“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks to registered financial planners Terry Gibson, vice president of EES Financial Services Ltd. in Markham, Ont., and Doug Macdonald, principal of Macdonald Shymko & Co. Ltd. in Vancouver.

The Scenario: A family holding company has $5 million in assets, the result of the sale of a computer software business two years ago. The assets comprise $2 million in fixed-income, $1 million in well-diversified equities and $2 million (at face value) in asset-backed commercial paper, which was earmarked to buy commercial rental property.

The collapse of the ABCP market, however, means the portfolio’s ABCP holdings are frozen and the face value of the paper is well above the $1-million cut-off to qualify for the redemptions offered to retail clients. When the ABCP market resumes trading, it is assumed the investment will be worth 42% less.

The family — a couple aged 55 who live in Ottawa and have three independent children — does not currently need income from the portfolio; the husband and wife both work for the firm that bought their business and each earn $100,000 a year. But when they retire in 10 years, they expect most of their annual income of $140,000 after taxes in today’s dollars to be provided by the portfolio. The couple also want to leave each child $2 million, also in today’s dollars.

The couple had expected the rental property to generate an 8% annual return. Added to the 4% the fixed-income portion would earn and the 6% (2% in dividends and 4% in appreciation) from the $1 million in equities, that would have met their annual needs. The couple also owns a $1-million home outright.

So, what do they do now? Can they still afford to buy the commercial property? What financial assets can they reasonably expect to have at age 65? How much income will that generate, and how big is their estate likely to be, in today’s dollars, when they reach age 95?



The Recommendations: Gibson and Macdonald agree that the clients should buy the commercial property, but the advisors recommend different strategies.

That is not the only point of disagreement. Gibson believes the couple can meet their income and estate goals, while Macdonald says one or the other will have to be revised.

According to Macdonald’s projections, the couple’s estate will be only $3.8 million after taxes in today’s dollars if they continue to spend $140,000 after taxes annually to age 95. This assumes an average 6% annual return on the investments after fees and inflation of 3%. But, he adds, it’s very difficult to project 40 years into the future and advises that the couple do another plan in 10 years, when they have retired.

Gibson’s calculations, on the other hand, produce an estate of $7.6 million. He, too, assumes 3% annual inflation but projects a 6.4% annual return initially, falling to 6% by the time the couple is 65.

In order to buy the commercial property, Gibson recommends selling the ABCP and swallowing the $840,000 loss. (That loss can offset future capital gains; he calculates that it will be used up by the time the couple turns 70.) With the $1.16 million in proceeds from the ABCP sale, plus $840,000 from selling some of the fixed-income, the couple can buy the property. He is assuming the 8% return on the property will be entirely income.

Gibson suggests withdrawing income from the holding company over the next 10 years, while the couple is still working, so each can make the maximum contribution (currently $18,000) to RRSPs. The rest of the holding company’s income plus the RRSP refund would be used to rebuild the fixed-income assets — except dividend income, which would be reinvested in equities.

Gibson calculates that at the end of 10 years, each partner will have RRSP assets of $276,000, invested in a balanced portfolio with an average annual return after fees of 6%. Beginning at age 65, husband and wife each will be able to withdraw $20,000 a year from their RRSPs until age 95. This, coupled with indexed Canada Pension Plan benefits of about $14,000 a year, will give each of them about $34,000 in guaranteed income in retirement.

@page_break@Macdonald, on the other hand, recommends keeping the ABCP, assuming it has good covenants. As ABCP is generally being converted to 10-year commercial paper, the couple would get their $2 million back in 2018. He would suggest then investing that $2 million to bring the fixed-income/equities asset mix to two-thirds/one-third.

To purchase the commercial property, Macdonald suggests selling $1.4 million of the fixed-income holdings and $100,000 of the equities, and taking out a 10-year, $500,000 mortgage at 5.5%. The couple might want to mortgage their house rather than the commercial property in order to get the best rate.

The mortgage would be paid out of the income from the commercial property and be paid off when the couple retires at 65. The remaining income from the property, plus income from the fixed-income investments, would be invested in fixed-income; the income from dividends would be reinvested in equities.

Macdonald is assuming 3% of the 8% return on the commercial property comes from appreciation. As a result, when the couple sells the property, there will be capital gains of $4.5 million, for which the tax liability would be about $1 million — vs zero capital gains for this asset in Gibson’s projections.

Macdonald doesn’t think there’s any need for RRSPs because if the holding company buys the commercial property, it will achieve many of the same tax-sheltering benefits, through the use of capital-cost allowances, as an RRSP.

The most critical step the couple needs to take, in Macdonald’s view, is to re-evaluate their estate goal.

One way to ensure that the estate goal is achieved would be to take out a universal last-to-die life insurance policy. But Macdonald calculates that this would require liquidating $2.8 million of their financial assets to acquire the policy. This would grow tax-free until the survivor dies at 95, leaving an estate, including the principal residence, of $19.6 million, which would be equivalent to $6 million in today’s dollars. He is assuming the value of the house will increase by 3% a year, in line with inflation.

Macdonald does not recommend this strategy, for a number of reasons. First, the couple can’t afford it; there wouldn’t be enough assets left in the holding company to generate the $140,000 in annual retirement income they require. So, they would lose their financial independence.

Second, in 40 years, their independent children will be in their 60s — not a time of life when people generally need a lot of extra money, assuming they have saved for retirement themselves. Financial assistance is most helpful when people are in their 30s and 40s.

Third, the clients’ situation could change. Although they believe that their current employment is secure, that might not be the case. They might need to draw on the holding company assets for income sooner than expected.

Another possibility is divorce.

Macdonald thinks 55 is too young to make arrangements that can’t easily be undone — undoing a universal life policy can be costly.

He suggests the couple wait until they are 65 to establish their estate goals. At that point, they will know how much in assets they have at their disposal for retirement, and will have a better view of how their children’s lives are developing.

In the meantime, Macdonald says, the couple could consider making their children shareholders of the family holding company and declaring dividends on those shares when one or more could use a cash infusion. Companies can have different classes of shares, so the parents could retain voting control while transferring some of the future growth.

Gibson also suggests giving shares of the holding company to the children, noting that the children are probably in lower tax brackets.

The couple also needs to determine whether the holding company is appropriately structured should either or both become disabled. They should have arrangements in place for backups to make decisions or sign cheques.

Neither advisor is in favour of critical illness or long-term care insurance for the couple. The cost is high and the couple has sufficient assets to cover any medical costs.

Gibson suggests a joint last-to-die life policy to cover potential capital tax liabilities. Macdonald, however, disagrees. Calculating capital gains in 40 years is impossible, he says, and the clients may overinsure. With their assets, there should be enough liquidity when the estate is settled to pay the taxes due.

Gibson does not manage money or make specific recommendations beyond the broad asset mix. In this case, he thinks the couple’s current asset mix — 40% fixed-income, 40% real estate and 20% equities — is reasonable.

Macdonald, who does provide investment advice, agrees the asset mix is suitable, given what’s known of the couple’s risk tolerance. He recommends that the fixed-income portfolio include a five-year rolling bond ladder, plus some 90-day T-bills to provide liquidity. He suggests using exchange-traded funds for the equities, divided into one-third Canadian, one-third U.S. and one-third international, with at least 25% small-caps in each category.

Macdonald charges an hourly rate for developing, monitoring and updating a financial plan and for personal and corporate tax and accounting work. The full slate of services would cost the clients $5,000-$10,000 a year. If the clients want him to implement the investment plan, including monitoring, analysis and quarterly reporting, he would charge about 0.75% of the assets. In this case, that would be about $19,000 a year.

Gibson would charge about $5,000 a year for developing the plan and monitoring it. There would be additional charges if they wanted him to do taxes or accounting. IE