“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with the team of Rob Harder and Todd Peters, both certified financial planners and branch managers with Investment Planning Counsel in Winnipeg; and Paul Vaillancourt, a CFP, chartered life underwriter, certified senior advisor and senior executive financial consultant with Investors Group Inc. in Ottawa.

The Scenario: Tom is a 40-year-old construction worker in Toronto who earns about $70,000 a year. His wife, Betsy, also 40, has been bringing in about $16,000 a year. They have two children, 14 and 16, and a $100,000 mortgage on the home they bought 10 years ago, currently valued at around $350,000. They have no RRSPs because they have been spending all their income.

Betsy has just won $2 million on a lottery ticket. The couple felt they were set for life and she quit her job. But they are now feeling alarmed because they have already spent $130,000 on a new truck for Tom ($70,000), a car for Betsy ($30,000), a trip to Disney World ($15,000), new TVs, clothes and so on ($15,000).

Tom and Betsy had planned to upgrade to a $500,000 home and to pay for their children’s university education, provided the children live at home (estimated at $70,000 in today’s dollars). Betsy doesn’t want to go back to work, and Tom would like to retire at 55. They want to have an after-tax income of $70,000 in today’s dollars after the children have finished university.

The couple don’t have any estate goals, as they would prefer to help the children while they are young — for example, by providing $50,000 (in today’s dollars) each for a down payment on a house.

The couple have no life or extended medical insurance. They are in good health, as are their parents, who are all in their late 60s. Both Tom’s and Betsy’s grandparents lived into their 80s and died of heart-related causes.

The couple want to know how much of their plans are feasible and how the money should be invested without running much risk.



The Recommendations:
The advisors say the couple’s goals are achievable as long as Tom continues to earn $70,000 in today’s dollars until he’s 55, and that the couple keep their after-tax spending to that amount. If they do so, they can pay off their current mortgage, upgrade to a $500,000 house, put aside $70,000 for the children’s education and provide a $50,000 in today’s dollars for a down payment for each of their two children.

Vaillancourt assumes a 5.5% annual average return on the non-registered assets, 5% on the assets in the RRSPs he recommends be established, 3% inflation and house appreciation of 2%. His projections show that Betsy, at age 95, could have about $300,000 in today’s dollars in financial assets; and as he expects the house to appreciate less than inflation, it would also be worth $300,000 in today’s dollars. He recommends an asset mix of 60% equities/40% fixed-income for the non-registered assets and 50/50 for the RRSP assets.

Harder’s and Peters’ projections show a higher estate value of $780,000 plus the house, which they assume would be worth $500,000 in today’s dollars. They are assuming a 6% annual overall return, 3% inflation and 3% appreciation for the house. They suggest an asset mix of 40% in equities, 33% in guaranteed income certificates and 27% in other fixed-income.

The IPC advisors note that a GIC ladder would be ideal for such unsophisticated, risk-averse clients. But the couple can’t achieve their goals without some equities. In the current, low interest rate environment, there is no way for them to earn enough money from GICs to maintain their lifestyle objectives for their entire planning horizon.

The 33% in GICs gives Tom and Betsy a stress-free way to invest a good chunk of their money while they get comfortable with investing in bonds and, particularly, equities.

Vaillancourt echoes this concern about the couple’s lack of investment knowledge: “I would not recommend anything exotic, alternative, complex or requiring any day-to-day involvement. They need professional money management, diversification and proper financial planning.”

The IPC advisors recommend that Tom set up an RRSP and each make maximum contributions each year as well as use up his unused RRSP room. That is, Tom should make additional contributions each year to the point at which he qualifies for the lowest tax bracket.

Vaillancourt agrees but suggests a spousal RRSP for Betsy as well, with all contributions divided equally between it and Tom’s RRSP to facilitate income-splitting when the couple are retired. Vaillancourt suggests that small RRIFs be established when they turn 65 so that they can withdraw the $2,000 a year that is eligible for the pension deduction.

Harder and Peters see no need for a spousal RRSP, as Tom can split all his RRSP income with Betsy. “She already has a considerably higher balance in investment assets, and our goal is to equalize the assets in each spouse’s name.”

Instead, the IPC advisors recommend that all living expenses be paid out of the income and capital from Betsy’s non-registered assets while Tom’s earnings are invested. This will help even out the couple’s assets and save taxes. The IPC advisors’ projections show that the couple can arrive at retirement with roughly equal assets and their combined tax bill the first year they retire would be $13,947 instead of $25,751 if Tom pays the expenses.

Other ways to reduce taxes include putting interest-bearing investments in RRSPs; investing in preferred shares that qualify for the dividend tax credit, rather than straight fixed-income; and buying capital-class mutual funds to delay paying capital gains.

Tom and Betsy should also each establish tax-free savings accounts, putting in the maximum in each from the non-registered assets, as this money will grow tax-sheltered and not be taxed upon withdrawal.

In addition, says Vaillancourt, the couple could look into permanent life insurance, as a significant portion of the premium could grow on a tax-sheltered basis.

All the advisors recommend that RESPs should also be set up, with $35,000 put in immediately for the eldest child and $20,000 for the younger child; $5,000 of the contribution for the younger child is eligible for the Canada education savings grant. The couple should then make contributions of $5,000 for the younger child in each of the next three years. These assets should be invested conservatively — mainly in fixed-income — given the short time horizon before the children start their post-secondary education.

Insurance is also strongly recommended, as Betsy will be in financial difficulty if Tom gets hurt or dies. Vaillancourt suggests Tom take out a 20-year term life policy for $650,000, costing $910 a year; a top-end disability insurance policy for $2,850; a $100,000 critical illness policy to age 75 for $1,650; and full extended medical insurance for $4,200. These premiums can be paid out of investment income or capital.

Harder and Peters suggest 15-year return-of-premium CI insurance of $250,000 for Tom and $100,000 for Betsy, which would cost $5,900 a year and be paid from investment income or capital. The advisors note that it’s worth paying this annually rather than monthly to avoid the financing charge. They also agree that having disability coverage is important for the next 15 years.

The IPC advisors also recommend a $1-million, joint last-to-die policy with a $500,000, 20-year term rider on Tom, which would cost $4,125 a year for 20 years and $3,400 thereafter. They note that people often develop estate goals when grandchildren arrive: “Having this piece in place will allow the couple to maximize the tax efficiency of passing some of their wealth on to future generations.” Premiums for all insurance would be paid out of the GIC component of the portfolio.

As for long-term care insurance, the IPC advisors say that it is too far into the future to be considered right now. LTC should be revisited when Tom and Betsy are older.

Harder and Peters strongly recommend that testamentary trusts be established for the children in Tom’s and Betsy’s wills, in case they die before the children are 25 or 30. Trustees and backup trustees need to be appointed.

Outside of that, says Vaillancourt, the couple need property and personal powers of attorney, with backups, and should review these and their wills on a regular basis.

He recommends mutual funds for the entire portfolio and suggests that the fixed-income portion — about 40% of portfolio — consist of short-term bonds, mortgage funds and a real property fund.

The equities component would be mostly Canadian equities (40% of the total portfolio), favouring dividend funds for additional investment income, along with some global (10%) and international exposure (10%). In the RRSP portfolio, Vaillancourt would replace that global exposure with Canadian asset-allocation funds.

In this portfolio, there would be diversification by market capitalization and investment style as well as by geography. Vaillancourt suggests a tilt toward value for this couple because of their lack of investment experience and because of their need to preserve capital.

Harder and Peters recommend that a GIC ladder (33% of the portfolio) that goes out five years and other fixed-income for 27% of the portfolio. The equities, 40% of the portfolio, would be invested two-thirds in Canadian dividend-paying stocks and one-third in broader Canadian equities, U.S. equities and international equities. This provides the couple with security through the GICs and other fixed-income, along with growth through the diversified equities component.

The IPC advisors would construct the diversified portfolio using a mixture of managers to ensure style, geographical and asset diversification. There would be automatic rebalancing to keep the asset allocation constant. The IPC advisors would use mutual funds with no loads and low management expense ratios.

None of the advisors would charge a separate fee to develop and monitor the plan as long as they were going to be managing the money.

Harder and Peters explain that the fees for managing money are tiered by asset size. With Tom and Betsy’s level of assets, they should expect the total cost to be about 1.5%-1.75%. That’s because the advisors receive a portion of the MERs, a fee of about 0.2% for each year in the terms of the GICs and commissions for the life insurance products. IE