Financial Checkup is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks to Ngoc Day, Canadian investment manager, registered financial planner and associate financial advisor with Macdonald Shymko & Co. Ltd. in Vancouver; and with Peter Murray, certified financial planner, RFP, registered trust and estate practitioner, and senior financial advisor with Assante Capital Management Ltd. in Calgary.



The Scenario: Stanley and Freda are a young couple living in Victoria. Stanley is 28 and Freda is 29. They have no children but plan to start a family in one year. They would like to have a second child and then adopt a third child from a developing nation.

Stanley, a minister at a local church, makes $45,000 a year, of which only $35,000 is taxed. His compensation also includes a defined-contribution pension plan, with his employer matching his contributions up to 5% of Stanley’s salary. Freda earns $50,000 annually as a co-ordinator for a large non-profit organization and has a defined-benefit pension plan. Both spouses have good benefits, including life insurance equal to two years’ salary. However, only Stanley’s benefits include disability insurance. Stanley and Freda each have term life insurance of $250,000 to age 80.

Stanley is also a part-time master’s degree student; his workplace is paying for his courses. Freda plans to work part-time in the fall while she takes a master’s degree over four years. The course will cost her $3,000 a year and should increase her earnings potential to $60,000 a year. (All figures are in today’s dollars.)

The couple recently purchased their first home, a $300,000 condominium. Their mortgage is $230,000 and they have a credit line of $10,000. They have a family-sized car and may want a second, less expensive car after they start their family.

After mortgage payments and taxes, they spend $36,000 per year. They expect to have at least $10,000 in savings by the fall, which they plan to use as an emergency fund. They think they can save $18,000 a year when Freda is working part-time.

Their goals, in order of importance, are:

> two modest vacations a year, costing about $1,200 each;

> retirement income of $50,000;

> upgrading the condo to a house worth $500,000;

> completing their MAs and potentially taking PhDs;

> providing $10,000 a year for each child’s post-secondary education;

> leaving an estate of $50,000 per child;

> taking out disability insurance;

> putting $100,000 toward a vacation home that would be purchased with other members of Freda’s family.

The couple estimates the cost of raising each child to be about $7,000 a year initially. That amount is likely to rise to about $10,000 once the child is around six and activities such as summer camp, sports and other recreational activities are desirable. The couple expects one-time expenses for the adopted child of about $20,000. With help from family members, there shouldn’t be child-care expenses until Freda returns to full-time work.



The Recommendations: Stanley and Freda have a lot of time, but if they want to achieve all or most of their goals, they also need to make some hard choices now. In addition, both Day and Murray say that disability insurance for Freda should be a much higher priority than it is now. If something happens to her, as Day says: “They don’t have a lot of wiggle room.”

Murray notes that there is twice the risk of being disabled as there
is of dying prematurely, which makes disability insurance as important, if not more so, as a life policy. The cost of $2,900 a month disability coverage for Freda would be about $85 a month, Murray says.

Day notes that Stanley’s $340,000 and Freda’s $350,000 in life coverage would take care of the mortgage should one of them die. However, once the couple starts having children, they should take out $1-million life policies, if they can afford to do so and assuming they feel strongly about contributing to the children’s education costs and leaving them $50,000 each. Day strongly recommends shopping around for those policies.

Murray suggests $900,000 in life insurance for both Stanley and Freda once there are children. The combined cost would be about $1,500 a year.

In addition, Freda and Stanley need to do a detailed analysis of their expenditures to see exactly what they are spending. Annual spending of $36,000, plus mortgage payments and savings totalling another $36,000 a year, exceeds their after-tax income. It may be that the amount they estimate is being saved is correct and they are spending less than they think. But they may also be underestimating their spending.

@page_break@Expenditures are a key factor in financial planning. A mistake in this assumption can mean that the financial plan that is developed won’t work. Another important assumption is that Freda will be able to get a job paying $60,000 when she completes her MA, says Murray. Freda needs to do research to see if this is realistic.

But whatever the result of the expenditures/income analysis, meeting the couple’s goals is going to be difficult and could place a lot of stress on Freda and Stanley individually — and on their marriage. Easing that pressure may mean rethinking their goal of three children — or, at least, the timing of that goal.

Under the couple’s current plan, they would need to take out a $50,000 line of credit to cover cash-flow shortfalls during the 2011-15 period, according to Murray’s analysis.

But if, for example, the couple doesn’t have a child until Freda has finished her MA and returned to work full-time for a year at the hopefully higher-paying job, they could potentially avoid going into further debt, says Day. That is because Freda’s entitlements for maternity leave under employment insurance would be 55% of the yearly maximum pensionable earnings — currently $46,300 and almost equivalent to her current full-time salary — rather than 55% of a $25,000 part-time salary.

The potential problem with this suggestion is that Freda could be past her mid-30s when she has the first child; it might be harder for Freda to conceive when she is older.

An alternative, says Day, would be for Freda to continue to work full-time while studying for her MA. This would allow her to collect 55% of her full-time salary when she is on maternity leave. At the same time, her full-time salary would allow her to build up savings and reduce the family mortgage until she goes on maternity leave.

Murray suggests the couple consider having only two children. That would lower expenses and allow them to remain in their condo a few years longer, to perhaps 2016. Then, when they upgrade to a larger home, a house worth $400,000 rather than $500,000 might be adequate.

Both financial advisors suggest paying off the $10,000 line of credit. However, it should be kept in place to allow for emergencies. Murray thinks they should have more than $10,000 available: an emergency fund should equal three months of expected expenses.

Day recommends that when the couple do have savings, they use them in the following order: first, to pay off the line of credit; second, to contribute to an RRSP for Freda; and, third, to pay off as much of their mortgage as they can.

Day recommends that Freda make maximum RRSP contributions and use up her unused RRSP room when it is financially feasible to do so. In Day’s view, Stanley doesn’t need an RRSP as long as he continues to put 5% of his salary into his DC pension plan, given that his employer is matching his contributions up to this level.

Both advisors note that Stanley’s income puts his marginal tax rate at only 20%. That means that, with his employment pension, Canada Pension Plan and old-age security, he will probably continue to have about the same income when he is retired. Freda’s marginal tax rate is 30%, which makes RRSP contributions more valuable in her case.

Day would put tax-free savings account contributions fourth on the list of priorities: that’s because TFSAs don’t provide the tax deduction that RRSP contributions receive. Day also believes that it’s more important to pay off debt.

Neither Day nor Murray thinks the couple will be able to afford a second car. Even their modest vacation plans will probably not be affordable, Murray says. When push comes to shove, the couple may find themselves eating a lot of macaroni-and-cheese dinners should they take these vacations.

The vacation home is also unlikely for many years. In Murray’s projections, he plans for its acquisition in 2030 but notes the financial pressure that will come with additional debt. Day adds that if the couple do buy such a home, they should seek legal advice on how to structure the title in order to protect their interest in the property.

Retirement income of $50,000 is probably achievable, says Murray, particularly if the couple lowers that goal to $37,500 at age 80, when they are likely to be less active. Murray’s projections suggest that each spouse could have about $725,000 in retirement funds at age 60, assuming Stanley continues to contribute to his DC plan and Freda uses up all unused RRSP room when her income is higher; doing so would generate sufficient income to age 95.

Whether the couple will be able to contribute to their children’s education will depend on how much they end up spending in the interim. But the goal of leaving $50,000 to each child can be covered through life insurance, and they could leave considerably more if they have not sold the residence and vacation property by then.

Both advisors emphasize the need for up-to-date wills and personal and property powers of attorney. Wills need to be reviewed after each child is born, and guardians and backup guardians appointed. Both advisors also emphasize the need to monitor and update the couple’s financial plan continually as situations can change enormously over a lifetime.

In Day’s experience, a financial plan costs $5,000-$8,000 to develop, and her firm charges an annual retainer of $400. That includes one hour for an annual review meeting to monitor progress and update the plan, if necessary.

Murray charges $1,500 plus expenses to prepare the initial plan and $150 an hour plus expenses for any followup. An annual review usually takes six to eight hours. IE