Reorganizing Investments and Taxes to Achieve Goals

This article originally appeared in Investment Executive, December 2008.
By Catherine Harris, Featuring Brad Brain

The Scenario

The clients, Bill and Carol, are a couple living in suburban Vancouver. Both are 55 years old and have two fully employed children in their late 20s. The couple have never borrowed except for real estate; they are frugal and fairly risk-averse.

Bill is a home-based management consultant, netting $70,000-$100,000 a year before taxes. Carol has a stable position with a non-profit organization, earning $37,000 a year. She earns another $9,000 a year by providing freelance administrative services to her husband’s practice. Carol’s employer provides the couple with good dental and extended health benefits and Carol with twice her salary in life insurance. Neither Bill nor Carol has a pension.

The couple has recently moved into a $500,000 home. As a result, they have a mortgage of $165,000 and payments of $528 every two weeks. After mortgage and taxes, they spend about $53,000 a year.

Both plan to retire at age 65 but would like to do it sooner if they can be confident of generating income of $30,000 each in today’s dollars until age 95.

Up until now, their main investments have been in real estate. They currently own two detached houses — free and clear — located in British Columbia. One of the houses could probably be sold for about $200,000, for a gain of $60,000, and the other for $400,000, for a gain of $20,000. With property-management fees, repairs and maintenance, Bill and Carol are, on average, breaking even on these properties in terms of annual income.

Bill has $120,000 in an RRSP, split evenly between exchange-traded funds and common stocks, which he trades online. Most of these assets are socially screened and are split between Canadian and U.S. equities, with a very small bond ETF. In a second RRSP, he has $16,600 in fixed-income that yields 3.5% in interest until November 2009.

Carol has $112,000 in her RRSP, with $63,000 in fixed-income and $49,000 in equities, which are mostly in ETFs and some “green” mutual funds. She also has $38,500 in a spousal RRSP; it is mostly invested in a pooled mortgage fund of first mortgages.

Bill and Carol have unused RRSP room of more than $40,000 each. Their only non-registered financial asset is a cashable certificate in the amount of $19,000, at 3% interest; this is money they have set aside to cover anticipated repairs to their new house.

From 1985 to 1995, the couple worked with a financial advi-sor and invested in mutual funds, which on average returned less than 2% a year. Since 1995, they have been handling their own investments. They are open to alternatives, but don’t want mutual funds.

The couple each has term life insurance to age 65: $198,000 for Bill and $132,000 for Carol. Bill has long-term disability coverage of $2,500 a month.

Both Bill’s and Carol’s parents helped the couple get started financially. They would like to carry on this legacy by leaving their children an estate, and would consider ways to transfer wealth to their children before their deaths.

The Recommendations

Both Brain and Corkum say the couple’s combined income goal of $60,000 annually in today’s dollars is achievable, although Corkum thinks the sale of at least one of the rental properties will probably be necessary.

But both advisors wonder how recession proof the couple’s jobs are. Consultant fees often drop and non-profits sometimes cut back on staff in economic downturns. Corkum recommends the couple set up a high-interest online or telephone banking savings account, with monthly contributions made until the account accumulates about $20,000 — or three months’ living expenses — for an emergency fund.

Neither Brain nor Corkum is impressed with the return the couple are getting on the rental properties. Corkum’s rule of thumb is that a rental should generate enough income to cover a mortgage for 75% of the property value amortized over 25 years, as well as the other costs.

The advisors are also disturbed by the lack of diversification: 68% of the couple’s assets are in real estate, with only 19% in equities and just 11% in fixed-income.

Unless there is an expectation of strong capital appreciation, Brain and Corkum recommend the sale of the properties as soon as it makes sense in terms of housing market conditions. Both advisors say that if the couple really want to have a real estate investment, they should look for a property that generates more cash flow.

Another possibility, says Corkum, is that the couple consider selling their new house and moving into one of the rentals, if one would work for them in terms of size and location. They won’t have to pay capital gains taxes on the rental property until it is sold — allowing them to invest all the proceeds from the sale of the new house. The only caveat is that they would have to pay taxes on any capital cost allowances they had previously claimed on the rental house they move into.

The question of how Bill and Carol should invest their financial assets, given their general aversion to mutual funds, is not a problem for Corkum. He feels the couple’s current strategy of investing in ETFs is fine, although he would recommend complementing this with some conservative, dividend-paying, blue-chip stocks — if they can find an investment advisor in whom they would have confidence.

Brain, however, thinks they should not rule out mutual funds. He is puzzled by their experience, noting that the 1985-95 period was a great decade for investment returns. Even cash had an annual average compound return of 8.9%, while Canadian equities returned 9.7%; Canadian bonds, European equities and Far East equities, 15.5%; and U.S. equities, 16.6%.

The reason for the couple’s poor returns, he suspects, may lie not in the products, but in the advisor or the couple themselves. Bill and Carol may have fallen into the trap of buying high and selling low. If that’s the case, the same thing is likely to happen in the future — unless the clients understand what happened and change their strategy to one of buying and holding for the long term.

Assuming they can get past their aversion to funds, Brain recommends investing in segregated funds with guaranteed minimum withdrawal benefits that are invested 40% in fixed-income and 60% in equities and pay out 5% of the asset value each year after they turn 65.

Brain’s projections suggest that if the couple invests their RRSPs and the proceeds from the sale of both rental properties in such funds, they could expect a minimum annual retirement income of $72,500 in today’s dollars. That is assuming an annual average compound return of 7% after fees, similar to the returns that occurred in the 1988-2007 period. At age 95, this would leave them with $400,000 in today’s dollars.

Corkum thinks the couple could have an estate — of around $1.4 million — assuming an asset mix of 50% fixed-income, 30% equities and 20% real estate. He uses the same 7% return as Brain, but factors in inflation of 3%. If Bill and Carol don’t want to leave that big an estate, Corkum adds, they could retire at age 60 instead.

Brain thinks Bill and Carol need to wait until age 61 to retire if they are assuming 3% inflation. If they are concerned about inflation eating into their purchasing power, they should assume 4% inflation in their projections. He notes that most people spend less in retirement than when working.

Brain says Bill and Carol could retire earlier if they spend less. He notes that their retirement income goal of $60,000 in today’s dollars is higher than the $53,000 they are currently spending.

Both Corkum and Brain recommend the couple start making maximum RRSP contributions. They also suggest Bill fund his wife’s spousal RRSP using his unused contribution room, to help with income-splitting in retirement. Bill’s annual contribution would depend on Bill’s income that year. If he makes $100,000 in any given year, he could contribute as much as $25,000 and get 38% of that back. If his income is $70,000, he gets a refund of only 32.5%.

Corkum adds that Bill should use his RRSP contributions to boost Carol’s total RRSP assets so that they are roughly equal to his by the time the two retire.

Brain thinks making RRSP contributions is more important than paying down the mortgage on the home because of the tax credit. If the couple also want to pay down the mortgage, he says, they can use the money they get back through the tax credit to do so.

Corkum feels either option is fine, as long as they are committed to the strategy.

Both advisors recommend that RRIFs be set up for Bill and Carol at retirement to maximize pension-splitting.

Brain feels insurance is crucial. Besides suggesting the GMWB funds, he recommends switching to a permanent life policy from the term 65 insurance they currently have. This will satisfy their desire to leave an estate for their family.

Critical illness and long-term care insurance should also be considered, says Brain. If anything happens, they are covered and wouldn’t have to worry about depleting their assets.

Corkum feels life insurance will not be needed after they reach 65 and the term policy is fine in the interim. “Their savings should be sufficient to cover the cost of long-term care,” he says.

Corkum agrees that CI insurance should be considered. He suggests leaving Bill’s term insurance, but cancelling Carol’s because Bill should have sufficient income if Carol dies before age 65.

Corkum also suggests personal liability in their home and auto insurance policies of $5 million. In addition, because of Bill’s consulting practice, he recommends that Bill incorporate, which would limit errors and omissions liability as well as provide creditor protection. If Bill doesn’t want to go that route, then he should at least make sure the family assets are in Carol’s name.

In addition, Corkum recommends evaluating Carol’s contribution to the business. If it’s worth more than $9,000, he suggests increasing her salary. He says the couple will save $100 in taxes for each additional $1,000 Bill’s company pays her.

Brain also suggests incorporation because it opens the door to the possibility of Bill setting up an individual pension plan. Greater contributions can be made to IPPs than to RRSPs, and additional contributions can be made if the income generated falls short of the annual income goal of the IPP. Calculations would have to be made to see if the couple would benefit from an IPP for Bill.

Both advisors suggest testamentary trusts for the children in the couple’s wills, but no transfer of capital to the children at this time. “They don’t have enough assets to deplete them safely,” says Corkum, “given their age and life expectancy.”

Testamentary trusts can save the children taxes, he notes, as such trusts are taxed separately. In addition, trusts may be creditor proof in the event of marriage breakdown or financial difficulties. The couple should consult a lawyer about setting up the testamentary trusts.

Brain would not charge a fee for the financial plan if he was managing their investments.

Corkum, who doesn’t invest money himself, would charge about $2,000 to develop a financial plan. Periodic reviews would probably cost $1,000 or less, given his hourly fee of $165 an hour.

This article was posted in Ask The Expert.
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