“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with registered financial planners Barbara Garbens, president of B.L. Garbens Inc. in Toronto, and Adrian Mastracci, portfolio manager at KCM Wealth Management Inc. in Vancouver.



The Scenario: a 50-year-old has just sold his company to a technology firm for $3 million of that firm’s stock, which doesn’t pay dividends. He also has $500,000 in RRSPs. He plans a second career as a consultant, at which he expects to make $100,000 a year.

His wife, 45, doesn’t work and has no assets. The couple’s home is worth $1 million but has a $500,000 mortgage.

The couple have three children, ages 8, 10 and 12, whom they plan to send to private school for their secondary-school education at a cost of $20,000 a child a year (in today’s dollars). The couple also plans to pay for the children’s university education, which will cost a similar amount. They have no RESPs.

The husband has $1 million in term life insurance to age 65 and there’s a term policy of $500,000 on the wife’s life. There is no other insurance.

The couple’s goal is to have annual after-tax income of $200,000 in today’s dollars and to leave an estate of $4 million, which will be divided equally among the children.



THE RECOMMENDATIONS: NEITHER Garbens nor Mastracci think the couple’s goals are realistic. Indeed, Mastracci considers the goals very aggressive and hard to achieve. “If they insist on these goals,” he says, “I might send them away.”

Assuming a 40% income tax rate, the couple would have to generate $230,000 in income in addition to the $100,000 the husband intends to make from his consulting business. Given a 6% return after fees, the $500,000 in RRSPs would generate just $30,000 a year. (Garbens uses an average annual inflation rate of 3% in her projections; Mastracci, 2.5%.) The $3 million in tech stock generates no income.

For this reason and for purposes of diversification, both advi-sors recommend the husband sell a large part of his tech holdings. Mastracci suggests the husband keep only $150,000 worth of stock; he should not have more than 5% of his portfolio in one investment.

Garbens recommends leaving $500,000 in the tech stock, assuming the outlook for the company is very positive. She notes, however, that tech stocks tend to be volatile. So, the clients might want to reduce their exposure further, to $250,000.

That additional $2.5 million-$2.8 million invested at a 6% annual return would generate another $150,000-$165,000 a year — which still wouldn’t be enough.

On the bright side, neither planner thinks the couple needs $200,000 in after-tax income. If they pay off the mortgage from the proceeds of the sale of the tech stock, they will save $30,000 before taxes and $50,000 after taxes. They could then spend a more reasonable $150,000 a year, says Mastracci. Even so, they will run out of financial assets by the time the wife reaches 95. If their estate goal is really important to them, Mastracci suggests, they could cut their expenditures to $120,000, or even $100,000 a year.

Garbens goes further: she recommends the couple reduce their spending to $90,000 a year. That would exclude the education expenses, which she thinks should be considered separately as they have a finite life. If the couple does reduce their spending, Garbens says, they could reasonably expect to leave a $2.5 million-$3 million estate in today’s dollars.

But the only way to ensure leaving a $4-million estate in today’s dollars is life insurance — and that would be expensive. Mastracci questions whether the couple really need to leave their children $4 million.

To trim the income-tax bill, both Garbens and Mastracci suggest that the husband incorporate his consulting business, with ownership of the shares divided between the husband and wife and, possibly, the children. Incorporation would not only split the income among family members but also make it easier to sell the business when the husband retires, Mastracci says.

In addition, Mastracci suggests the couple set up a family trust to hold some or all the shares of the business. This means that any profits would be taxed in the trust and not added to the husband’s income. It’s also a way to split those profits among the family members.

@page_break@Garbens and Mastracci both also suggest that the wife be employed in the business at an annual salary of $15,000-$20,000 to do book-keeping, invoicing and bill-paying. This, too, would allow for income-splitting. If all the wife’s earnings are put into a non-registered account, she will be taxed on the income when she retires, but presumably at a lower rate than her husband. She would also qualify for some Canada Pension Plan benefits.

The children, too, could be employed in the business, says Garbens, pointing out that a 12-year-old can do filing. As the children get older, they could work in the business during their summer vacations. This would provide further income-splitting because the children’s income would not be taxable. She suggests that the payments to the children combined with the wife’s salary not exceed $20,000 a year in today’s dollars.

In addition, both advisors recommend that RRSP contributions should take the form of spousal contributions to establish and grow an RRSP for the wife. This, too, will help split income in retirement.

If either spouse dies or both die before the children are financially independent, there are enough assets to take care of the children financially. The couple should assign good guardians in their wills.

Garbens also suggests that their wills establish a testamentary trust for each child, spelling out instructions about capital encroachment. Although individual trusts might cost slightly more, she feels that’s much better than a family testamentary trust because it ensures “there’s no squabbling about who gets what.”

Both advisors say RESPs are a good idea, but Mastracci favours a family plan while Garbens prefers an individual RESP for each child. Garbens argues that given the ease with which beneficiaries can be changed, as well as the ability to move the untaxed earnings into an RRSP should the beneficiary not attend university, individual plans are virtually as flexible as family plans. But, as with the testamentary trusts in the wills, she wants to avoid arguments among the children.

Maximum contributions and the allowed catch-up contributions should be made for all the children.

On the insurance side, both advisors recommend that the husband purchase disability insurance as soon as possible. Mastracci suggests a policy that would give him the maximum allowable percentage of his annual income, which would probably be $40,000-$50,000 after taxes.

INSURANCE NEEDS

The advisors also recommend medical insurance once the husband starts working again, pointing out that a family policy is considered a business expense, with the premiums tax-deductible. Mastracci suggests that dental and travel medical insurance be included in the package.

They also suggest looking at critical illness because the husband and wife are well under 60; people are most vulnerable to critical illness such as heart attacks, strokes and cancer in their 40s and 50s. This is not, however, a firm recommendation. The couple have sufficient assets if one of them should become ill. So, it’s a question of looking at family medical histories and weighing the protection insurance offers against the cost of annual premiums.

Consideration of long-term care insurance can be left until the couple retires. Again, given the amount of their assets, it depends partly on whether conditions such as Alzheimer’s run in either of their families.

When it comes to investing the couple’s financial assets, Mastracci recommends a 60% equities/40% fixed-income split; Garbens suggests a 50/50 mix.

Mastracci would put only the fixed-income into the RRSPs, but Garbens suggests including at least some equities. “I’m a big believer in equity in RRSPs, at least until retirement, because above-average returns can often be achieved with this strategy,” she says. “Once the couple retires, you have to see how much money needs to be taken out annually and structure the RRSP accordingly. A heavier concentration of fixed-income investments might make sense at that time in their lives.”

Both advisors recommend discretionary money management for its rebalancing feature, with Garbens recommending using pooled funds only for the equities portion. For the fixed-income portion, the couple can do a bond ladder for themselves.

Both advisors think a good deal of foreign content is advisable. Garbens is particularly enthusiastic about emerging markets such as China and India and suggests putting 5% of total financial assets into those countries. She would put 10% in the U.S. and 5% in other foreign markets. That would leave about 30% of the portfolio in Canadian equities.

Mastracci recommends a 50/50 split between Canadian and foreign equities. With his 60% equity asset allocation, that would work out to 30% of the total portfolio in Canadian investments, 20% in the U.S. and 10% in the rest of the world. Outside of the tech stock, he would recommend using exchange-traded or index funds, which have low fees. Mastracci would put the fixed-income portion into T-bills, bankers’ acceptances and strip coupons.

Total fees for the portfolio suggested by Mastracci, who is a portfolio manager, would be around 120 basis points before taxes and 70 to 80 bps after taxes. Garbens, who doesn’t manage money herself, guesses they would pay $10,000-$20,000 a year for management of the portfolio she suggests. IE