“Portfolios” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with Randall Takasaki, vice president at HSBC Securities (Canada) Inc. in Vancouver, and Hong Wang, client advisor at UBS Bank (Canada) in Toronto.

The scenario: a couple has been married two years; the 50-year-old husband has two children, ages 10 and 12, from a previous marriage; the children live with their mother, who works and does not receive spousal support; he does pay $1,000 a month in child support and will until the children reach 18; he also plans to pay for half of their university education.

The current wife, who is 40, also has two children from a previous marriage, ages six and eight, for whom she receives $700 a child every month; that continues until the children reach 18. Her previous husband will not pay any of the costs of the children’s university education; there are no RESPs. But the current husband has agreed that the couple will pay the full costs of her children’s education out of their joint income.

The couple have a six-month-old child of their own.

The husband has financial assets of $2 million, all in non-registered assets. He earns $125,000 a year before taxes. As well as full CPP benefits, he will receive a pension indexed to inflation of $75,000 a year in today’s dollars and full medical benefits when he retires at age 65. His wife will get 60% of the pension and medical benefits after he dies.

The wife earns $60,000 a year. She will not receive a workplace pension but will get full CPP benefits. She has $500,000 in an RRSP.

Their home, which is in the husband’s name, is worth $1 million. Their current after-tax income of $135,000 is sufficient for their expenses as long as both are working. Their goal is to have the same level of income in retirement.

There is no prenuptial agreement. But the partners have agreed that she will get the widow’s portion of one-third of her spouse’s assets upon his death. He will waive his entitlement to her financial assets should she die first, but would keep his 50% widower’s entitlement to the marital home. The couple have not specified this in wills.

Both husband and wife want to make sure their children are taken care of financially. The wife wants to leave each of her children $500,000 in today’s dollars, assuming she survives her husband, and at least $300,000 if she is the first to die. The husband wants to leave each of his children, including the child they have had together, $750,000 in today’s dollars.

Then there is the more immediate concern that the couple could both die in an accident. The wife wants to be sure that her children are taken care of financially, and she doesn’t want her previous husband to have control of her assets. But neither the husband nor the wife have life, long-term care or critical illness insurance, and they want to know if they need coverage.

They want to know how they can structure their finances and wills to achieve these objectives.



The Recommendations: The return the couple’s financial assets earn will make a huge difference in meeting their retirement income and their estate planing goals for their five children.

If the annual return is 7% after fees, which Takasaki is assuming, the couple will achieve both income and estate goals even if both partners live to age 95. Indeed, his projections indicate that the couple would have $4.8 million in today’s dollars when the wife turns 95. Takasaki is assuming 3% inflation a year.

If the annual return is 6%, which Wang uses for her projections, the couple could meet their income goals but would have virtually no assets left at age 95. Wang is assuming annual inflation of 2.5%.

The difference in the return assumptions lies mainly in the recommended asset allocation. Takasaki suggests 70%-80% be invested in equities because the couple is relatively young and has a long-term investment horizon.

But Wang thinks that with five dependent children, the couple should be running less risk, and invest only 65% of their financial assets in equities.

To reach their estate goals, Wang says, the couple needs to cut their expenses so they can live on $125,000 a year, not the $135,000 on which they currently live. She suggests the spouses take a look at their income requirements and see how they can reduce them.

@page_break@As for insurance, both Takasaki and Wang believe term and CI insurance are necessary to ensure that the children are taken care of should either or both spouses die before the children are financially independent. Even with Takasaki’s projections, there would be problems if the husband died before that time, although possibly not if the wife died.

The cost of $2 million in 20-year term insurance for the husband and $400,000 for the wife would be about $8,000 a year, assuming the spouses are nonsmokers in normal health, Takasaki says.

CI insurance coverage to provide a lump-sum payment of $100,000 if the husband is diagnosed with an eligible illness and $50,000 if the wife is would cost $3,700 a year for a term of 20 years.

Wang notes that certain CI policies return the premiums paid if the spouses remain healthy for 20 years, but these tend to be more costly.

The husband presumably has disability coverage through his company benefits. The wife probably does not need disability coverage.

The spouses agree that the decision about whether to take out LTC insurance can be left until their CI coverage runs out in 20 years.

Takasaki believes the insurance premiums can be paid out of capital. Wang, on the other hand, says the spouses should pay them out of current income; that would mean they would need to reduce their income requirements by a further $11,700 annually for the next 20 years if they want to meet their estate goals.

Both advisors strongly recommend the couple draw up wills stipulating who will take care of the children and the financial obligations of the husband to the wife’s children from her previous marriage should the wife die before those children are independent.

Given the complexity of this blended family’s situation, Wang says, the couple require a lawyer’s advice.

Wang suggests the couple consider setting up two testamentary trusts for the wife’s two eldest children. This would not only allow income-splitting between the trust and the children, but would also ensure that her previous husband would never have control of the assets. She could also set up a spousal testamentary trust with her current husband if she trusts him to provide what she wants for her children.

Testamentary trusts may also be a good idea for the husband’s two eldest children, although if he trusts his ex-wife to provide for the children as he wants, trusts may not be required.

Once the wills are drafted, they need to be reviewed every few years, particularly when the children are young. A review would be particularly necessary if the family moved to another province or country, as the rules concerning spousal rights differs among jurisdictions, says Wang.

She suggests that if the marital home is put in both partners’ names, that would avoid probate taxes on the home when the first spouse dies.

Takasaki and Wang both strongly recommend setting up RESPs and contributing the amount required to get the maximum government grant of $500 a child a year to top up the savings. For maximum flexibility, Wang suggests a family RESP for the three youngest children and a second family RESP for the husband’s two children who are living with their mother.

From a tax point of view, both advisors agree that all equities should be in the husband’s name because he is in the higher tax bracket and would benefit more from the dividend tax credit on Canadian equities and the lower taxes on capital gains. The wife’s portfolio, which is tax-sheltered in an RRSP, should be in fixed-income investments.

The wife should also continue to make her maximum RRSP contributions; the husband should set up an RRSP if his company pension contributions leave any room to contribute to one.

Takasaki says the husband could pay most or even all of the family’s expenses, allowing the wife to accumulate some non-registered savings. This would mean that more income could be taxed in her name at her lower tax rate.

Wang suggests 75% of the couple’s equity investments be in foreign equities because she believes global investments significantly reduce a portfolio’s volatility. She also says it is UBS’s view that the Canadian dollar will probably return to the US85¢-US90¢ range in the next two years. If this happens, returns on foreign investments will be enhanced in C$ terms. As part of the foreign equity allocation, Wang recommends an investment in UBS’s global multi-strategy fund of hedge funds equal to 15% of the total financial assets, aimed at further reducing the portfolio’s risk.

Takasaki takes a different tack, however, recommending that foreign stocks be only one-third of the equity allocation. In his view, prospects for Canadian stocks are good and the couple doesn’t want too much currency exposure in an environment in which the C$ could go up, thereby shaving returns in C$ terms.

In addition, he wants the couple to get as much of the benefit of the dividend tax credit as is consistent with minimizing risk. Takasaki suggests 10% of the total portfolio be in Canadian alternative investments and he would include that in the allocation to Canadian equities.

Both advisors suggest a bond ladder for the fixed-income portion of the joint portfolio.

Outside of alternative investments, Takasaki and Wang both recommend purchasing individual securities because the couple have enough assets to get good diversification without going into mutual funds, wraps accounts or pooled funds, all of which have higher costs.

Takasaki suggests a flat-fee, non-discretionary account with a 1% fee that includes all trading costs. Wang believes the spouses would be better off with a discretionary account with a fee of 1%-1.5%, depending on how much global equities they hold; the fee is higher for global equities. IE