“Financial Checkup” is an ongoing feature that discusses financial planning options. In this issue, Investment Executive speaks with registered financial planners Lenore Davis, senior partner at Dixon Davis & Co. in Victoria; and Karen Hall, vice president of financial education and employer services, and Judith Fulton, senior consultant, both with T.E. Wealth in Calgary.

The Scenario: a couple in Winnipeg, aged 62, have financial assets with a market value of $1.7 million, as well as a $700,000 mortgage-free home.

Of the $1.7 million, $1 million belongs to the husband and is invested in Canadian bank stocks with a cost base of $750,000. The wife has $700,000 in the stock of demutualized life insurers, with a zero cost base. Before the global credit crunch hit, the portfolio was worth $2 million; at its current level, it has a dividend yield of 5%.

The husband works and makes $100,000 a year and will get an indexed pension of $60,000 when he retires. The wife, who has not worked since the birth of the first of their three children when she was 28, will get 60% of his pension should he die first. The children are all independent.

Neither the husband nor the wife has RRSPs, but the husband became eligible for maximum RRSP contributions in 2007 as his pension was then fully funded. Their income goal after age 65 is $100,000 after taxes in today’s dollars until age 75 — they expect to travel extensively in those years — and then $60,000 thereafter.

They want to leave an estate of $2 million in today’s dollars, split evenly among the three children.



The Recommendations:
All three advisors say the income and estate goals are achievable, assuming a 4% average annual return in real after-inflation terms, particularly if there are no major medical expenses. Davis assumes a 6% nominal return and 2% inflation, while Hall and Fulton assume a 7% nominal return and 3% inflation.

All three advisors note that many assumptions go into projections, so the resulting numbers should be used only for guidance; ongoing planning is necessary to monitor the couple’s evolving situation.

Given the husband’s indexed pension, Hall and Fulton calculate that the couple’s financial assets will be worth about $1.5 million in today’s dollars at age 95, assuming they both live that long. Since the estate will also include the residence or additional assets from its sale, the estate goal of $2 million in today’s dollars is achievable. Davis agrees that these projections are reasonable.

Hall and Fulton would follow the advice of their firm’s investment-management arm, T.E. Investment Counsel Inc., and recommend that the couple reduce their exposure to Canadian financial services stocks to 40%, at most — ideally, to 20% — of the portfolio.

Davis assumes that the portfolio will remain as it is. “There’s no reason to fix something that isn’t broken,” she says. Financial services equities have clearly done well for the couple — as demonstrated by the accumulated capital gains — even with the recent drop in stock prices. Once the global credit crunch is resolved, stock prices should return to their previous levels and then climb.

“Good-quality stocks generally go up,” Davis says, adding that investment gurus such as Warren Buffett recommend buying good companies and holding them. She also notes that financial services companies’ dividends tend to increase.

Davis would, however, go along with some diversification if the couple feel strongly about it. In that case, she recommends that the husband set up an RRSP and contribute $36,000 this year (the maximum contribution plus the allowed one year of catch-up contributions) and $18,000 in each of the next two years. He would be able to use the RRSP deductions to offset $72,000 in capital gains. If the couple want more diversification than that, Davis suggests that they determine each year how much capital gains can be taken without pushing them into higher tax brackets.

Hall, however, considers the 100% exposure to financial services risky, and recommends diversifying the portfolio. She suggests selling 60% of the financial services stocks over the next three years and putting one-third of the proceeds into fixed-income and two-thirds into global non-financial services equities.

Hall would then discuss with the couple whether further diversification was advisable. She notes that 40% fixed-income is often recommended to people in retirement. That tends both to lower the volatility of a portfolio and decrease the possibility of another big drop in the value of the financial assets should one of the stocks or sectors experience a decline.

@page_break@If the couple agree, Hall would suggest selling another 20% of the financial services equities over the following three to five years and putting that into fixed-income. The target would be an asset mix of 40% fixed-income, 40% global equities and 20% Canadian equities.

Fulton agrees with Davis that the couple’s income requirements should be reviewed each year to determine how much capital gains to take in that year.

Fulton also agrees that it’s worthwhile for the husband to set up an RRSP to take advantage of the tax deduction. She suggests putting fixed-income investments into the RRSP to shelter the interest income. She also recommends that annual contributions of $5,000 by each partner be put into tax-free savings accounts, proposed for 2009 in last February’s federal budget.

This is a “no-brainer,” Fulton says, because income earned in the TFSAs will not be taxable when withdrawn. However, Fulton cautions that, depending on the wording of the final legislation, selling assets to put funds into these accounts could trigger capital gains.

Fulton notes that as people move into retirement, they often make changes that may result in what she calls the “lumpies” — a series of big purchases or expenditures that are paid for in lump sums out of capital. It’s critical to realize that these purchases lower the capital left in the portfolio, she says. It’s advisable to limit these purchases or spread them out, particularly when equity prices are low. Capital lost by selling equities at low prices is gone forever, Fulton says.

Hall and Fulton both point out that people don’t usually know how much money they will need in retirement until they have been retired for a while. A discussion 18 months into retirement provides an opportunity to rethink both the income and estate goals.

Davis says most retirees experience a drop in spending after the first burst of travel, and notes that after age 75, people tend to settle into a more home-based lifestyle.

All three advisors think the couple should consider gifting some of their assets to their children and, perhaps, to charities, in which case the tax credit would cover the capital gains taxes payable. Gifting to children would decrease the couple’s taxable income and, potentially, their tax brackets.

However, Davis points out, this is a question of the couple’s philosophy — specifically, their feeling about giving their children assets when those children are still relatively young. Davis also argues that gifting decisions should not be based solely on tax considerations.

Hall and Fulton caution that the couple shouldn’t give their children so much that the couple fall short of their income goals. The advi-sors recommend going slowly on gifting, and suggest the couple wait until they are a couple of years into retirement and then do the giving over a period of years. The couple need to feel financially comfortable when each gift is made. Hall notes wryly that relatives are more likely to visit if they know there is a sizable estate to be distributed.

Fulton also recommends that the couple provide for testamentary trusts in their wills, with the husband or wife as the initial beneficiary, followed by the children. This would allow for income-splitting when one of the couple has died because a testamentary trust’s income is taxed separately.

None of the advisors suggests critical illness or long-term care insurance because the couple has enough assets to cover whatever costs may arise. Davis does, however, say that the estate goal of $2 million in today’s dollars could be compromised if one or both require significant care. She suggests taking out a $2-million joint last-to-die term-to-100 life insurance policy if the estate goal is really important to the couple. The cost of such a policy would be about $25,000 a year, assuming both the husband and wife are non-smokers in normal health. This policy would form the basis of the children’s inheritance; inflation protection would be provided by the growth in the value of the family residence.

Davis does not manage money, so she has no specific recommendations on investments beyond saying that if the couple decide to keep their financial services securities, they should do that in a discount brokerage account, for which there are no management fees or commissions if stocks aren’t traded.

If the couple want to diversify the portfolio, Davis suggests hiring a professional investment-management firm, preferably one that includes financial planning among its services. A number of her clients have done this, with the financial planning contracted out to her. The cost is usually about 1.5% of assets a year — in this case, about $25,500 a year. Davis would charge $2,000-$3,000 for the initial financial plan. In cases in which her services aren’t covered by an investment-management firm, she charges an annual retainer of about $2,500, which entitles clients to 10 to 12 hours of her time spent monitoring the plan, preparing income tax returns, meeting with the clients and answering questions.

T.E. Wealth does provide investment management. Hall and Fulton recommend that the couple’s assets, including the fixed-income portion, be put in T.E.-sponsored pools, which are managed by outside managers and offer diversification in terms of style, geography and size of companies. The annual fee for financial planning, tax preparation and the pools would be around 1.7%-1.9% of assets — in this case, around $30,000 a year. IE