Financial Checkup: Leaving an estate will be no issue

They have a house in an Edmonton suburb worth $850,000 with a $400,000 mortgage, as well as a second home on Vancouver Island that’s worth $650,000 with a $500,000 mortgage. Henry has $400,000 in RRSP assets; Melissa, $200,000. Henry’s unused RRSP contribution room is $63,000; Melissa’s, $30,000. The couple also have $400,000 in jointly held, non-registered assets but no tax-free savings accounts (TFSAs). Each partner has term insurance of $100,000 to age 99, which is convertible to permanent insurance, but no health insurance.

Henry had been making $200,000 a year as president of the business; Melissa was earning $60,000 as its bookkeeper. The couple had been spending $80,000 a year after taxes, mortgage payments and RRSP contributions. They want to increase that to $100,000 to age 90. Their other goal is to leave their three financially independent children $250,000 each in today’s dollars. Henry and Melissa also would like to contribute to their two grandchildren’s post-secondary education.

Recommendations: both financial advisors say Henry and Melissa will have no problem achieving their retirement income and estate goals and can provide as much as they wish to their grandchildren’s education costs.

Both advisors’ projections assume an average annual return on the investments of 5% after fees. However, Falkenberg-Poetz assumes 2% a year for inflation and real estate appreciation, while Mastracci assumes 2.5%. These assumptions result in $150,000 in maximum spending, in today’s dollars, to age 90 in Falkenberg-Poetz’s case but $140,000 in Mastracci’s projections.

Mastracci notes that higher than expected inflation can be the “real killer” in financial plans, as much more will be required in future dollars to meet the purchasing power target. For example, he says, if inflation averages 3.5% annually over the next 35 years, Henry and Melissa would need about $400,000 in nominal dollars at age 90 to get the equivalent purchasing power of $100,000 today but would need only $285,000 if inflation averages 2.5%.

That would be OK if the average annual return is correspondingly higher. If it isn’t, there will be a significant reduction in the estate that will be left. If inflation averages 3.5% and the return is still 5% a year – and Henry and Melissa don’t dip into capital for any other reason – the couple’s net worth at age 90 would be around $5 million vs the $6 million they are likely to have if inflation is 2.5%.

Falkenberg-Poetz ran projections to gauge the impact of paying off the mortgages now and maximizing the couple’s RRSP and TFSA contributions vs paying the mortgages off over 25 years and not making more contributions toward the RRSPs and TFSAs. In the former case, the couple could have an estate, including both houses, of about $7.8 million in today’s dollars; in the latter case, they could still leave about $7.3 million in today’s dollars.

As a result, both Falkenberg-Poetz and Mastracci recommend that Henry and Melissa pay off their mortgages now, contribute the $93,000 in unused RRSP room as soon as possible and make maximum TFSA contributions.

Both advisors also recommend setting up a family RESP for the grandchildren and contributing $2,500 a year for each grandchild in order to maximize the government grants. Falkenberg-Poetz notes that making the maximum allowable contributions of $50,000 per child now and skipping the ongoing annual grants would produce a greater amount within the RESP only if the plan earns an average return of 6% after fees.

Falkenberg-Poetz recommends the couple take out a $750,000 “permanent” joint, last-to-die universal life insurance policy. He obtained a quote for such a policy for 55-year-old non-smokers in good health for which they could contribute up to $65,000 a year to the policy for 10 years – of which $23,000 would be the annual premium. The assumed rate of return within the policy is 5.4%, which would accrue to $1.5 million (the face value of the policy plus death benefits) at age 85. The advantages of this strategy include:

– It would guarantee $500,000 in nominal dollars for each of the three children when Henry and Melissa have both passed away, which would translate to about $250,000 in today’s dollars if inflation averages 2% annually.

– It would protect this portion of the couple’s assets from the impact of a lower average return.

– It would save on income taxes, as the income from that portion of the couple’s assets, net of the annual premiums, would compound tax-free within the insurance policy.

– It would save on probate fees because the death benefit would flow directly to the beneficiaries.

The term insurance that Henry and Melissa currently hold could be converted to a joint, last-to-die universal life policy if the product and terms of their current policies are favourable. Otherwise, another quote can be obtained. To be safe, the current term insurance should not be cancelled until the couple know replacement insurance can be obtained.

“Permanent insurance may fit their overall goals better,” Falkenberg-Poetz says, “as it has an investment side to it for universal life and a participating side for dividends for whole life. By maximizing contributions each year, they could shelter more capital from taxes and get tax-free compounding, increasing the value of their estate.”

Mastracci prefers to keep financial plans simple. As a result, he doesn’t see any reason to keep the term insurance or add another policy when Henry and Melissa are already “more than comfortable, financially.”

Given the couple’s financial and real estate assets, both advisors consider Henry and Melissa to be “self-insured” for any health-related care that’s needed or desired and thus don’t recommend either critical illness or long-term care insurance. However, Mastracci recommends the couple purchase enhanced medical insurance, which he estimates would cost about $500 a month for each of them. Medical costs, he notes, can be very steep.

Both advisors recommend that Henry and Melissa wait as long as possible before starting to collect old-age security and Canada Pension Plan benefits. The advisors also say the couple should wait until they are 71 years old to move all their RRSP assets into RRIFs, although enough should be put into the RRIFs to enable the couple to withdraw $2,000 a year tax-free by using the pension income deduction.

There also are some other strategies the couple could pursue. For instance, Falkenberg-Poetz says, they could pay off their mortgages and take out an investment loan, the interest on which would be tax-deductible. But he wouldn’t recommend that “because leverage can create a different client mindset. That is, should the portfolio go down [in value], the clients may sell their investments and run the risk of having less in financial assets than their loan value.”

The couple also could set up a charitable foundation if they want to leave money to charities. Once investments are transferred to a charity, the income from those investments no longer is taxed in the hands of the donor.

Another possibility, says Falkenberg-Poetz, is to provide monetary gifts to the couple’s children so that the income would be attributable to the children, thus reducing Henry’s and Melissa’s taxable income.

Both advisors recommend Henry and Melissa leave money to their children in testamentary trusts, as the trusts’ income would be taxed separately and not added on to the children’s other income, potentially moving the children into a higher tax bracket.

Falkenberg-Poetz and Mastracci both are conservative in their investment recommendations. Neither suggests high-yield fixed-income or alternative investments.

The only alternative investments Mastracci would consider are global real estate and infrastructure – and that would be for only 2%-5% of the total portfolio.

“In theory,” Falkenberg-Poetz says, “hedge or alternative funds can be a good investment, as they are set up to be negatively correlated to equities and tend to perform better in down markets. The disadvantage of these investments is that very few of them are transparent enough to let you know what they are holding at any time.”

Falkenberg-Poetz’s recommendation for this couple is 40% in Canadian bonds, 25% in Canadian dividend-paying value equities, 20% in U.S. dividend-paying value equities and 15% in international growth and value equities – all in portfolios managed by institutional portfolio managers.

“The key is to use managers with proven track records who outperform the market with less risk and have good downside protection,” he says. “It is equally important how these managers fit within the optimal portfolio modelling to reduce risk overall.”

The tilt toward value equities is because, in a low interest rate environment, you want to have a good deal of dividend yield to generate cash flow.

Mastracci suggests 25% be held in a three- to five-year bond ladder, 25% in large-cap Canadian dividend-paying equities, 25% in other Canadian equities, 15% in U.S. equities and 10% in global equities. He calls this a “pension plan” style of portfolio and emphasizes that the focus remain on the long-term rate of return.

He recommends using exchange-traded funds. He doesn’t think actively managed products are worth the fees charged “because of the tendency for most products to revert to the mean over time.”

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