Extended vacation is doable

The Scenario: Bob and Ann are both 50 years old and want to take a couple of years off now to do some extensive travelling and hone their hobbies instead of waiting until retirement. The couple have a $100,000 mortgage, with payments of $1,400 a month, on their $500,000 home in Kitchener, Ont. Their three children are financially independent, and Bob has just inherited $500,000 from his widowed mother.

Bob, a salesman who earns about $100,000 a year, has $400,000 in his RRSP; he has $100,000 in unused RRSP room. Ann, an executive assistant earning $50,000 annually, has $100,000 in her RRSP; her unused RRSP room is $50,000. Neither spouse has a pension or other benefits through work.

Ann also has $200,000 in non-registered savings, the result of an inheritance from her parents. Bob has $100,000 in non-registered savings besides his recent inheritance. Each spouse has $15,000 in tax-free savings accounts.

Bob and Ann think they will need $300,000 to fund their two-year break: $25,000 for six weeks in a rental house in the south of France; $120,000 for a six-month trip by motorhome around the U.S.; $55,000 for the mortgage and other house-related expenses; and $100,000 while they are at home pursuing their hobbies.

Both spouses are confident they can get new jobs paying an amount equivalent to their current salaries in two years’ time, but want to know the implications of taking this break on their retirement income. They also want to know what they can reasonably expect to spend each year after taxes in today’s dollars from ages 65 to 95 (in addition to replacing their car for $20,000 every six years, paid for out of their TFSAs).

Bob and Ann have been spending about $65,000 a year and have been making maximum RRSP and TFSA contributions.

They are non-smokers in good health and want to leave each of their children at least $50,000 in today’s dollars.

 

The Recommendations: Berton and Gainor both say that taking two years off is doable for the couple, but risky in terms of what jobs and salary they will be able to get when they return to the labour force. “What if the Canadian economy stalls?” asks Gainor, who points out that if the couple can’t find jobs, they wouldn’t be able to collect employment insurance and would be spending more of their savings as a result.

That said, as long as Bob and Ann can get jobs that pay an amount equivalent to their current earnings, they would be able to fund a comfortable retirement.

Berton’s projections indicate that if Bob and Ann take two years off and spend $300,000 during that period, they should be able to spend about $67,500 a year in today’s dollars in retirement to age 95. That would be without dipping into the equity in their house, which would provide the inheritance they want to leave their children. Gainor says the couple should be able to spend $70,000-$75,000 a year to age 95.

In the advisors’ projections, Berton assumes a 5% average annual return after fees; Gainor, 6%. Both advisors assume average inflation of 3% a year. Berton assumes only a 1%-a-year increase in old-age security and Canada Pension Plan benefits; Gainor, 3%.

Berton assumes no increase in the couple’s employment income after they return to work, saying that many people at their age aren’t getting salary increases. Gainor assumes a 3% a year increase in salary for each spouse.

Berton has included car purchases every six years until age 79; Gainor, to age 77.

Both Berton and Gainor recommend paying off the mortgage as soon as is feasible without paying large penalties. Berton notes that if Bob’s inheritance is used, the remainder of that money will then become a joint asset in the event of a divorce. If this is a concern, the spouses could each take $50,000 from their non-registered accounts.

With mortgage rates currently so low, it could make sense to keep the mortgage. But, Gainor says, “The emotional peace of mind that comes from having no debt can far outweigh the opportunity for financial gain.”

This is particularly applicable in this couple’s case because they are taking two years off work and aren’t guaranteed jobs when the two years are up. If the couple has trouble finding work at that point, they won’t have to come up with $16,800 a year to pay the mortgage.

Berton suggests that Bob and Ann consider renting out their house while they do their long trip in the U.S. The rent received would probably cover the mortgage payments — if they still have the mortgage at that time; if they have no mortgage, the rent would more than cover ordinary operational and maintenance costs.

Gainor recommends using up both Bob’s and Ann’s unused RRSP room immediately, noting that the deduction for that can be spread out over many years, so they can deduct the optimum amount for maximum tax savings each year. However, Berton’s projections suggest that Bob and Ann are only “marginally” better off if they don’t use up their unused RRSP room and leave the assets in non-registered accounts.

Both advisors recommend that Bob and Ann make the maximum RRSP contributions while working and maximum contributions to their TFSAs every year until at least age 65. Berton also notes that Bob has much more in his RRSP and could contribute to a spousal RRSP for Ann until their accounts are more equal.

Bob’s and Ann’s most urgent insurance need is travel medical, which both advisors assume will be paid for out of the $300,000 Bob and Ann are putting aside for their two years off work. The couple also need to apply for an extended leave of absence to maintain their Ontario Health Insurance Plan coverage. Without that, they can be out of Canada for only about seven months in any 12-month period without losing coverage.

Gainor also suggests that Bob and Ann start to buy U.S. dollars in anticipation of their trip there. He recommends dollar-cost averaging — buying a certain amount each month rather than trying to time the ups and downs of the Canadian dollar vs the US$.

Bob and Ann’s wills and their financial and health-care powers of attorney need to be up to date before they start travelling.

Both advisors think critical illness and long-term care insurance would be a good idea, with regular reviews to make sure the coverage is still warranted and adequate.

CI coverage is particularly important because of the upcoming two-year break from work and because Bob and Ann are in the age group in which critical illnesses are particularly likely. Berton recommends a 15-year, return-of-premium, $130,000 policy for each spouse, which would cost about $3,200 a year combined.

As for LTC, it would ensure the couple wouldn’t have to use the equity in their home if they need such care, thereby protecting their children’s inheritance. Berton suggests policies for each spouse that provides $120 a day for home or facility care; combined, that would cost almost $4,000 a year.

An alternative way to get the same coverage would be a CI policy that could be turned into a LTC policy at age 65. That would cost about $2,400 a year for Bob and $1,900 for Ann.

Both advisors recommend transferring some RRSP assets to RRIFs at age 65 (so Bob and Ann can each utilize the $2,000-a-year pension credit) but wait until age 71 to transfer the rest. Gainor suggests periodic pro forma tax returns to see if income sources should be adjusted to minimize taxes.

Both advisors recommend a 40% fixed-income/60% equities portfolio, assuming Bob and Ann have moderate risk tolerance — at least, until they retire. Berton would suggest planning to shift the equities portion to 50% at age 65 and then to 40% at age 75 to reduce portfolio volatility and enhance income certainty. Gainor agrees that shifts in asset mix are likely to be appropriate to reflect income needs and risk tolerance as Bob and Ann age. However, he emphasizes, these should not be done suddenly: gradual shifts are preferable because they avoid the pitfalls of unfortunate market timing.

For tax efficiency, both advisors would put most of the interest-bearing investments in the registered plans and the more tax-efficient equities in non-registered accounts.

Berton suggests the couple invest their assets in a mix of exchange-traded funds and mutual funds or in a wrap portfolio that provides automatic rebalancing and doesn’t require the couple’s continued active involvement in these matters. The latter option would be particularly convenient while Bob and Ann are travelling.

Noting that most people are Canada-centric, particularly as they get older, Berton suggests two-thirds of the equities be Canadian, but he would urge that the remaining third be international. The S&P/TSX composite index is dominated by resources and financial services companies; as a result, he believes, investors should have more diversification than that.

Berton points out that there are many multinationals that are U.S.- or Europe-based only in the sense that this is where their headquarters are located. Many are, in fact, global companies that offer a broad geographical diversification and usually pay good, frequently rising dividends. He wouldn’t suggest investing directly in emerging markets; rather, get exposure to them through global companies.

On the fixed-income side, Berton suggests the combination of a bond ladder, which would be short-term while interest rates remain low, corporate bonds within a managed product and real-return bonds.

Gainor is more concerned about the lack of sector diversification in Canada and would suggest more foreign content on the equities side: one-third each for Canadian, U.S. and international, including a small amount in emerging markets. He would recommend a multi-manager, multi-style pool.

For the fixed-income, Gainor suggests the combination of an ETF to keep costs down and an actively managed corporate bond fund to try to add some value.

Berton would charge about $1,500-$2,000 for a plan of this nature. Quite a few of his clients pay an annual fee of $1,200 a year for ongoing services, including a $300 credit toward tax-return preparation. His fees for managing assets comes from mutual fund trailer fees, which would be 0.85%-1% for the assets he recommends, as well as insurance commissions.

Gainor, who doesn’t sell insurance, charges an annual fee of 1.75% of assets on the first $500,000 and 0.75% on the next $1.5 million for his services, including developing and ongoing monitoring of the financial plan, doing income tax returns and managing the assets. IE