“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with John Bajc, a licensed professional engineer, certified financial planner and senior executive financial consultant with Investors Group Inc. in Toronto; and Vera Vlaovich, financial advisor, certified financial planner and certified divorce specialist with Rogers Group Financial Ltd. in Vancouver.

The Scenario: Tom and Sarah are a couple living in Winnipeg. They are both 53 years old and have three independent children, one in Winnipeg, one in Toronto and one in Vancouver. Both Tom and Sarah have lost their jobs and need to reinvent their lives.

They own their home mortgage-free, which was worth $600,000 in 2007 and is now worth around $540,000. Tom has $400,000 in RRSPs, $200,000 in non-registered assets (from an inheritance) and $100,000 in severance pay. Sarah has $200,000 in RRSPs, $50,000 in non-registered assets and $40,000 in severance pay. All financial assets, except the severance money, are invested in balanced Canadian mutual funds.

Sarah also has just inherited 100% of the shares in a holding company that owns a small apartment building, which has retained its value and is worth $800,000. (For tax purposes, it has a depreciated value of $200,000.) The net return on the property was 8% annually, when her father, who was a builder, did all the maintenance and leasing. If Tom and Sarah keep the building, they will have to pay about 10% of the cash flow generated to someone for maintenance, management and marketing. There is about $167,000 in capital gains taxes due as a result of Sarah’s father’s death. There is also a tax liability of $277,000 related to the holding company and Sarah’s father’s estate that will have to be paid off when the holding company is wound up.

Neither Tom nor Sarah wishes to go back to their previous profession. Tom was a middle manager earning $90,000 a year; Sarah was an executive assistant earning $50,000. The couple would prefer to retire and do some travelling.

The couple were spending $80,000 a year, excluding taxes and maximum RRSP contributions, and think they could get by on $60,000 in today’s dollars for everyday living, and they want to know how much they could reasonably spend on travelling during the next 10 years. Besides visiting their out-of-town children once or twice a year, Tom and Sarah would like to take an extended driving trip through the U.S. for six months in the near future, as well as a couple of month-long trips to Europe and a one-week trip to the U.S. in other years.

Tom and Sarah would like to leave $200,000 in today’s dollars to each of their three children.

The couple want to know whether they should take out critical illness or long-term care insurance, or both. Tom and Sarah are non-smokers in good health, but all their parents died in their 70s or early 80s from heart-related problems.

The couple also want to know if they should keep the rental property; if not, when should they sell it and how should they invest the proceeds? Another question is whether they should have non-Canadian investments.



The Recommendations:
Both advisors agree that Tom and Sarah should be able to meet their goals. Both say the couple could spend $5,000 a year to visit their children, but differ on how much the couple can afford for other travel. Bajc thinks they could afford $25,000 a year for major trips; Vlaovich thinks they would be wise to spend only $10,000.

The couple’s annual income will likely be higher if they keep the apartment building. Bajc calculates that the rents could be expected to yield about $56,000 a year in net income after paying a firm to manage and market the property. To generate the same income if they sold the property, the couple would need a return of 7.5% after fees on the $810,000 in their total non-registered assets. (But Bajc recommends assuming an annual average return on investments of 6%, while Vlaovich would use a 6%-7% return.)

Bajc, however, says that keeping the property could be burdensome, given the couple’s lack of experience in managing a rental property. Even with a firm managing it, Tom and Sarah would still have to keep an eye on things to make sure everything was being done to their satisfaction. And the couple could be forced to borrow to pay for any major repairs.

@page_break@Furthermore, Bajc points out, liquidity could be an issue because Tom and Sarah will have to use funds from the first year’s rental income and cash in their non-registered assets to pay the tax liabilities due on Sarah’s father’s estate and the holding company.

Bajc says the couple won’t have to pay the capital gains taxes if they wind up the holding company within a year of Sarah’s father’s death because that would create a loss that can be carried back to Sarah’s father’s final tax return and used to offset the $167,000 capital gains liability.

“If this isn’t done within the year, they lose their ability to recoup the taxes,” Bajc says, noting that if the holding company isn’t wound up, the tax liability will grow as the property appreciates in value.

However, Vlaovich thinks that Tom and Sarah can sell the building at any time. She suggests the couple retain it for the time being “as they move through important life transitions resulting from the passing of her father and the loss of their respective jobs” and, in the meantime, enjoy a somewhat higher income.

Both advisors assume an annual inflation rate of 3%; appreciation in the value of their home of 4% a year; and life expectancies of 85 for Tom and 90 for Sarah.

The advisors recommend both Tom and Sarah make maximum RRSP contributions this year, including taking advantage of the special RRSP rules that allow them to put in the “eligible retiring allowances” — $30,000 for Tom and $14,000 for Sarah — from their severances.

Both advisors also suggest that Tom and Sarah start taking Canada Pension Plan benefits at age 60, which, in both cases, should amount to about half of the maximum. In addition, Bajc recommends that Tom and Sarah make withdrawals from their RRSPs rather than their non-registered assets — provided that doesn’t put them into a higher tax bracket. Both income-splitting and calculations of probable taxable income each year will be important to ensure that the couple remain in a low tax bracket, particularly after CPP and their old-age security benefits kick in.

Annual contributions of $5,000 each to tax-free savings accounts are a must. Bajc notes that this could result in $125,000 for each by age 65.

Bajc also recommends that non-registered assets be in equities in order to benefit from the dividend tax credit and low taxes on capital gains; he recommends that the fixed-income portion of their portfolios be placed in their RRSPs.

If Tom and Sarah sell the apartment building, this will result in an asset mix of 53% equities and 47% fixed-income; but as they withdraw from their RRSPs, the mix will shift to 60% equities and 40% fixed-income, which Bajc thinks is appropriate.

Bajc recommends 35% of the equities investments be foreign, with the U.S. and international at around 15% each and emerging markets no more than 5%, because the couple doesn’t need a lot of risk.

As cash flow and rebalancing will be key to Bajc’s proposed plan’s success, he recommends the use of one of seven model portfolios he has developed that incorporate automatic rebalancing. He notes that a collection of exchange-traded funds would also do the job, but the transactions would have to be monitored to keep costs down; he adds that segregated funds would not be appropriate because guarantees would be ground down with each redemption.

Vlaovich, meanwhile, suggests that a 50% fixed-income/50% equities asset mix is a better target for Tom and Sarah, noting that they don’t need to run the additional risk that comes with a 60% equities weighting. She agrees, though, that a major portion of their non-registered assets be in equities rather than fixed-income.

Vlaovich suggests the equities be divided into 30% foreign and 70% Canadian, with most of the foreign content in U.S. stocks. She doesn’t recommend specific emerging-market investments but, instead, a couple of global mutual funds with a long history of proven performance.

Vlaovich would recommend using a combination of mutual funds, pooled funds and individual securities. The 50% fixed-income component would consist of 30% bonds and 20% short-term instruments or cash.

Neither advisor recommends alternative investments because of the risk involved.

Both advisors think CI or LTC insurance is unnecessary. Bajc notes that if one of the spouses becomes ill during the next 10 years, the money set aside for major trips could be used for medical expenses; he adds that even if that money isn’t available, their cash flow “should be sufficient to provide for high-quality care.” If the couple feel strongly about being protected, he would recommend CI insurance with a return-of-premium option.

Bajc doesn’t think the couple need life insurance because they should be able to leave their three children more than $200,000 each in today’s dollars without relying on insurance. If the couple want a contingency plan, Bajc suggests a joint last-to-die life policy that would have a $550,000 death benefit, which would cost about $3,600 a year for the next 10 years. Then, with major travel behind them, they could increase the premiums to bring the benefit to $1.5 million.

Vlaovich agrees that life insurance isn’t necessary, but says Tom and Sarah could consider a joint last-to-die policy to pay any taxes after they have both passed away. She notes that if Sarah’s father had done this, the couple would not have to cash out their non-registered assets to pay the taxes on the rental property, should they decide to keep it.

Bajc recommends the use of spousal and testamentary trusts (for the children and, if desired, grandchildren) in their wills. He notes that testamentary trusts are taxed separately from a beneficiary’s other income and at graduated rates identical to personal tax rates. Such trusts are also protected from family-law issues, such as claims from estranged spouses.

Bajc would not charge a fee to develop and monitor the couple’s plan; he would be compensated through mutual fund trailer fees.

Vlaovich would be similarly compensated but would also charge a fee to develop the initial plan, probably about $1,000. Ongoing monitoring would probably be paid for through service or trailer fees. IE