Can couple succeed without stocks?

The Scenario: Brian, 58, and Joan, 56, are a couple in Vancouver who are tired of volatile stock markets affecting their retirement savings. They developed a financial plan 10 years ago and, as advised, invested in a globally diversified portfolio of equities run by what they were told were “some of the best portfolio managers.” But the portfolio didn’t grow much in the 2003-07 period, and then it was halved during the global financial crisis. While the couple’s portfolio has recovered somewhat, they still have $300,000 in embedded losses. They don’t want to experience such losses again — although they are prepared to take some losses on bonds.

The couple retired a few months ago after selling their family business for $750,000. They have no debt and their current assets include a home worth $1.5 million, a corporate cash account with $1.5 million (including the proceeds from the sale of the business), $300,000 in Brian’s RRSP and $250,000 in Joan’s RRSP.

Their goal is pretax cash flow of $80,000 a year in today’s dollars before old-age security (OAS) and Canada Pension Plan (CPP) benefits to age 90 without investing in equities. They also want to have access to $400,000-$500,000 of their assets to help their children out with their mortgages, or to travel, buy a vacation home or rent one in the future. Leaving an estate is only a distant consideration, as Brian and Joan are more concerned with making sure they enjoy their lives now and whatever is left for their children will be enough.

The couple are reluctant to have a fee-based account. With a fee of 1%, they would be paying $20,050 in fees, 25% of their required annual income.

The Recommendations: both advi-sors note that taking capital out of the corporate account will be expensive, as it will be taxed as income in Brian’s and Joan’s hands. Thus, the advisors suggest not moving the capital to personal accounts; rather, leave it in the corporate account and just take the full income generated each year in whatever form the couple’s accountant recommends. Mastracci emphasizes that it’s very important that the couple get professional advice on how to minimize taxes, both for the yearly withdrawals and for taking larger capital amounts out of the corporate account.

Mastracci and Pownall also say they understand why Brian and Joan don’t want to be dependent on government benefits such as OAS and CPP. There have already been changes in the age at which Canadians are eligible for OAS, and there could be further changes to that or to the level of benefits, the level of taxable income at which OAS is clawed back or whether and how much the benefits are indexed to inflation. The CPP is less threatened because that program is fully funded. Nevertheless, the couple are likely to receive both OAS and CPP benefits, and that will make their situation easier than the advisors’ projections suggest.

Mastracci’s projections show that even with good tax planning, the couple won’t meet their goals without some equities-related risk. Thus, he recommends the couple put 20% of their portfolio into equities to start with and raise that gradually to 30% or even 40% if they can tolerate the risk. For the fixed-income portion, Mastracci recommends low-risk, investment-grade bonds.

However, Pownall believes that Brian and Joan can achieve their goals without exposure to equities. The key is getting a good return on fixed-income without too much risk, which he believes is possible through careful selection and monitoring of short- to mid-duration high-yield bonds. He points out that Brian and Joan qualify as “accredited investors” because they have more than $1 million in financial assets, which increases their investment options because accredited inves-tors can buy private-placement bonds.

High-yield bonds can have less risk than equities, Pownall says, both in terms of lower price volatility and lower downside risk, if the issuing company has plenty of real or salable assets on its balance sheet that can be sold if the issuer defaults on its bonds. The first step in analyzing the risk of a bond is to assess the company’s balance sheet and cash-flow statement to make sure it has good asset coverage and consistent cash flow. Then, goodwill and intangible assets should be excluded to see if what’s left would more than cover its liabilities. The next step is to read the prospectus carefully in order to understand the priority of claims on assets and the bondholders’ rights.

In Pownall’s view, high-yield bonds that combine the benefits of interest payments and repayment of principal at a specified date with plenty of salable assets have potentially less risk than equities, whose stock prices can plunge even if the company’s assets and cash flow remain solid.

If the couple stick mainly with these kind of bonds, Pownall says, there would be a higher probability of preserving their capital. They might face losses if they had to sell before maturity, but as long as there are real assets, he adds, the risk shouldn’t be nearly as great as with equities — especially with shorter-duration bonds, which are less sensitive to changes in interest rates and credit spreads. Pownall suggests an average duration of 3.5 years.

Pownall’s projections are based on a portfolio of 60% high-yield bonds, 30% in a pooled bond portfolio sold via an offering memorandum (pools of bonds professionally managed for accredited investors, which convert interest income into capital gains), plus 7% in investment-grade bonds and 3% in cash. He believes this asset mix can deliver an average return of 5.7% after fees, which, assuming inflation of 1.7%, would allow the couple to withdraw $80,000 a year before taxes in today’s dollars until Joan is 90 without selling the house or taking any equity out of it.

The only time this strategy wouldn’t work, Pownall says, is if there’s a period of stagflation (persistent high inflation combined with high unemployment and stagnant economic growth) or hyperinflation. In either of those environments, exposure to equities would be required to make up for the losses in purchasing power attributable to the inflation.

Mastracci is not comfortable recommending high-yield bonds to clients who are so risk-averse that they won’t invest in dividend-paying equities. If turns in interest rates are missed -— and a portfolio manager does very well if he or she gets six or seven out of 10 turns correct — there would be substantial losses on paper, even if the bonds are held to maturity.

Mastracci’s approach would be to try to educate Brian and Joan about risk of equities vs fixed-income and why the couple need at least 20% in equities to start with and 30% in the longer term to meet their goals. He recommends that the couple initially invest 80% of their assets in lower-risk fixed-income — Government of Canada bonds, guaranteed investment certificates and some investment-grade bonds — and put 20% in large-cap stocks, mostly in those that pay dividends and have a track record of increasing those dividends. As the couple grow more comfortable with equities, Mastracci would encourage them to increase their exposure to 30% gradually over five to 10 years.

Mastracci also suggests short duration for the bonds, recommending an average duration of 2.5 years — for now, at least — using a five-year bond ladder. As soon as interest rates start rising, bonds will lose value, so a short duration is desirable. This way, the bonds will mature fairly quickly and the proceeds can be invested in higher-yielding ones. Once interest rates return to normal levels, the duration can be increased.

With 20% equities to start (and 30% within 10 years), Mastracci anticipates this asset mix will generate an average annual return of 5% after fees. Assuming 2% annual inflation, his projections show that Brian and Joan might just manage to take out $80,000 in today’s dollars to age 90 if they downsize their house in about 10 years. Without downsizing, the couple could withdraw only $40,000-$50,000 a year before taxes in today’s dollars to age 90.

Neither advisor have included the $400,000-$500,000 to help the kids, travel and/or buy a vacation home. In Pownall’s projections, Brian and Joan could withdraw this amount by using the equity in their home; but there’s no leeway with Mastracci’s recommendations, as he’s already assuming the couple will take $500,000 out of their home by downsizing in 10 years.

Initially, the full annual income in the corporate account will be more than the couple need. Mastracci and Pownall both recommend that Brian and Joan put what they don’t need into tax-free savings accounts (TFSAs) until they are maximized and then into non-registered accounts. Both advisors recommend that TFSAs be set up, with contributions maximized as soon as possible, as this will shelter investment income, particularly interest, from taxation.

Both advisors recommend that Brian and Joan wait until age 72 to start withdrawing from their RRSPs, although they should put a small amount into RRIFs when they turn 65 so they can take advantage of the $2,000 annual pension income-splitting deduction on their income taxes.

Mastracci recommends that the couple consider long-term care (LTC) insurance, as well as enhanced medical insurance, if they can get it.

Pownall suggests the couple consider LTC, but not until they have finished travelling and their cash-flow demands are lower.

Brian and Joan should make sure they have up-to-date wills, as well as health and property powers of attorney (called representation agreements and enduring powers of attorney, respectively, in British Columbia). Mastracci notes that the property power of attorney needs to include the making of decisions on the real estate.

Pownall would not charge to develop and monitor the financial plan. The transaction costs on the high-yield investments would be low, he notes, at around 25 basis points, as only about a third will be rolled over each year. The overall portfolio fee would be around 0.75% a year.

Mastracci would charge 1.5% a year, which includes developing and monitoring the plan, plus portfolio management and financial planning, including annual re-running of projections and advice on minimizing taxes. He suggests exchange-traded funds for most of the investments, which would keep other fees down. He notes that portfolio-management fees are deductible for taxable, non-registered accounts.  IE