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FINANCIAL FACELIFT: Can this couple still retire in three years after their investments took a major hit?

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Below you will find a real life case study of a couple who are looking for financial advice on how best to arrange their financial affairs. Their names and details have been changed to protect their identity. The Globe and Mail often seeks the advice of our VP, Wealth Advisor, Matthew Ardrey, to review and analyze the situation and then provide his solutions to the participants.

gam-masthead
Written by:
Special to The Globe and Mail
Published April 10, 2020

Robert and Rachel have worked hard, raised three children and – thanks to high income and frugal living – amassed an impressive portfolio of dividend-paying stocks, which they manage themselves. When they approached Financial Facelift in February, their combined investments were worth about $2.7-million.

After the coronavirus tore through financial markets last month, their holdings tumbled to a little more than $1.8-million by late March, a drop of roughly $900,000, or 33 per cent. Markets have since bounced but are still well below their February highs.

“The recent market downturn caught us by surprise,” Robert acknowledges in an e-mail, “but we are hoping we can weather the storm.”

Robert, a self-employed consultant, is 57. Rachel, who works in management, is 52. Together they brought in about $285,000 last year, although Robert’s income prospects for this year are uncertain. They have three children, ranging in age from 9 to 19.

“We feel burned out,” Robert writes, “but we have no company pensions or other safety blankets. Can we retire now?”

Leading up to retirement, the couple want to do some renovations costing $100,000 and take up recreational flying, which they estimate will cost about $150,000. Their goal is to quit working in three years with a budget of $100,000 a year after tax. Can they still do it?

We asked Matthew Ardrey, a vice-president and financial planner at TriDelta Financial in Toronto, to look at Robert and Rachel’s situation.

What the expert says

“The rapid decline and subsequent volatility of their investments is a result of how they are investing,” Mr. Ardrey says. Their portfolio is 85 per cent common stocks and 15 per cent preferred shares, the planner notes. “Of the common stock, about 90 per cent is Canadian. This lack of diversification in their investment strategy will affect their retirement plans.”

For the first quarter, major stock markets were down more than 20 per cent, he says. “The fixed-income universe in Canada was up 1.56 per cent for the quarter.” Having some fixed-income securities “would have mitigated the couple’s losses.”

In preparing his forecast, Mr. Ardrey weighs some different situations. He assumes their investment returns from this point forward equal the long-term average for this type of portfolio of 6.25 per cent. This rate of return continues until they retire from work in three-and-a-half years.

When Robert and Rachel retire, the planner assumes they reduce their exposure to stocks and switch to a balanced portfolio of 60 per cent stocks and 40 per cent bonds. This would give them a return of 4.5 per cent. “From there we can compare how much impact this market decline had on their portfolio.”

Their original $2.7-million would have given them a net worth at Rachel’s age 90 of $10-million, adjusted for inflation, including their residence and rental property valued at $5.4-million, Mr. Ardrey says. If they chose to spend all of their investments, leaving the real estate for their children, they could have increased their spending from $100,000 a year to $136,000, adjusted for inflation, giving them a comfortable buffer.

With their current portfolio – about $2.2-million as of April 6 – they would have a net worth of $8.4-million at Rachel’s age 90, including $5.4-million in real estate. They would have the option of increasing their spending to $118,000 a year. “This is half of their former buffer, which is a significant difference,” Mr. Ardrey says.

Even if the markets returned double the couple’s historical rate of return, or 12.5 per cent, from now until they retire, “it would still not make up all of the difference of what they have lost,” the planner says. Their net worth at Rachel’s age 90 would be $9.5-million and they could increase their spending to $130,000.

This market downturn speaks to the value of a balanced, diversified portfolio and professional money management, Mr. Ardrey says. “In so many cases, people try to invest on their own without truly understanding their ability to tolerate risk, or without a financial plan in place” to help them understand the implications of market returns on their retirement.

He recommends Robert and Rachel gradually shift to a professionally managed portfolio that includes both large-capitalization stocks with strong dividends, diversified geographically, and a fixed-income component comprising corporate and government bonds. This strategy could be supplemented with some private income funds – which do not trade on financial markets – to stabilize their returns and potentially enhance their income.

By making this change, they could increase their rate of return in retirement from 4.5 per cent to 5.5 per cent, giving them an additional financial cushion of $12,000 a year. “This would be especially beneficial if markets take a long time to return to their former highs,” Mr. Ardrey says.

The plan assumes Robert will get 85 per cent of Canada Pension Plan benefits and Rachel 75 per cent, starting at age 65. They will both get full Old Age Security benefits.

Fortunately, this couple have ample resources, including real estate, that they can use to insulate themselves against unexpected expenses, Mr. Ardrey says. Many other Canadians who have been investing in the same manner do not. Worse, many investors may have other financial stresses such as a lost job or mounting debts that could force them to liquidate their portfolio at an inopportune time, the planner says.

“What the past month has shown is that there are significant risks to do-it-yourself investing and not having a proper asset mix in place – especially as you approach retirement.”

Client situation

The people: Robert, 57, Rachel, 52, and their three children.

The problem: Can they retire in about three years without jeopardizing their financial security?

The plan: Retire as planned but take steps to draw up a proper financial plan that includes a more balanced investment strategy.

The payoff: Lowering potential investment risk to better achieve goals.

Monthly net income: $16,720

Assets: Cash $32,875; stocks $589,775; capital in his small business corporation $157,080; her TFSA $82,220; his TFSA $57,035; her RRSP $446,145; his RRSP $621,755; her locked-in retirement account from previous employer $76,405; his LIRA from previous employer $184,825; registered education savings plan $81,260; residence $1,800,000; recreational property $650,000. Total: $4.78-million

Monthly outlays: (including recreational property): Property tax $1,215; home insurance $125; utilities $495; maintenance $240; transportation $650; groceries $1,105; clothing $435; gifts $215; vacation, travel $325; dining out, entertainment $385; pets $45; sports, hobbies $625; piano lessons $160; other personal $415; doctors, dentists $200; prescriptions $70; phones, TV, internet $140; RRSPs $1,830; RESP $630; TFSA $915; savings to taxable accounts $7,460. Total: $17,680.

Liabilities: None

Want a free financial facelift? E-mail finfacelift@gmail.com.

Some details may be changed to protect the privacy of the persons profiled.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230

FINANCIAL FACELIFT: Can Olivia and Larry retire early with an ideal income of $10,000 a month?

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Below you will find a real life case study of a couple who are looking for financial advice on how best to arrange their financial affairs. Their names and details have been changed to protect their identity. The Globe and Mail often seeks the advice of our VP, Wealth Advisor, Matthew Ardrey, to review and analyze the situation and then provide his solutions to the participants.

gam-masthead
Written by:
Special to The Globe and Mail
Published January 10, 2020

People with ambitious financial goals are wise to start planning well in advance. So it is with Olivia and Larry, both 38, who hope to retire from work in their late 50s with substantially more discretionary spending power than they have now.

Larry brings in $125,500 a year plus bonus in a senior management job. Olivia earns $65,000 a year in education. They have a daughter, 4, whom they want to help get established financially when the time comes.

First, though, they plan to sell their Toronto-area house and move back to Montreal soon to be close to family and friends. Larry’s income is not expected to suffer in the move, but Olivia’s could be cut in half. Also, her defined benefit pension entitlement will be lower than if she stayed in her current job.

In 20 years or so, when they retire from work, Olivia and Larry hope to travel extensively, which partly explains why they have set their retirement spending goal so high: $120,000 a year.

“Can we retire early with an ideal income of $10,000 a month after tax?” Larry asks in an e-mail.

We asked Matthew Ardrey, a financial planner and vice-president at TriDelta Financial in Toronto, to look at Larry and Olivia’s situation.

What the expert says

Mr. Ardrey starts by reviewing the couple’s cash flow. According to Larry and Olivia, they spend everything they earn and sometimes have to dip into their tax-free savings accounts (TFSAs) to keep up with their car payments.

Yet when Mr. Ardrey runs the numbers, Larry and Olivia provided, he finds they actually have a surplus of $12,800 a year. (Income includes tax refunds from RRSP contributions.)

“This is a significant difference and does not even account for Larry’s variable bonus, which he requested to keep out of the projection,” the planner says. Because most people know what they earn and save, “we can assume the difference lies in the spending part of their budget,” Mr. Ardrey says. “Thus, a full review of their budget and spending is recommended.” In his analysis, the planner assumes they are spending the extra $12,800 a year on outlays not listed in their monthly expenditure form. That would include items such as household maintenance and repair, for example.

They are saving $650 a month to Larry’s RRSP, which his company matches 100 per cent, $160 to their child’s registered education savings plan (RESP) and $150 each to their respective TFSAs. Olivia contributes $600 a month to her work pension plan, an amount that is estimated to drop to $300 a month when she begins working in Montreal.

Some time in the next couple of years, Olivia and Larry would like to leave Ontario and return to Montreal. They would sell their house and purchase a smaller home in Montreal for about $600,000. “If we assume selling/moving costs of 10 per cent of the selling price, and that they pay off all their existing debts, they will need only a small mortgage of $30,000 for this transaction, which they can pay off in a few years at $1,000 a month,” Mr. Ardrey says.

The move to Montreal will affect their financial situation both positively and negatively, the planner says. Olivia’s income will drop about 50 per cent, which will also affect her DB pension. But their ability to save will increase because of the lower debt obligations. The planner assumes they direct these savings to their TFSAs and Larry’s RRSP. Any remaining surplus could go to a non-registered investment account.

The couple want to retire at the age of 57. Mr. Ardrey’s forecast assumes that at 65, Larry and Olivia will get 80 per cent and 60 per cent, respectively, of CPP/QPP (Quebec Pension Plan) benefits, and full Old Age Security benefits. Olivia’s pension estimate at age 57 is $27,182 a year in today’s dollars because of her reduced income. The couple’s baseline retirement spending target is $7,000 a month, plus $1,000 a month for five years to help their daughter, and another $2,000 a month for 25 years for travel.

Next, Mr. Ardrey looks at what Olivia and Larry can expect to earn from their investments. Their portfolio is 90-per-cent stocks and 10-per-cent fixed income, which produced a historical return of 6.1 per cent a year, he says. In retirement, he assumes their mix becomes more conservative (60-per-cent stocks/40-per-cent fixed income) and that they earn 4 per cent a year net of investing costs.

“Based on these assumptions, they fall short of their retirement goal,” Mr. Ardrey says. “They run out of savings in 2059 when they are 78.” (They would still have Olivia’s pension, their government benefits and their residence.)

If Olivia retired at 57 and Larry worked to 59, “they will reach the break-even point in their retirement spending,” the planner says. To have a surplus, they would have to work even longer, spend less or achieve a better rate of return.

To generate better returns, they could make some improvements to their investment strategy, he says. Larry’s group RRSP is well diversified, but their other investments are almost solely in five Canadian large-cap stocks. This lack of diversification “is adding significant risks,” the planner says.

As long as their portfolio is less than $500,000, they should consider broad-based exchange-traded funds, he says. ETFs offer low-cost diversification by company, asset class and geographic location. Once their portfolio passes the $500,000 threshold, they could consider hiring an investment counsellor or portfolio manager, Mr. Ardrey says. These firms charge a fee based on the size of the portfolio and have a fiduciary duty to act in their clients’ best interests. Investment counsellors tend to offer their clients investments that are not available on publicly traded markets – such as private debt and equity funds – designed to provide steady returns that are not subject to the ups and downs of financial markets.

Client situation

The people: Larry and Olivia, both 38, and their daughter, 4

The problem: Can they afford to retire at the age of 57 and spend $10,000 a month even if Olivia’s income drops?

The plan: Olivia retires as planned, but Larry works another two years to 59. They take steps to diversify their holdings and improve their net returns.

The payoff: Goals achieved.

Monthly net income: $11,685

Assets: Cash $3,120; his TFSA $74,020; her TFSA $66,350; his RRSP $125,510; her RRSP $16,210; estimated present value of her DB pension $42,250; RESP $13,160; residence $1.1-million. Total: $1.44-million

Monthly outlays: Mortgage $3,165; property tax $505; home insurance $60; utilities $300; transportation $650; groceries $570; child care $510; clothing $265; car loan $660; gifts, charity $540; vacation, travel $415; dining, drinks, entertainment $660; personal care $145; other personal $145; life insurance $150; cellphones, internet $170; RRSP $650; RESP $160; TFSAs $300; her pension plan contribution $600. Total: $10,620 Surplus of $1,065 is spending unaccounted for.

Liabilities: Mortgage $526,640; line of credit $26,865. Total: $553,505

Want a free financial facelift? E-mail finfacelift@gmail.com.

Some details may be changed to protect the privacy of the persons profiled.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230

Why investors should pay for all investment fees out of non-registered accounts

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The Department of Finance Canada’s recent letter to the Canada Revenue Agency (CRA) stating that paying investment fees for registered accounts out of non-registered accounts does not constitute a tax advantage is a big win for investors, who are now free to pay their investment costs from any source they choose.

There are various advantages for investors to pay all investment fees out of a non-registered account. At the core, though, investors will end up with more money, after taxes, if they pay all the investment fees for a tax-free savings account (TFSA) or registered retirement savings plan (RRSP) from assets held outside of those accounts.

So, how did this all come about? In 2016, the CRA announced at a tax conference that its position on paying investment fees for registered accounts from non-registered accounts constituted an unfair advantage. Furthermore, the CRA stated that as of 2018, any taxpayer who engaged in this activity would be subject to a special advantage tax equal to the amount of fees paid outside of the registered account. The implementation was then postponed a couple of times pending a review from the Department of Finance.

Then, the Department of Finance sent a letter this past August recommending that the Income Tax Act be amended to reflect its finding that there is no advantage to paying registered fees outside of a registered account and that such a decision by a taxpayer may not necessarily be tax motivated. In effect, it means the CRA will not penalize a taxpayer for paying investment fees for a registered account from a non-registered account.

For financial advisors and investors, there are various benefits to taking this approach, which is a way to increase assets with no added risk.

For one, investors may have investments that are less liquid in the registered account. So, paying for investment fees from a non-registered account can provide ease of cash management over the portfolio. In addition, paying all investment fees out of one account rather than from multiple accounts may be easier from an administrative perspective.

The main advantage for investors, though, is that registered accounts have an ability for greater compounding of returns than non-registered accounts because of the registered accounts’ tax-deferred or tax-free nature. That was the CRA’s main issue with this practice.

As an example, let’s consider an investor who has $100,000 in a TFSA and $100,000 in a non-registered account. Each account incurs investment expenses of 1.5 per cent, or $1,500, annually.

If all expenses are taken from the non-registered account, it results in more assets growing tax-free within the TFSA, as they’re not impeded by investment costs. Furthermore, it helps the investor save taxes as the capital base in the non-registered account will be lower, which will result in lower taxes against the income within that account as well as lower taxes on the capital gains when the funds are withdrawn.

The strategy is similar for an RRSP, except that the income from the RRSP will be fully taxable when it’s withdrawn from an RRSP or from a registered retirement income fund (RRIF) once the investor reaches retirement. Thus, the investor reduces the capital in the non-registered account today in favour of a much larger payment from a RRIF in the future. Although that payment will be taxable, it will presumably be when the investor is retired and in a lower tax bracket. In addition, as inflation will erode the value of money, it’s preferable to pay $1 of taxes in the future than $1 of taxes today.

Although the advantage in the TFSA is clear, the advantage for the RRSP will be dependent on many factors, such as an investor’s tax bracket now and in retirement, inflation and even potential changes in tax policy.

For investors, this may not be the top tax-saving strategy available, but they should take advantage of every opportunity to improve their returns and reduce their taxes – especially when it can be executed with a simple administrative change.

 

Reprinted from the Globe and Mail, December 18, 2019.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230

Pensions 101: The importance of understanding your pension

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I have been involved with the Financial Facelift articles since 2013 and in the financial planning industry since 2000. In my time working on the Financial Facelifts, I have been asked many questions about my calculations and recommendations; but bar none, questions about pension calculations have been the most frequent.

With that in mind, there is no time like the present to give a refresher course on how pensions work, how their value is calculated and why they are so important.

There are two main types of employee pensions in Canada, defined contribution (DC) and defined benefit (DB). Both are important to the financial well-being of their members in retirement, though they both work in different ways.

DC pension plan

The DC pension is more like a registered retirement savings plan (RRSP) in the way it works than what most people would traditionally think of as a pension. In this type of pension typically both employee and employer make contributions to the plan. They are usually based on a percentage of income, up to the contribution limit. These contributions are then invested in underlying investments directed by the employee and vetted by the employer.

How the contributions affect RRSP room is fairly straightforward to understand as well. For every dollar contributed, the employee accumulates a dollar of pension adjustment and thereby their available RRSP room is reduced by a dollar. This is regardless of who makes the contribution. The only difference in the contributions is the employee contributions are eligible for a tax deduction and the employer contributions are not.

The purpose of the pension adjustment is to equalize the retirement savings an employee with a pension can make versus someone who does not have a pension.

On retirement, the employee can transfer the value of the plan to a locked-in retirement account (LIRA), use it to purchase an annuity or a combination of the two. With recent federal budget changes a variable payment life annuity (VPLA) or an advanced life deferred annuity (ALDA) are also options to consider.

The current value of this pension is easily known by taking a look at the value of the underlying investments. What is unknown is what future income this pension will produce. As the name says, it is a defined contribution pension, which means the contributions to the plan are known, but the retirement income is dependent on the investment returns earned and contributions made.

One of the main benefits of a DC pension is that it forces the employee to make retirement savings. By having it as part of the employment culture, and the savings coming right off of one’s pay, it encourages employees to save for their future.

The other key benefit of the DC pension is the employer contributions to the plan. Each plan is different. Some employers may choose to match employee contributions, some may choose to make contributions regardless and some may combine the two in some fashion. No matter how they do it, the benefit is clear to the employee, it is free money toward their retirement savings.

The DB pension plan

The DB pension is what most people think of when they think of a pension. This type of pension provides a known future income stream to the employee – in other words, a defined benefit to the employee. For this benefit the employer, and sometimes the employee, make contributions to the plan that are invested to provide the future income stream. Depending on the investment performance, this may require more or fewer contributions from the employer.

While the end result – a guaranteed income stream – is easy to understand, getting there is a bit complicated. For starters, the DB pension adjustment is harder to calculate than its DC counterpart. Formulas that determine your future benefit involve such inputs as one’s yearly maximum pensionable earnings (YMPE), final average earnings (FAE) and years of service.

To further complicate the DB pension calculation, some pensions have Canada Pension Plan/Old Age Security integration. This is where a bridge payment is made between when the pension commences and age 65 to be later offset by the receipt of CPP and OAS. To note, this integration is not perfect, often being different than the actual CPP and OAS received.

There is also the matter of survivor benefits. If the pensioner is married/common-law, then the pension will pay out a survivor benefit to the spouse upon the death of the pensioner. The automatic selection is typically 60 per cent of the full pension amount, but a higher or lower percentage can be selected. This will raise or lower the actual calculated pension payment based on mortality rates.

So now that we have a base understanding of how the pension gets paid out at retirement, we can discuss the next problem: What is the pension worth today? Unlike the DC pension which has an easily determined value, the DB pension “commuted value,” is another matter entirely.

So, how much money is needed today to pay the employee a pension for the remainder of their life? The main factors that can influence this calculation include:

· Age at retirement

· Penalties for early retirement

· Mortality of the pensioner and, if applicable, the spouse

· Current age

· Expected rate of return on the investments (often called the discount rate)

· Pension indexed or not

· Rate of inflation

Change any one of these factors and the commuted value can change drastically. Why is this so important? For a number of reasons.

First, if the employee dies before starting the pension, often the surviving spouse does not receive a survivor pension. Instead they receive the commuted value of the pension eligible to transfer into their RRSP. This happens without tax implications, much like an RRSP rollover on death.

Even if the pensioner does not die but ceases employment with the employer who has the pension plan, then one option is to take the commuted value and transfer it into a LIRA in their name. Depending on the length of service, this is a common outcome versus waiting to take the pension at their normal retirement date.

Finally, at retirement the pensioner can choose to take the commuted value instead of taking the pension. Why would someone do that? I have gone through this exercise with many clients over the years and some of the main reasons for making this choice are:

· Financial flexibility – With pension unlocking rules available in some provinces, the pensioner can access more of their funds earlier or keep them tax-deferred longer. Either way, there is increased choice about how to deal with the asset.

· Limited life span – The commuted value can provide a larger death benefit for the surviving spouse. (With most survivor pension benefits being a percentage of the full pension payable or having to take an actuarially reduced pension to receive 100 per cent survivor benefits, the full commuted value can provide more value than taking the payments at a reduced level.)

· Company/pension concerns – though this is rare and there are some funding guarantees, one only has to look at the collapse of Nortel or, more recently, Sears Canada to see examples of where a DB is not fully secure.

· Increased wealth potential – As I mentioned previously, each pension is different. It is prudent to take a look at what the breakeven rate of return is. In other words, what would the portfolio created from the commuted value have to earn to match the pension payments. If the comparable rate of return is reasonable, the pensioner may consider in their best financial interests to take the lump-sum. This happens more often than you might think.

Regardless of what option is chosen, the benefits of the DB pension are apparent. Most of the savings required and all of investment risk in building the retirement portfolio is the responsibility of the employer. This takes the decision to save for retirement out of the hands of the employee.

The value of the DB pension – especially if indexed to inflation – of a long-standing employee will provide a solid base on which to retire, even if the employee has no other assets. If someone worked 35 years at an employer with a DB plan, they could conceivably replace 70 per cent of their pre-retirement salary if they had a pure 2 per cent pension formula. This would, of course, also drive a substantial commuted value if that option was chosen.

For those of you lucky enough to have a workplace pension plan, understanding how it works is an important first step in financial literacy. They don’t teach this in school, though I think they should. Whether it is the more straightforward DC pension or the more complex DB pension, understanding how to maximize the benefits and choose the best options available are important steps on your road to financial independence.

++

The DB plan: crunching the numbers

The pension adjustment (PA) for a defined benefit pension is more complicated to calculate than its defined contribution counterpart.

The calculation for the PA equals nine times the value of the benefit earned for the year (2 per cent of final average earnings is the maximum value of the benefit permitted by the government in pension calculations – someone with a 2 per cent pension who works for 35 years would have 70 per cent of their former income in pension) minus $600.

  • For example, if the employee had a 2 per cent pension with a $100,000 salary, the PA = 9 x ($100,000 x 2%) – $600 = $17,400. Note: While the PA will reduce the amount of available RRSP contribution room available, only a portion – the employee’s contributions to the pension – is tax deductible.

So, based on this example, the DB plan will reduce this person’s RRSP contribution room by $17,400.

The formula to calculate the future benefit varies as well. Most DB pensions work on a percentage of earnings. Often the earnings are a final or best average of some time period, such as three or five years.

Next, a percentage is applied to the average earnings figure. As stated above, 2 per cent is the maximum per year, though the percentage can be lower than this. Plans may also have tiers of earnings often separated by the average year’s maximum pensionable earnings (YMPE) over the final three or five years.

(YMPE is the earnings level set by the government – $55,900 for 2019 – where an employee maxes out on their CPP contributions. So any income above YMPE does not require a payroll deduction for CPP. It is often used in pension formulas as part of a CPP offset.)

Lastly, are the years of service an employee has in the DB pension. The formula of earnings and percentage is multiplied by the years of service.

  • A typical formula for an employee with a salary of $100,000 and 30 years of service may look like this: (1.4% of Final Average Earnings (FAE) up to YMPE plus 2% of FAE above YMPE) x Years of Service, or
  • (1.4% x $55,900 + 2% x 44,100) x 30 = $49,938 for $100,000 of FAE.

So, in this example, the employee can expect to have a future benefit, or annual income post-retirement, of $49,938.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230

FINANCIAL FACELIFT: What can I do to be more financially successful as I enter my 40s?

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Below you will find a real life case study of an individual who is looking for financial advice on how best to arrange their financial affairs. Their name and details have been changed to protect their identity. The Globe and Mail often seeks the advice of our VP, Wealth Advisor, Matthew Ardrey, to review and analyze the situation and then provide his solutions to the participants.

gam-masthead
Written by:
Special to The Globe and Mail
Published November 8, 2019

Philip has a well-paying government job with a defined benefit pension plan, for which he is “fortunate and grateful,” he writes in an e-mail. He earns $112,000 a year in salary plus another $9,500 a year, net of expenses, consulting.

At 40, though, Philip is feeling uneasy about his prospects and wondering “how to better manage my finances for the near and distant future.” His near-term goals are to buy a new car and, in five years, a larger condo than the one-bedroom he owns now. In pricey Toronto, this would mean taking on a much bigger mortgage. He still has 23 years left to go on his existing mortgage loan.

Long term, Philip’s goal is to retire from work at age 58 and maintain his lifestyle. He recognizes that these might be competing goals. “I’ve been managing my finances to the best of my knowledge, reading up on budgeting and investment strategies, and now worry if I’m on the right track,” he writes. “What can I do to be more financially successful as I enter my 40s?”

He asks, too: “Am I saving enough for retirement at 58 with a desired after-tax income of $70,000? Am I investing my money wisely? Will I be in a position to purchase a bigger condo in five years?”

We asked Matthew Ardrey, a financial planner and vice-president of TriDelta Financial in Toronto, to look at Philip’s situation.

What the expert says

In reviewing the initial numbers Philip submitted, Mr. Ardrey detected a few things that seemed out of whack. As it turned out, Philip had overstated his consulting income and understated his expenses. After adjusting his income, there is still some missing money, the planner says. Philip is saving about $850 a month outside his registered retirement savings plan. “The remaining $895 per month is real budget leakage,” the planner says. “The first thing Philip should do is a full and complete review of his budget.”

Philip acknowledged this in a follow-up e-mail. “I’m clearly not accounting for all my expenses and travelling,” he writes. “I need to be more mindful of this.”

Next, Mr. Ardrey looks at the car purchase. He assumes Philip buys a new car at the beginning of 2021, taking $5,000 from his savings for a down payment and making monthly payments of $300 for five years. If interest rates stay low, he could likely finance the car at zero interest “or near to it.”

Philip is contributing about $12,200 a year to his defined benefit pension plan, plus making $3,100 a year in additional voluntary contributions (AVCs) to a work RRSP run by his pension plan manager. He is putting $10,200 a year into a savings account.

When Philip sells his condo and buys a larger one in 2025, he will no longer be able to tuck away $10,200 a year in his savings account, the planner says. The condo purchase price, adjusted for inflation, is assumed to be $911,000. Not only will he have transaction costs, Philip will have to pay off his existing mortgage. Mr. Ardrey’s forecast assumes Philip takes on a new mortgage of $590,000 at 4 per cent interest, amortized over 25 years. His payments will rise to $3,092 a month from $1,705 now. Unless he makes extra payments, he will still have a mortgage balance of about $344,465 outstanding when he retires from work in 18 years. To pay off the mortgage before then, he would have to make extra payments of $8,800 a year, putting a strain on his finances, the planner says.

At age 58, Philip will be eligible for an unreduced pension of $73,000 a year, plus a bridge benefit of $15,250 a year to age 65. “Both are indexed to inflation, which is assumed to be 2 per cent,” Mr. Ardrey says. By then, Philip’s spending target will have risen in line with inflation.

Philip’s spending goal is over and above any mortgage payments he might still be making, the planner notes. “Based on these assumptions, Philip would fall short of his goal,” Mr. Ardrey says. By the time Philip turned 65, he would be running budget shortfalls of about $45,000 a year in future dollars, the planner says. This would fall after his mortgage was paid off – assuming he could hang in that long – but he would still be in the red by about $20,000 a year.

“He would need to reduce his retirement spending by $1,000 per month or work another six years until age 64,” the planner says. By working longer, his pension would be larger and the number of years he would be retired smaller.

What if Philip stays put and doesn’t buy the more expensive place?

Suppose, instead, he moves his savings ($59,000) to a tax-free savings account, tops it up to the maximum ($63,500) and contributes $6,000 to it each year? With savings of $10,200 a year, that would leave him with $4,200 to put into a non-registered investment account. Both the TFSA and the non-registered account would be invested in a balanced portfolio of stocks and bonds. The assumed rate of return would be 5 per cent, Mr. Ardrey says.

These small changes could be enough to enable Philip to achieve his goal of retiring at 58 and spending $70,000 a year, the planner says. “The big differences would be the better rate of return than he is getting in his savings account, the continued ability to save each year that he is working and a smaller mortgage, hence smaller mortgage payments, in retirement.”

Philip has been using his savings account as an emergency fund, Mr. Ardrey says. “Instead of holding large amounts of cash, I’d suggest he use a secured line of credit against his home.”

Client situation

The person: Philip, 40.

The problem: Can he afford to buy a bigger place and still retire early with $70,000 a year?

The plan: Work longer, invest the cash stash and consider putting off the condo upgrade entirely.

The payoff: Recognizing that he can’t achieve all of his goals at once and may have to make some choices.

Monthly net income: $7,940

Assets: Savings account $59,000; chequing account $5,000; RRSP and AVC (additional voluntary contributions) $63,000; estimated present value of DB pension $376,800; residence $610,000. Total: $1.1-million

Monthly outlays: Mortgage $1,705; condo fee $455; property tax $200; home insurance $30; hydro $35; car insurance $250; fuel, maintenance, parking $355; groceries $250; clothing $55; vacation, travel $200; dining, drinks, entertainment $950; personal care $35; club memberships $35; other personal $25; health care $20; disability insurance $200; phones, TV, internet $125; RRSP $255; pension plan $1,015; spending that is unaccounted for $895. Total: $7,090. Surplus $850 to savings

Liabilities: Mortgage $345,000

Want a free financial facelift? E-mail finfacelift@gmail.com.

Some details may be changed to protect the privacy of the persons profiled.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230

FINANCIAL FACELIFT: Can Chelsea and Chad ‘make it all work’ with a second baby on the way and a possible career change?

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Below you will find a real life case study of a couple who are looking for financial advice on how best to arrange their financial affairs. Their names and details have been changed to protect their identity. The Globe and Mail often seeks the advice of our VP, Wealth Advisor, Matthew Ardrey, to review and analyze the situation and then provide his solutions to the participants.

gam-masthead
Written by:
Special to The Globe and Mail
Published October 4, 2019

Chelsea and Chad are earning big and saving mightily, but with a second baby on the way, Chelsea is mulling a possible career change that would cut her income substantially. They are both 34 with a toddler, a mortgage-heavy house in Toronto, and two rental condos.

Chelsea earns $250,000 a year in sales, Chad $115,000 a year in technology. Their condos – their principal residences before they got together – are both generating positive cash flow. With the “main breadwinner” taking a year off and big mortgage payments, they are wondering how to “make it all work.”

They ask whether they should continue paying down their home mortgage aggressively, and whether they should borrow against their rental units to invest. “There is a lot of money coming in and out of our accounts monthly, with property tax, condo fees, and so on,” Chelsea writes in an e-mail. They wonder whether they are managing it optimally.

“We just keep saving but with no clear goal in mind or understanding if our planning is sound,” she adds. They have a “strong desire to maintain a safety net,” and to have a “sound strategy for retirement.”

We asked Matthew Ardrey, a vice-president and financial planner at TriDelta Financial in Toronto, to look at Chad and Chelsea’s situation.

What the expert says

Mr. Ardrey started by running the numbers Chad and Chelsea provided for their income, savings and expenses. To his surprise, his software showed the couple had a $45,000 a year surplus – even after accounting for savings and tax refunds from RRSP contributions. “I believe this is significant leakage in their spending that they have not recorded,” he says.

“Because most people know what they earn and what they save, I can only assume this is being spent,” the planner says. He has included an additional $45,000 worth of expenses in their plan to account for the discrepancy. This takes their adjusted spending to $205,000 a year, including mortgage prepayments.

“This is the primary issue that Chelsea and Chad need to address before any others,” Mr. Ardrey says. “A material change in expenses will affect all financial projections and analysis, including making sure they have sufficient life and disability insurance,” he adds. “I recommend that they go through a detailed budgeting process as soon as possible.”

Both Chelsea and Chad have defined contribution pension plans or group registered retirement savings plans at work to which both they and their employers contribute. As well, they both make maximum contributions to their tax-free savings accounts.

In addition to the registered savings, they make an extra payment of about $12,000 each quarter ($48,000 a year) on their mortgage, and tuck away $2,000 a month ($24,000 a year) in a non-registered savings account. In the past, they have used this money for RRSP top-ups, TFSA contributions and mortgage payments. More recently, they have been setting it aside to help offset the drop in income during Chelsea’s mat leave. Chelsea will get 60 per cent of her salary for the first 16 weeks and employment insurance benefits thereafter.

Their rental properties bring in an additional $19,800 a year for Chelsea and $14,820 for Chad after expenses, but before taxes.

Chelsea and Chad have a $719,000 mortgage on their principal residence and a $42,000 mortgage on one of the rentals.

It is unfortunate that Chelsea and Chad have so little debt against their rental properties and so much against their principal residence, because the rental mortgage interest is tax deductible, but interest on their principal residence mortgage is not.

Although a common thought would be to leverage the equity in the rentals to pay off the principal residence, the Canada Revenue Agency has recently disallowed a similar strategy. For interest to be tax deductible, the use of the borrowed money must be to produce income, the CRA says. The intention of the transaction and the assets pledged for security are both immaterial in this determination. The agency is reviewing tax deductibility on a case by case basis.

Chad and Chelsea ask whether they should use their surplus cash flow to pay off the mortgage or invest. They might be better off financially investing, Mr. Ardrey says. That’s because the after-tax cost of the mortgage interest is low: 2.54 per cent based on the current mortgage rate on their principal residence.

“To break even on investing instead of making extra mortgage payments, assuming a 50 per cent tax bracket and earning interest income, they would need to earn 5.1 per cent on their investments,” he says. This would be even more appealing if they engaged in tax-efficient investment planning and had more of their returns coming from dividends and capital gains, Mr. Ardrey says.

For their children’s education, the annual RESP savings of $2,500 for each child will fall short of the future costs by about 50 per cent, the planner says. The current average cost of postsecondary education is $20,000 a year. Historically, these costs have outpaced inflation, so he assumes the education costs rise at the rate of inflation plus two percentage points. If Chad and Chelsea want to fully fund their children’s education costs, they will be in a position to do so at the time simply by redirecting the surpluses from their non-registered investing to the education expenses, he says.

Next, Mr. Ardrey looked at how Chelsea’s lower income would affect the family finances. If Chelsea changes careers, earning $125,000 a year, they will not be able to make extra payments to their mortgage for the time being. As well, they would not be able to add to their non-registered savings. They would have to reduce their spending by a significant amount: $20,000 a year after-tax, to $137,000 a year. That’s a reduction of the $48,000 for the extra mortgage payments and $20,000 of actual spending. This would continue until their first child is 12, in 2029. If they are both working full-time with good income, they will likely have to have some form of before and after school care, the planner says. By the time the older one is 12, most agree that they can be responsible enough to babysit.

The reduced savings would affect their retirement, but they would still be able to retire comfortably, Mr. Ardrey says.

Finally, Chad and Chelsea would benefit from having a full financial plan prepared, Mr. Ardrey says. “A comprehensive financial plan will create a road map for them to follow.” In their case, it is not the retirement that is unclear, it is the next 10 years, he adds. “Having a plan will help them make the right financial decisions for both today and tomorrow.”

Client situation

The person: Chad and Chelsea, both 34, and their children.

The problem: How to prepare themselves financially for the career change Chelsea is considering. Should they keep paying down the mortgage, or should they borrow to invest?

The plan: Draw up a budget that tracks their actual spending to determine where the leakage is. If Chelsea changes jobs, be prepared to cut spending and halt the mortgage prepayments for a few years.

The payoff: A clear road map across the next decade or so when their cash needs will be greatest to open roads later on.

Monthly net income: $22,900

Assets: Bank accounts $100,000; her TFSA $69,000; his TFSA $71,000; her RRSP (including group RRSP) $233,000; his RRSP $83,000; his DC pension plan $8,000; RESP $9,500; principal residence $1-million; her rental condo $700,000; his rental condo $350,000. Total: $2.6-million.

Monthly outlays: Mortgage $3,820; property tax $695; home insurance $160; utilities $160; maintenance, garden $75; extra mortgage payments $4,000; transportation $455; groceries $350; child care $1,300; clothing $200; gifts $50; vacation, travel $1,000; dining, drinks, entertainment $380; grooming $75; subscriptions, other personal $60; drugstore $10; life insurance $275; disability insurance $225; phones, TV, internet $70; RRSPs $3,500; RESP $210; TFSAs $835. Total: $17,905. Surplus: $4,995.

Liabilities: Residence mortgage $719,000 at 2.54 per cent; rental mortgage $42,000 at 3.15 per cent. Total: $761,000.

Want a free financial facelift? E-mail finfacelift@gmail.com.

Some details may be changed to protect the privacy of the persons profiled.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230
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