“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with Don Fraser, a portfolio manager and vice president with Connor Clark & Lunn Private Capital Ltd. in Toronto, and Sybil Verch, a vice president and investment advisor with HSBC Securities (Canada) Inc. in Victoria; she holds the chartered professional strategic wealth, the fellow of the Canadian Securities Institute and the Canadian investment manager designations.



The Scenario: John is a 62-year-old engineer in Vancouver who earns $120,000 a year. He inherited $1.5 million seven years ago and used $500,000 of it to buy and renovate a new family home. The remaining $1 million was invested entirely in Canadian equities, which grew to $1.9 million by May 2007 and then plunged to $1.1 million by the autumn of 2008, when he sold everything, including another $200,000 in RRSP assets. He has not yet reinvested that cash.

Additionally, John’s wife, Anne, sold her $200,000 in RRSP assets in 2008; they remain in cash. Anne is 55 and works as an executive assistant to the president of a small company. She earns $50,000 a year.

John and Anne have one daughter, to whom they would like to leave an inheritance of at least $500,000. Anne’s parents are alive but she comes from a large family, so no significant inheritance is expected.

The couple have a $400,000 mortgage on their home, which is currently worth about $900,000. Neither spouse will have a pension. They have been spending all their income and haven’t bothered to make any additional RRSP contributions as they had thought the inheritance John received would leave them with plenty of money when they retired.

John knows he and Anne should reinvest their assets, but he is too scared to do so. He wants to know what their investment options are and wants to invest in products that could insulate them from the possibility of another experience like they suffered in the past year. John doesn’t like the idea of guaranteed products because of the lack of upside potential. That said, he also needs to understand why the plan developed will work over the long term, so that they aren’t tempted to sell out at another market bottom.

The couple plans to retire in three years, when John is 65, and they want to know how much income they can expect to have in today’s dollars until Anne is 95. There is a history of longevity on both sides of her family.



The Recommendations:
The couple should be all right as long as they reinvest their assets as soon as possible, Fraser says. Assuming an average annual return of 6% after fees, with inflation of 2.5% a year, his projections indicate that John and Anne could have $80,000 a year in today’s dollars until Anne is 95. If the couple sell their house and buy a smaller residence for around $500,000, they could have $90,000 a year. These figures include Canada Pension Plan and old-age security benefits.

Verch assumes a higher annual return of 7% with inflation of 3%, which she projects would give the couple $82,000 a year, or $95,000 if the couple downsized to a $500,000 home. She adds that if they downsize, they shouldn’t have to lower their standard of living in other areas. The annual income they would have would be equivalent to $125,000, as they wouldn’t have to pay $30,000 a year on a mortgage.

In both advisors’ scenarios, there would be no financial assets left when Anne is 95. But the couple would still have a house, whose value should at least go up with inflation — unless it is needed to pay for long-term care. Verch points out that if LTC is needed, the couple could take out a home-equity loan rather than sell the house.

Neither Fraser nor Verch is enthusiastic about LTC insurance; they feel the couple have enough assets. However, both advisors agree that LTC insurance could be considered if John and Anne feel that leaving an estate to their child is very important and/or if they are concerned about running out of money if LTC is needed. Verch says it would cost about $4,200 a year in total for benefits of up to $3,000 a month for each of John and Anne.

@page_break@If an estate of $500,000 in today’s dollars isn’t critical, but they want to be sure to leave some money behind for their daughter, they could take out a joint last-to-die universal life insurance policy for $500,000, costing about $4,500 a year, and skip the LTC insurance. If Anne lives to 95, this would be worth about $150,000 in today’s dollars. The benefit of the life policy is that there would eventually be a payout, whereas the LTC insurance might never be used.

Another approach would be to take $36,000 of the non-registered assets and put them into a separate account, Verch says. If invested aggressively in equities, with the expectation of a 10% a year average return, it could result in $500,000 in today’s dollars when Anne is 95.

Even if the couple don’t downsize, Fraser recommends paying off the mortgage because, he says, carrying debt when you don’t need to is a bad idea.

Verch also recommends paying off the mortgage, but suggests borrowing back the funds for investing and generating income. With the interest being tax-deductible, this strategy could increase their income by $8,000 a year. But Verch wouldn’t recommend doing this right away; she would need to be sure that John and Anne would not sell if there’s another market downturn. Verch would watch for signs that the couple are feeling sufficiently confident to stick with their plan, which could be in another six months — or not at all.

John and Anne could also get a higher retirement income if they reduce their expenditures by $30,000 a year for the next three years and put those assets into maximizing their RRSP contributions. Verch says this would probably increase their retirement income by $5,000 a year and would also get them used to living on less money.

Yet another way to increase the couple’s income would be to defer property taxes, which can be done in British Columbia by those aged 55 and older upon application. The resulting interest charged is less than 2% a year and isn’t compounded — but the estate would have to pay the taxes plus the interest.

Both Fraser and Verch strongly recommend that John and Anne maximize their RRSP contributions in the next three years from current earnings and also take advantage of any unused RRSP room by transferring non-registered investments to their RRSPs. If they had $100,000 in unused room and invested the tax savings, that could boost their retirement income by $2,000 annually, says Verch. The tax deduction should be taken over the three years in whatever yearly amounts their accountant recommends.

Verch says the couple shouldn’t need to withdraw from their RRSPs until they are 72. But she suggests that if they both retire when John is 65, Anne should withdraw enough between the ages of 58 and 64 to make her income equal to the personal income tax exemption. If she takes CPP at age 60, which Verch recommends, then less will need to be withdrawn when Anne is between 60 and 64.

Both advisors recommend John and Anne to have up-to-date wills as well as personal and health powers of attorney. Verch also suggests that a testamentary trust for their daughter could be set up if it looks like she will earn enough to make the separate taxation of the testamentary trust beneficial.

Fraser recommends that John and Anne immediately invest 40% of their assets in fixed-income. This strategy shouldn’t be nerve-wracking for them. Bonds are less volatile than equities and pay a lot more than cash. Currently, cash pays about 0.5%, while Fraser’s suggested basket of bonds — 5% short-term bonds, 15% high-yield bonds, 30% government bonds and 50% corporate bonds — could produce an average annual return of 6%.

Fraser admits there is greater volatility investing in bonds than in cash — especially if interest rates rise sharply. However, CC&L believes the bond market still offers more value than holding cash. The yield curve is steeper today than it was a couple of years ago, and CC&L does not believe rates are going to rise sharply in the near term.

Fraser suggests putting the remaining 60% of their assets into equities over a period of time. This is a good way to proceed in markets that are volatile and choppy. The theory, which Verch endorses, is that this dollar-cost averaging results in a good average price of re-entry.

Fraser strongly recommends an equities mix that is widely diversified by geography, sector and style. Specifically, he suggests placing 50% of the equities in Canadian large-cap stocks, 8% in Canadian small-caps, 21% in U.S. equities and 21% in international stocks. This mix can be achieved using CC&L’s pools; in each case — except for the small-caps — the equities would be further diversified by the pool managers’ styles. Currently, CC&L’s pools have a value tilt, with 60% of Canadian equities managed with a value style, 20% with a combined growth/income style and 20% with a “growth at a reasonable price” style. CC&L would charge a fee of 1.25% a year. This would include all investment management services, including reporting and quarterly investment reviews.

Diversified portfolios tend to do better than more concentrated ones in downturns. Fraser points to a client whose portfolio dropped to $1.5 million in the autumn of 2008 from a peak of $2 million in June 2007 and which now sits at $1.7 million. He notes that this is $500,000 above the client’s initial investment of $1.2 million when Fraser started managing the account in December 2005. This, he says, is typical of his clients’ experience.

Verch suggests a 50/50 fixed-income/equities asset mix. In the current economic environment, this would consist of 30% in Canadian equities, 5% in U.S. equities, 15% in international equities, 18% in guaranteed investment certificates, 17% in investment-grade bonds and 15% in high-yield bonds. The fixed-income component would have laddered maturity dates to manage interest rate risk. These assets would be in separate managed accounts, handled by money managers chosen by HSBC Securities, and be registered in the couple’s names.

The equities’ investment style would be equally divided between growth and value to smooth out the volatility experienced by the couple. There would be a 2% fee for this strategy, which would cover the financial plan, ongoing monitoring and all other expenses. IE