In Toronto, a woman we'll call Veronica, 50, has built her financial life on hard work and independence. She brings home $2,660 a month as a self-employed media consultant, keeps up her small house on a tree-shaded street, maintains financial records diligently, but worries that when she wants to retire, she won't have the means to make it work.
“I would like to build up my assets so that I can enjoy a comfortable retirement, not needing to be such a scrupulous saver as I have been,” Veronica explains. “I also want to build a cushion for possible health problems or the inability to live independently down the road.”
You could say that this is what most people want, but Veronica's case is unusual. She is her own sole support, has no job security but has a nearly debt-free house that has appreciated to $500,000. Assuming that she will keep her house in retirement and retires at age 65, as she allows — though she would prefer 60, her problem will be to stretch her financial assets, currently $198,700, for what could be three or four decades.
Family Finance asked Dan Stronach, a financial planner who heads the Stronach Financial Group Inc. in Toronto, to work with Veronica. In his view, she can manage a comfortable retirement, but only with commitment to maintain her high savings rate. In her favour, she has just finished paying off her bank-financed mortgage at $917 a month. She already saves $458 a month in her Tax-Free Savings Account. Her total savings are, therefore, $1,375 a month. And she is perfectly healthy.
Focusing on savings
Veronica's rate of savings, including $112.00 she uses to pay off a small Home Buyers Plan loan of $9,241 to be eliminated in seven years, is an extraordinary level of frugalness — 55% of her earnings.
If she resumes RRSP savings and puts $7,400 a year into the account from the $917 a month that had been used for mortgage payments and maintains her $5,500 annual savings in her Tax-Free Savings Account, then by 2028, when she is 65 and ready to retire, she will have total RRSP assets of about $394,150 and TFSA and other non-registered assets of $162,540 in 2013 dollars assuming 3% growth after inflation. The total will be about $556,700.
Assuming that Veronica will live to age 95, her retirement after she ends work at 65 will be 30 years. To sustain her income in this period, she can consider annuities, which are contracts with insurance companies which agree to provide a fixed income for the life of the annuitant. Variations include a minimum number of payments, which ensures that the capital is not lost if the annuitant dies soon after purchase, and joint and last to die policies which are appropriate for couples but not relevant for single persons.
Annuities transfer all management risk to an insurance company. The insurer pays out a guaranteed income that consists of interest and return of capital. Conventional annuities do not pace inflation for their payments are fixed.
The concept is solid, but this is not a good time to buy an annuity. Bond interest rates, which are the foundation of the annuity's returns and payouts, remain near historic lows. However, Veronica would not be in the market for an annuity for at least another decade.
Starting at age 65, she could buy annuities slowly with a tenth of her capital every five years. She would be getting guaranteed income growing over time as she buys more annuities and as her life expectancy shrinks. Veronica would be averaging interest rates over as much as three decades. And she would still retain a good deal of her capital under her own management even in her 90s.
Using an annuity payout calculation and conservatively assuming continuing 3% annual growth of assets, her total financial assets as estimated at 65, $556,700, would yield $27,575 a year for 30 years to her age 95 at which time all capital would have been paid out. Veronica could add her Canada Pension Plan benefits of $8,880 a year at 65 and, at age 67, Old Age Security, currently $6,600 a year.
These calculations project total pre-tax retirement income of $43,055 a year. After personal and age credits, assuming her average tax rate is 12%, she would have $3,160 after tax a month, which exceeds her present after tax income by $500 a month. If Veronica should live beyond 95 when her financial assets are exhausted, she could sell her house to obtain additional funds. She would then rent or have an assisted living situation.
There are other ways for Veronica to increase her financial assets. She has a dozen mutual funds in her RRSP and TFSA portfolios. All the funds are managed by reputable though expensive managers. Moreover, Veronica has no bond funds that can gain value in a stock market downturn. Government bonds are at substantial risk of loss in today's climate of rising interest rates, but an exchange traded fund which holds investment grade corporate bonds maturing in five years or less would be substantially immune from these losses.
Switching high fee mutual funds that charge an average 2.5% per year in management expenses to exchange traded funds which charge no more than 0.5% would save Veronica about $4,000 a year in management fees.
A retirement safety net
If Veronica remains a diligent saver and does not retire until 65, she will have more income in retirement and far more discretionary income than she had in her pre-retirement years. She has no children and no plan to leave money to anyone.
Were Veronica disabled, she might need long term care. She can buy a long term care policy for $1,500 per year for $2,500 per month of coverage. She owes it to herself to investigate this insurance product, Mr. Stronach suggests. Her savings can easily cover these premiums.
As a backup, she would have her house which could be sold or downsized and equity harvested. The combination of slow conversion of financial assets to annuities with rising yields based on diminishing life expectancy, retention of some financial assets in active management and maintenance of her house as a final reserve is a plan for a very frugal lady, Mr. Stronach says.