“Portfolios” is an ongoing series that discusses various asset-allocation options. In this issue, Investment Executive speaks with Brent Bowen, division director at Investors Group Inc. in Vancouver and Paul Green, president of Green Financial Group, an Investment Planning Counsel affiliate in Woodstock, Ont.



The Scenario: a hus-band and wife living in British Columbia are both working. The husband, 55, earns $100,000 a year, while his wife, 45, makes $60,000. They have two children, aged 12 and 15, whose university educations the couple expect to finance. They don’t have RESPs.

When the husband retires, he will get an annual pension of $60,000. He has term life insurance to age 65, as well as disability, health and dental benefits. He has $500,000 in non-registered assets — all in income trusts, with 30% in oil and gas trusts.

The wife won’t get a pension but will receive 60% of her husband’s pension should she survive him. She also has $500,000 in assets — $300,000 in income trusts in her RRSP, and $200,000 of non-registered investments in blue-chip stocks.

The couple owns a home worth $700,000, with $100,000 in mortgage debt. The mortgage is scheduled to be paid off in 10 years.

Their current annual expenditures are $140,000, including $13,000 in mortgage payments.

Both plan to retire when the husband turns 65, at which point they expect their annual expenditures to drop to $100,000 in today’s dollars. They would like to leave their children an estate equal to the current value of their assets.



The Recommendations: both Investors Group’s Bowen and IPC’s Green agree: the income trust exposure should be reduced as soon as possible. But it depends on how much capital gains taxes the sales will trigger. It may make sense to spread the sales and, therefore, the tax liability over two or three years. But it could take as much as five or six years, says Bowen. He’s not worried about losses on the trusts in 2011, when they will be taxed the same as corporations; he believes that is already priced into the valuations.

Although Bowen would reduce the income trust exposure significantly, he recommends keeping 10% because the distributions are a perfect way to supplement income. He also wants to minimize the capital gains tax liability.

On the other hand, Green recommends selling all the income trusts over whatever period of time is reasonable, given capital gains. That’s not because he believes income trusts are never an appropriate investment, but because he recommends using professional money managers to pick investments, including income trusts.

Both advisors think the couple will have a problem meeting their goal of leaving a healthy estate for their children. But the couple should be able to generate the income they want up to age 95, if they take steps to reduce taxes.

First, they should use $100,000 from the sale of the income trusts to pay off their mortgage; then take out an equivalent investment loan to replace those assets. The interest on the investment loan is tax-deductible and, Green says, the reduced taxes and eliminated mortgage payment will improve cash flow by $9,000 annually.

Second, the wife should contribute the maximum annual amount to her RRSP, taking the money out of capital. Bowen assumes an annual contribution of $11,000 in today’s dollars, which would produce a $3,500 refund. Green adds that either spouse’s unused RRSP room could be used to reduce taxes further. He suggests the husband make spousal contributions, as he is in the higher tax bracket.

Both Bowen and Green believe these moves will sufficiently reduce the couple’s annual withdrawals of capital to make their money last until she is 95. But there wouldn’t be much left over — only about $200,000 in 2057 dollars, according to Bowen’s projections.

However, in Green’s experience, expenses usually decline by about 15% once one of the spouses reaches age 80. Green’s projections are based on this assumption, which forecast about $2 million in assets remaining in 2057 dollars when the wife is 95.

Both Bowen and Green assume an asset mix starting at 20% fixed-income and 80% equities, which would generate an average annual return of 8%. When the husband turns 65, the asset mix will change to 50/50 — creating a 7% return, according to Green’s projection; 6.5%, in Bowen’s.

@page_break@Another key assumption is that the husband does not die in his 70s or the second half of his 60s. If he dies, the wife’s pretax income will drop by $24,000 a year in today’s dollars but, as Bowen notes, it is unlikely her expenditures will decline by that much.

The scenarios also assume that husband and wife remain healthy and don’t need expensive home or institutional care. If either becomes seriously ill, medical expenses could eat up the portfolio very quickly.

Bowen notes that people often assume governments will pay most medical expenses. But that is not the case for home or institutional care, and for many medications.

Insurance is a solution, but it would require the couple to reduce expenses — by $7,500 a year, Bowen says — to pay the premiums on the following:

> Term Life. Term life insurance of $200,000 to age 100 for the husband, purchased when he retires and his current term insurance expires, would cost about $3,200 a year in today’s dollars if he is a non-smoker with standard health. Assuming a 6.5% return when the $200,000 is invested upon his death, this would generate $13,000 in additional pretax income for the wife, making up for more than one-half of the drop in her after-tax income given her lower tax bracket.

> Critical Illness. CI insurance of $100,000 for both husband and wife to age 75 would provide a lump-sum payment in the event either develops cancer or has a heart attack or stroke. The cost would be about $2,000 a year for the husband and $1,000 for the wife. Bowen notes that more than 90% of people recover from a first heart attack and more than 75% survive an initial stroke. He adds that the coverage can be enhanced at extra cost to include 19 other illnesses, such as Parkinson’s, Alzheimer’s, multiple sclerosis and diabetes.

> Long-Term Care. LTC insurance for life for both spouses, paying out $500 a week indexed to inflation for 250 weeks, would cost about $1,000 a year for the husband and $500 for the wife.

Given the higher portfolio return he is assuming, Green is less concerned about the couple running out of money, but would suggest they look at LTC insurance.

If their estate goal is very important to them, Green suggests they look at a last-to-die life insurance policy. They could buy a $1.5-million policy for about $7,000 a year, assuming standard health.

Green recommends RESPs, even though the children would have only six and three years, respectively, of contributions that qualify for the government grant. The grant portion is 20%, or $500 if the maximum $2,500 annual contribution per child is made. Green notes that catch-up grant-qualifying contributions of up to $2,000 a child are allowed each year, resulting in an additional $2,700 for the 15-year-old and $5,400 for the 12-year-old.

To modify the portfolio, both Bowen and Green would sell the wife’s income trusts — which are in her RRSP and so aren’t liable for capital gains taxes — and replace them with fixed-income investments. Both want to see 20% of the overall portfolio in fixed-income as soon as possible; the wife’s RRSP is the ideal place for it because the interest is tax-sheltered.

The wife’s blue-chip stocks can be kept, says Bowen, but he would sell $400,000 of the husband’s income trusts as quickly as is reasonable, given capital gains tax implications. He would leave the other $100,000 in income trusts, noting there are still some good income trusts in the oil and gas sector.

Green suggests a segregated discretionary managed account with an annual fee of about 2%, consisting of 1.25% for the equities management, 20 basis points for the bonds and 1% for the advisor. If the assets rise to more than $1 million, the advisor’s fee will drop to 0.5%; if they surpass $3 million, it drops to 0.25%. The income trusts would be held in a separate transaction account until they are sold.

Bowen suggests a transaction account because there will be little trading after the portfolio is modified. He would use Investors Group mutual funds — with MERs of 2.4%-2.5% — for about 40% of the portfolio, specifically the equities portion (except for the $200,000 in blue-chip stocks). There would be an average $100-$200 charge on each stock sale, while the fee on bonds is built into the price.

Both would use bond ladders for the fixed-income portion, initially going out five or six years because the yield curve now is relatively flat. Green would buy only bonds, while Bowen would include a mortgage mutual fund for up to 5% of total assets, a real property fund for 5%-10% and some GICs for 5%-10%.

Bowen favours a mix of 40% foreign equities and 60% Canadian, but Green would go 40% Canadian equities, 50% global and 10% global alternative investments — the last comprising a multi-strategy fund and a long/short fund. Bowen does not like alternative investments.

For the foreign equities, Bowen suggests $120,000 should go into good global and European dividend funds; $30,000 into U.S. growth and value funds; $25,000 into good merger and acquisition funds, mostly U.S.; and $25,000 into emerging markets. He notes that M&A funds have a different management style, which adds to the portfolio’s diversification.

Green would use two managers for the Canadian equities, one with a growth style and the other with a value style, and do the same for global equities. But if the client preferred one style, he’d tilt the asset allocation to that style.

Bowen would put the husband’s non-income-trust Canadian equities into mutual funds with a growth style, with half in small to mid-cap companies. IE