Situation: A couple with a six-figure income and two secure jobs fears stocks, bonds and professional advice
Solution: Do the math and take some risk, with study and advice. Be aware of the cost of inflation
In Alberta, Bill, 55, and Lucy, 49, have raised two children, one of whom lives at home while attending university. Their monthly income after tax and deductions is $13,810, mostly from Bill’s work at an electrical firm. He’ll have no defined benefit pension, but Lucy, a health-care professional, can take a $2,500 monthly defined benefit pension at age 55 if she works at her present salary, $5,750 per month before tax, until retirement.
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A major problem is that the income they will earn from Lucy’s $30,000 annual work pension and $1,372,000 in financial assets will be badly eroded by inflation unless they change from holding almost all their savings in GICs and cash. The couple is nervous about investing in stocks and bonds, and would rather accept asset depreciation by inflation than losses in capital markets. They have refused to work with financial planners because they don’t believe the advice provided will be worth the fees they would have to pay. They asked Family Finance to help.
Inflation erodes savings
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with the couple. He notes they have no debt and modest expenses, except for $1,600 per month they spend on travel and entertainment. The problem is the couple’s current asset mix is unlikely to produce sufficient retirement income should they decide to take the plunge in approximately five years. Cash would pay bills for a while, but the erosion of purchasing power, at a loss of about 3 per cent per year, would cut 30 per cent of their real income (apart from indexed Canada Pension Plan and Old Age Security) in a decade and twice that in 20 years. An aversion to stocks and bonds is a path to poverty.
The couple’s present monthly allocations include RRSP, TFSA and non-registered savings that total $6,765 per month. Peel those away and the couple’s core spending is reduced to $7,045 per month, or $84,540 per year. That represents 6.2 per cent of their $1,372,000 financial assets. They could achieve that return from a mix of bank and utility stock dividends and appreciation, but an all stock portfolio is risky, especially one loaded with interest-sensitive stocks such as utilities. When interest rates rise, utilities with lots of debt will see their earnings, share prices and perhaps even dividends decline. Banks also have a lot of interest rate risk as they borrow for short terms from depositors and lend for long terms to mortgage holders. Some bond content is essential, but the mix with stocks should change over time.
Safety and taxes
The safest portfolio immune to loss of capital is 100 per cent government bonds. Government bonds pay an average of 2 per cent for 10 to 30 year issues when held to maturity. Recently, a rush to the safety of bonds has boosted their prices and returns an unusual 6 per cent at annualized rates. Stocks return about 7 per cent, counting 2.5 per cent dividends and 4.5 per cent capital appreciation.
Transitioning from being salaried employees to pensioners is problematic from a tax perspective. As employees, there are few things they can do to escape high taxation beyond exempting gains on sale of their house, which is a relatively modest 23 per cent of their total assets, investing in tax-deferred RRSPs and TFSAs. Bill pays a marginal rate of 42 per cent and Lucy 31 per cent of gross taxable income.
Were Bill to loan some of his savings, for example $402,000 of non-registered investments and cash, to Lucy with a documented spousal loan, on which she pays interest to him at a government prescribed rate of 1 per cent annually, they would save tax. On eligible Canadian dividends from banks, utilities and other public companies, his tax rate is 23.4 per cent, hers is 7.6 per cent.
In retirement, Lucy can count on a $30,000 per year pension, with 60 per cent indexed to inflation.
They have $140,000 in their TFSAs. If, accepting market risk, they continue to add $6,000 each year for five years at 3 per cent over the rate of inflation, they can have $226,000 at the beginning of Bill’s retirement in five years. That capital can generate an income of $10,050 per year for 36 years from his age 60 to Lucy’s age 90 with the same return assumption.
If Lucy and Bill save for five more years in their RRSPs, with a current value of $830,000, they will gain nothing after inflation if they stay in cash and GICs. If they continue to add $2,388 per month, which is the sum of his RRSP contributions plus Bill’s company match, to the $830,000, it would become $1,114,350 in five years in 2019 dollars at a 3 per cent return over inflation. That capital, if invested at the same rate for the 36 years from Bill’s age 60 to Lucy’s age 95, would generate $49,550 per year.
Their taxable investments, $402,000 with additions of $4,150 per month, at a 3 per cent annual real return will rise to $730,425 in five years and generate $32,500 per year at 3 per cent over the rate of inflation for the following 36 years.
When both spouses are 65 and retired, they would have Lucy’s pension of $30,000 per year, TFSA income of $10,050 per year, RRSP income of $49,550 per year, taxable investment income of $32,500 per year, CPP income of an estimated $25,324 per year, and OAS income of $14,579 in 2019 dollars, for a total annual income of $162,003. The TFSA exclusion would cut income to $151,953. That’s $75,977 per person, slightly more than the current clawback trigger point, $75,910, which would be modest at 15 per cent of the difference.
The remainder, taxed at 20 per cent, plus TFSA income put back in, would provide $10,967 to spend each month. Without the monthly allocations to RRSP, TFSA and other savings, their monthly budget would drop to $7,045. They would begin retirement affluently, but if they do not raise returns by taking on a little more risk, they could end up unable to pay bills.
Retirement stars: 3 *** out of 5
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