Internet $70; dining out $130; entertainment $390; miscellaneous $445; gifts, charity $250; medical payments $150; insurance: car $225, life and travel $104, house $70; fees, dues $110; travel $800; savings $576.
Total: $5,150
Liabilities: Nil
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