In a small town in B.C.'s Lower Mainland, a couple we'll call Burton and Maria, each 64, have worked for several decades in back-office positions in merchandising. Like a great many B.C. residents, they are top heavy with real estate — in their case, it makes up about 60 per cent of their $1.55 million total net worth.
Roaring real estate prices have been the foundation of their portfolio, which is chock full of mutual funds, insurance-based segregated funds — promising to return not less than 80 per cent of initial cost after 10 years — and income funds, which target returns. Their children, now in their 30s, are grown and gone. The couple has only their own future to plan.
“Our goal is to retire at 67 with no debt and to live a simple life with no financial stress,” Burton explains. “Are our plans likely to work out”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Burton and Maria. “They got to be millionaires one slow step at a time,” he says. But there is risk in the heavy real estate allocation. They have no job pensions. They are on their own with only their investments, Old Age Security and Canada Pension Plan benefits to sustain their way of life.
The real estate market has been good to B.C. property owners. Now it is time to consider whether to stick with what has obviously worked well to build net worth or to cash in some property in favour of diversified financial assets. And that, in turn, requires an analysis of the couple's single rental property, a $340,000 condo. Their home, worth $720,000, is mortgage free.
The condo was Burton's home from 1992 to 2003, so about half of the 23 years would be exempt from capital gains taxes if the property were sold. It generates monthly rent of $1,350, less $226 for property taxes, $264 for condo fees and $356 of mortgage interest alone (not counting additions to equity), for net income of $504 a month. That's $6,408 a year on an estimated sale price of $340,000, less $175,000 mortgage debt, for about $165,000 cash. It's a 3.9 per cent return, which is not a lot considering the risks of vacancy, tenant damage and the other hazards of renting. Of course, the unit could appreciate. Or not.
They could get returns of four per cent or so from shares in a major chartered bank and have more liquidity, as good or better chance of capital gains, no tenant risks and preferential treatment of dividend income.
Looking to the future, if they keep the rental unit and pay off the mortgage, they would have $340,000 equity, with the same expenses — $226 for taxes and $264 for condo fees. Net income would be $860 a month, or $10,320 a year. That would be three per cent of the full value of $340,000. If borrowing costs rise from 2.44 per cent, as they are now, to 5.89 per cent, net rental income would be zero. This is just not an investment, or a risk, worth keeping, Moran concludes. Selling the unit and putting the proceeds into dividend paying stocks or so-called “dividend aristocrat” ETFs would add liquidity to their portfolio, cut risk and probably raise returns, Moran says.
Budgeting for retirement
Beyond investments, there is the question of whether Burton and Maria can sustain their relatively modest way of life in retirement. At present, they spend and allocate $8,832 a month. However, when various monthly savings — $1,250 for TFSAs, $1,333 RRSP contributions, $85 for mortgage life insurance, the condo mortgage of $859 and $1,000 for other savings — are taken out, their core remaining expenses are just $4,305 a month, which will be easily sustainable.
They can boost retirement income by making additional use of their RRSPs, Moran notes. Maria has no RRSP room, but Burton has $30,000 of space. He can shift $30,000 from a taxable account and save some of the $800 or so annual fees he pays for management of the account if he uses low-cost ETFs for investing the transferred money. If he and Maria add $30,000 to Burton's RRSP and her annual bonus of $8,000 for 2016 to Maria's RRSP, the present sum of the two plans ($359,465) will rise to $408,248 in one year, assuming modest growth.
If they work two more years, to age 67, and add only Maria's annual $8,000 bonus to their RRSPs, they will have $449,350 in 2018, assuming three per cent growth after inflation. If they spend the RRSP account so that no capital remains after their age 90, the RRSPs could generate income over the next 23 years of $27,326 a year, paid at the end of each year, in 2015 dollars.
Their TFSAs and taxable accounts have a total of $266,755. If they grow the accounts reduced by the $30,000 transfer to RRSPs at three per cent over inflation, they would grow to $251,173 and could support annual payouts of $15,274 at the end of each year, assuming three per cent growth after inflation for 23 years.
If Burton and Maria sell their rental condo, they could liberate $165,000, less capital gains taxes and selling costs. Assuming that $140,000 is left, they could spend $40,000 to replace their two aging cars and have $100,000 left for investment. If that money is paid out on an annuity basis with three per cent growth and no capital remaining after age 90, they could have further income of $6,080 a year if spent over the 23 years from ages 67 to 90, Moran estimates.
Constructing durable income
Adding up their investment income and pensions at age 67, they would have total investment income to age 90 of $48,680. They would have CPP of $8,466 for Burton and $12,780 a year for Maria. Their OAS, based on deferred application and a boost in benefits of 7.2 per cent for each year application is made, and Burton's being a resident of Canada for only 29 of the 40 years required after age 18 for full benefits, would be a combined total of about $13,000. That adds up to $83,726 before tax — or $77,646 if they do not sell the condo and convert $100,000 of equity after car purchases to income, Moran estimates.
After splits of eligible pension income, application of age and pension credits and average tax of 13 per cent, they would have $6,070 or $5,630 to spend each month, respectively. Their expenses would have dropped and can indeed drop more if they qualify for the B.C. property tax rebate for seniors, which would save them $3,240 at a cost of one per cent of annual savings in simple interest accumulating until sale.
“Burton and Maria are zealous savers,” Moran says. “If they rationalize their property holdings and cut investment costs on their numerous high-fee mutual funds, perhaps by using a fee-only investment adviser at a cost of perhaps 1.5 per cent of assets under management, they will have a financially secure retirement.”