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By Andrew Allentuck
Special to The Globe and Mail
Saturday, August 25, 2007
A couple we'll call Mark and Nancy, both 30, have been married for two years. Mark, who works for a construction company, and Nancy, a school teacher, live in Toronto. Their gross income, $121,340 a year, provides a house and allows them to make investments. But they anticipate challenges when they begin a family.
Adrian Mastracci, fee-only portfolio manager at
KCM Wealth Management in Vancouver, says, "This is a savvy couple who are able to handle their present debts and build up capital."
And if Nancy goes back to university to get an advanced degree, even on a part-time basis, their income could decrease. In an expensive city, their plans could put what they have built at risk.
"We would like to hold on to our current property and use it for rental income," Mark explains. "We assume that real estate in Toronto will continue to increase in value and is a worthwhile investment. What is the best way to allocate our money in order to save for a second home and our other goals?"
WHAT OUR EXPERT SAYS
Facelift asked Adrian Mastracci, a portfolio manager and financial planner who heads KCM Wealth Management Inc. in Vancouver, to work with Mark and Nancy to test the feasibility of their plans and to devise a way to realize their goals.
"The couple want to start having children, likely within one year, accumulate a down payment for a second home, reduce their mortgage and, in the future, buy a second home, fund a registered education savings plan [RESP] pay off their debts, and retire by 55 or 60," the planner says. "It's a tall order."
Mark and Nancy have a good chance of achieving some of their goals. The reason - out of a net monthly income of $7,665, they save $2,412 each month. That's 31 per cent of their disposable income after payment of their mortgage each month. Currently, those savings are allocated to $625 to registered retirement savings plans, $100 to Nancy's education fund and $1,200 to home renovations later this year. They also put away $487 for a down payment on a second home.
The couple's finances are sound right now, but that could change if they were to borrow another $240,000 for the second house. That would give them a total debt of $553,332, including a $17,000 Home Buyers' Plan loan. That sum would be six times their $91,000 annual net income, Mr. Mastracci calculates. Their plan would be to live in the second home and rent out the remainder of the room in their first house, in addition to space they already rent to produce $12,000 in net annual income.
Mark has $47,000 in unused RRSP room in plans with a total value of $5,800. Nancy has $20,500 of room in RRSP plans with a present value of $11,800. They have $4,800 of non-registered investments, $11,000 in cash, and $5,000 in shares of Mark's company. Their house mortgage, with a 4.74-per-cent loan that has 5½ years to run, carries a balance of $296,300.
There are substantial costs in raising a child, but Mark and Nancy can begin to cover those costs by reallocating the $1,200 they have been saving each month for home renovations to infant care costs of perhaps $500 to $800 a month, the planner notes.
Mark and Nancy are exceptionally well organized in their finances, Mr. Mastracci observes, but there are problems. They have many savings accounts and plans, but they have not been co-ordinated and there is no structure or strategy in place.
Rather than borrow more money, Mark and Nancy should reduce risks. They should increase their emergency fund from its present level of $5,100 to three months of living expenses, about $15,000. Mark and Nancy have roughly similar annual incomes that average $54,370. They are in a 31-per-cent tax bracket. Every dollar contributed to their RRSPs generates a 31-per-cent tax reduction. Paying down their 4.74-per-cent mortgage has a 6.9-per-cent "yield" on an after-tax basis.
Putting $7,500 a year into their RRSPs is an acceptable compromise, Mr. Mastracci suggests. The $2,325 tax refund can be used for mortgage paydowns, he adds.
Mark and Nancy can increase their liquidity by extending the amortization period of their house. If they use a graduated repayment plan, they can pay perhaps $10,000 a year for two or three years, then raise the payments as their incomes and mortgage agreement permit. There could be interruptions when the baby arrives, but the idea is to raise payments as their income allows, with time out for Nancy's maternity leave.
At the age of 30, Mark and Nancy should not worry unduly about retirement.
Debt reduction should be their focus. But, for planning purposes, the couple could support their way of life on an annual income of $60,000 in today's dollars, before tax, starting at 55 or 60. If inflation runs at an average annual rate of 2.5 per cent a year and investments return 6 per cent a year, then, assuming that Mark lives to age 83 and Nancy to age 88, they would need $950,000 of capital in addition to the net value of their house, Canada Pension Plan and Old Age Security payments, and an estimated $31,500 employment pension for Nancy at age 56. If they want $80,000 a year before tax, they would have to build up capital of $1.7-million. A $100,000 annual income before tax would require capital of $2.45-million, Mr. Mastracci explains.
The couple's investments should be restructured to improve their chances of reaching their retirement goal. At this stage of their lives, they can comfortably afford the risk that goes with a fairly aggressive 70-per-cent allocation of assets to stocks and 30 per cent to fixed-income investments. Index funds or exchange-traded funds with low fees are an efficient way to achieve that allocation, the planner says.
After their first child's birth, the couple can consider setting up a family registered education savings plan.
The March, 2007, federal budget raised the bar for contributions so that each child can get $2,500 a year to qualify for the $500 Canada Education Savings Grant. If the parents deposit $2,500 a year for 15 years, the RESP would grow to $81,500 at an assumed 8-per-cent annual rate of return on invested assets, Mr. Mastracci estimates.
When their child arrives, it will be appropriate for the couple to buy life insurance. Mark would need $400,000 of death benefits and Nancy $200,000 of death benefits. Costs would be about $350 a year for Mark, depending on policy details. Nancy's policy would be about $200. A joint "first to die" policy could be an economical way to provide the coverage and would save perhaps $100 of annual premiums.
"This is a savvy couple who are able to handle their present debts and build up capital," Mr. Mastracci says. "But adding to their debt to buy a second house is unwise right now. It is essential that they reduce their present mortgage to less than $100,000 before they add the debt that would go with a second property. They must not sacrifice what they have built with disciplined saving."
AT A GLANCE
The Couple
Torontonians with good incomes eager to build assets with borrowed money.
The Problem
Leverage adds risk that could cripple financial plans.
The Plan
Raise cash levels, reduce debt and invest with moderate aggressiveness.
The Payoff
More security for the family they plan to start.
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