“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with Jay Nash, an associate portfolio manager with Wellington West Capital Inc. in London, Ont., who holds the Canadian investment manager and the fellow of the CSI designations; and Greg Stevenson, a certified financial planner, holder of the FCSI, and first vice president and associate portfolio manager with Richardson GMP Ltd. in Calgary.



The Scenario: john and Susan are 68-year-old retirees in Victoria who are getting worried about their investments. They have $160,000 of their $400,000 in non-registered assets held in perpetual preferred shares, which pay 5% a year in dividends. The couple have been told these investments could face significant losses in purchasing power, given sensitivity to interest rates, if inflation starts rising.

John is a retired bookkeeper with an unindexed pension of $40,000 a year, with survivor’s rights of 60%. Susan had raised their three (now independent) children, and she has never worked. The couple are currently spending all their income.

In addition to the perpetual preferreds, the couple have $40,000 in money market funds and $200,000 invested in stocks of Canadian banks and insurance companies, which have an annual dividend yield of 4%. They have no RRSP assets and have not yet established tax-free savings accounts. Half of the assets are in John’s name and half are in Susan’s. They fully own their $300,000 house.

The couple have long-term care insurance that would provide each of them with $1,000 a month for home care and $2,000 a month for institutional care. John also has $200,000 in permanent life insurance, fully funded, with Susan as the beneficiary. The couple pay the premiums out of current income and have no other insurance.

John and Susan want to know how their portfolio should be adjusted and what average annual after-tax income they can count on, in today’s dollars, until age 95. They are open to downsizing their house or renting. They would be happy to leave some money to their children, but that isn’t a priority.



The Recommendations: Spending cuts of about 15%-17% will be required, as Nash believes John and Susan can spend about $64,000 a year in today’s dollars after taxes and not run out of financial assets until age 95. Stevenson puts the figure at $62,000. Both advisors assume the house would be retained, providing a security blanket should unexpected expenses arise.

Nash says the couple have a second option: to spend just their investment income and leave the capital intact. That would mean reducing spending by much more, but it would leave them with a bigger security blanket and provide the possibility of leaving more to their children. He points out that people often find that leaving an estate becomes more important as they get older — particularly if one or more of their children or grandchildren develop a need for additional income.

Both advisors assume 3% inflation. Stevenson uses a slightly higher average annual return of 5% after fees vs Nash’s 4.7%.

Both advisors recommend that John and Susan sell a good portion of their perpetual preferreds — and do so fairly quickly because of the possibility of rising interest rates.

Stevenson assumes that the couple will not incur a capital loss from the sale of the perpetual preferreds and, as a result, suggests they immediately sell $133,000 of the funds they hold in these shares.

However, Nash expects John and Susan to incur a $16,000 capital loss if they follow his recommendation to sell $80,000 of the perpetual preferreds. That’s based on the 20% discount to issue price at which many of these shares, issued before the 2008 market correction, are trading. He suggests using $20,000 of the proceeds to buy a perpetual preferreds exchange-traded fund.

Nash notes that up until 2008, perpetual preferreds generally behaved similarly to long-term government bonds. Using the example of a 37-year, 5% Government of Canada bond, this would suggest that every increase in rates of one percentage point could decrease the value of a perpetual preferred by more than 15% from current levels.

Nash and Stevenson also agree that the couple need to sell a good portion of their bank and insurance stocks because those, too, are sensitive to interest rates.

@page_break@As both advisors point out, the couple’s portfolio currently consists almost entirely of interest rate-sensitive investments. This would be much too concentrated at any time, but is particularly so now, when there’s a risk of sharply rising inflation (given the huge amount of liquidity governments around the world have been injecting into the financial system). Furthermore, governments may encourage inflation, as that would make it easier for them to pay back their large debt loads.

Nash recommends that $170,000 of the bank and insurance stocks be sold; Stevenson suggests disposing of $158,000 worth of these shares. Nash notes that the sale of these equities could be done over two years if there is a substantial capital gains tax liability. John and Susan will have to check on any tax losses carried forward and will be able to use any capital losses created by the sale of the perpetual preferreds to minimize the tax implications of the portfolio changes.

Both advisors recommend much more diversified equities holdings. Nash also suggests a reduction in the equities portion of the portfolio, to 35% from 50%, given the couple’s need to preserve capital. Stevenson is fine with the 50% equities component and notes that the couple need the growth usually obtained from exposure to stocks.

The portfolio Nash recommends would consist of 25% perpetual preferreds, 10% regular preferreds, 5% government bonds, 20% corporate bonds, 5% cash, 15% Canadian bank and insurance stocks, 10% other Canadian blue-chip stocks and 10% in global equities exposure.

Stevenson suggests 7% perpetual preferreds, 13% fixed-reset preferreds, 25% diversified government and corporate bonds (with a strong tilt toward government), 5% cash, 11% Canadian bank and insurance stocks, 16% other Canadian equities, 13% U.S. equities and 10% international equities.

Notable differences include the portion invested in the perpetual preferreds, with Nash favouring a greater proportion. He explains that the perpetual preferreds’ after-tax income is excellent and the real impact of rising rates may be more muted on preferreds than on government bonds. There is a good chance that central banks will not raise rates until they are sure the economy is improving. And, in a strengthened economy, investors are not likely to require the same yield spread between government and corporate debt. That means the price of the perpetual preferreds are likely to drop by less than their 20-year-plus government bond counterparts.

On the other hand, Stevenson believes the value of perpetual preferreds could drop — “No one knows by how much or when,” he says — so his recommended proportion in the portfolio is lower.

Stevenson leans toward government bonds, saying corporate spreads have been compressed almost to the level of provincial bonds, so there’s no need to take on a lot of corporate risk. He recommends a staggered bond ladder, with an average duration of 2.6 years.

In contrast, Nash has a larger weighting for investment-grade corporates vs government bonds. He feels government bonds are aggressively priced in the current market and that higher-quality corporate debt offers considerably better yield without a significant increase in risk. He also suggests staggered maturities for the bond portion, but says the average duration should be maintained in the four- to five-year range.

Stevenson also suggests a greater proportion of foreign equities. With Canada accounting for only about 3% of global capitalization, he says, foreign equities offer lower volatility and greater choice.

The downside of foreign investments is currency risk. Thus, he recommends the international equities be hedged back to Canadian dollars, but not the U.S. equities — “It doesn’t hurt to have some foreign currency exposure.”

Nash would hedge foreign currency exposure if John and Susan don’t plan to travel outside Canada. If they do plan to make trips, he would hedge only an appropriate portion.

Both advisors recommend John and Susan continue to hold individual Canadian stocks, with which they clearly are comfortable. Stevenson also thinks the couple should have individual securities for the bonds and preferreds. But Nash suggests ETFs to get broad exposure to corporate bonds and to diversify the preferreds portfolio. He also suggests actively managed mutual funds for sector and geographical diversification on the equities side.

Both advisors also recommend that John and Susan should each establish tax-free savings accounts immediately and each put $10,000 into the TFSAs. Nash recommends that these assets be invested in short-term bonds or cash and be used as an emergency fund. However, Stevenson thinks the TFSAs should be used to shelter capital gains and dividend income from taxes.

Stevenson also mentions the possibility of unused RRSP room for John. If there is any, contributions should be made to use it up with an amount each year that lowers his taxable income to the most tax-efficient level. Stevenson suggests putting fixed-income into the RRSP, and notes that John wouldn’t need to take out any money until he is 71 — allowing the assets to grow on a tax-free basis until then.

Nash thinks the insurance John and Susan currently have is adequate for their future needs. His only recommendation, in terms of estate planning, is that the assets be held jointly.

Stevenson agrees, unless John’s pension drops by 40% on Susan’s death, which he says is an element of many pensions. If that were to happen, the couple should consider buying $200,000 in 10-year, term life insurance for Susan. If she is a non-smoker in reasonable health, this would cost about $2,300 a year.

At the size of the couple’s account, Nash would charge a fee of 1.5% of assets to develop, monitor and implement the plan. This represents total compensation for portfolio management, including all trading and administrative fees, the investment policy statement, the financial plan and quarterly and annual reviews.

Stevenson doesn’t charge clients with assets of $1 million or more for financial planning, but does charge for investment management. If clients hold less than $1 million, Stevenson’s fees vary depending on the services provided. IE