In Vancouver, a couple we’ll call Adrian, 62, and Vicky, 58, are moving toward retirement as they reduce their work in management consulting. Their goal is to retire fully in a few years, but they are not sure if they can afford to maintain their way of life in their $1.7-million house. For now, they are spending $5,850 per month. But their current after-tax income is $2,600. Their secured line of credit, $435,000, pays the difference. Their total liabilities are 14 times their annual income. They have nearly $947,000 in retirement savings and $28,000 in other savings. The problem is eliminating debt before they retire.
Family Finance asked Graeme Egan, a financial planner and portfolio manager with KCM Wealth Management Inc. in Vancouver, to work with Adrian and Vicky.
The dilemma
“The old saying that you can’t have your cake and eat it pretty well sums up Adrian and Vicky’s problem,” Mr. Egan says. “Their house has an after-tax opportunity cost — what its value could earn if invested — of, let’s say, conservatively, 3% of $1.7-million or $51,000 per year or more if the return estimate is raised. They have to live someplace, but the house costs them the equivalent of rent at $4,250 per month or more if upkeep and heat are added. They can’t afford it. Either the house has to be downsized, remortgaged with a longer amortization and cash extracted or a few rooms rented out. Hard decisions have to be made.”
The five-year plan
Year 1 (2011) There is no need to force the retirement decision for at least two years. Adrian and Vicky should continue to work to the end of 2012 or early 2013. They can use their $21,000 tax-free savings accounts and sell $7,000 of non-registered mutual funds for cash to reduce their line of credit annual drawdown as they wind up their business toward the end of the two-year period. They should pay interest only on the line of credit that includes their $435,000 home debt. It has a variable interest rate, 3% for now. They can pay off the line of credit when the house is sold, Mr. Egan suggests.
Year 2 (2012) The couple can wrap up their consulting business toward the end of the year. Both will be retired and dependent on pension and investment income.
Year 3 (2013) Vicky will be 60 in 2013 and can take Canada Pension Plan benefits, albeit at a rate reduced by 0.6% compared to what she would get at age 65. Her CPP benefits will therefore be reduced by 36% if she takes them at age 60. Based on an expectation that she could receive $857 per month at age 65, she will receive $548 per month if she begins benefits at age 60. Adrian already receives $800 per month in CPP benefits before tax.
It is time to make a decision about keeping or selling the house, cutting debt and converting the high intrinsic cost of occupancy to an income-generating asset. Incurring more debt, as they have done by living on their line of credit, is unwise. The bill would eventually have to be paid and probably at a higher interest rate than the 3% they have been paying. Renting a room would reduce their privacy and would not produce enough income.
Sale and investment of proceeds is the best alternative. Assuming they can harvest $1.7-million less their $435,000 mortgage (about $415,000 by 2013) — roughly $1.25-million after selling costs for investment, they will need to replace their home. If they spend $500,000 on a condo, they will have $750,000 left for investment. While the capital gain on the sale of their house will not be taxable, any income flowing from investment of that capital will be subject to taxes, Mr. Egan says. Thus, they should split the proceeds of the sale, assuming they made similar financial contributions to the property.
Year 4 (2014) Adrian is 65 and can convert some of his RRSP to a Registered Retirement Income Fund. He can then take $2,000 per year as pension income exempt from tax. He can also begin to receive Old Age Security benefits.
Year 5 (2015) Funds surplus to the couple’s immediate needs can be put into a tax-free saving account. They could direct $5,000 of contributions to a Registered Education Savings Plan for their two grandchildren. Those contributions will qualify for grants of the lesser of $500 per child or 20% of amounts contributed.
For the longer term
Adrian and Vicky need $5,000 per month, or $60,000 per year after tax, for retirement expenses — about what they spend now less mortgage payments they will no longer make. If they pay a 25% average income tax rate, they will need $80,000 before tax. They will have $16,176 combined annual CPP benefits and $6,322 each in annual OAS benefits for a total of $28,820 in total public pensions before tax when both are 65. To reach the $80,000 target, they will need another $51,180 in pre-tax income.
If they have $750,000 from downsizing their house and $947,000 in their RRSP balance, they will have total registered and non-registered financial capital of almost $1.7-million. If that sum were invested to sustain a 5% annual payout before inflation adjustment to Vicky’s age 90, they would have pre-tax investment income of $110,392 per year and total pre-tax annual income of $139,212. Careful splitting of pensions will avoid almost all the OAS clawback that currently begins at $66,733. They can spend or save this surplus income or direct it to their children, grandchildren or to good causes.
Adrian and Vicky should be able to get 5% from their portfolio before inflation adjustment and tax. These days, investment-grade corporate bonds pay 4.5% to 5.5%, depending on term and quality. In combination with diversified utility and financial stocks that offer dividends of 3.5% to 4.5% and some capital appreciation, the 5% overall rate of return is attainable, the planner says.
Adrian and Vicky have invested their money in several well-chosen mutual funds. The problem is the fees on their funds average 2%, which is below the 2.4% average for stock funds that historically return 6% to 7% per year. But the fees eat up a lot of their bond interest and dividend income. Currently, 70% of their investments are in fixed income while 30% are in equities. They are paying a lot for the income they are receiving, Mr. Egan says. All their mutual funds are front loaded; they have paid their sales fees. If they can save 1% to 2% in management fees, their net returns will rise, especially in predictable bond interest. They should discuss use of low-fee exchange-traded funds with their investment advisor or seek portfolio management at fees of 1% to 1.5% per year.
“If Adrian and Vicky downsize their house, eliminate debt and guard their investment returns, they should have a similar way of life to what they have now,” Mr. Egan says. “Most of all, they will have financial security.”
Financial Post
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