“Portfolios” is an ongoing series that discusses various asset-allocation options. In this issue, Investment Executive speaks with Dixie Allen, senior financial advisor at Assante Capital Management Ltd. in Toronto and Randall Takasaki, vice president of HSBC Securities (Canada) Inc. in Vancouver.



A couple, consisting of a recently retired 65-year-old husband and a 60-year-old wife who has never worked, are looking to structure their portfolio in a way that will provide them with part of their income in U.S. dollars — they plan to live in Florida four months of each year — and leave a sizable estate for their four children.

The couple has $1 million in taxable assets. The husband has an annual pension of $60,000 and full Canada Pension Plan benefits. The wife would receive 60% of the pension, which has full medical benefits, if he were to die first.

They have a house in Florida, purchased five years ago for $200,000 and now worth $500,000. Their principal residence is in Canada and worth $500,000. There is no mortgage debt on either property. Of the $1 million in taxable assets, $400,000 is in the wife’s name and the other $600,000 in the husband’s name. They have no life insurance but take out travel medical insurance for the time they spend in the U.S.

Their annual income goal is $100,000 before taxes, or $70,000 after taxes, in today’s dollars to age 95. Of this, they need US$24,000 after taxes to pay their U.S. expenses.

They have four independent children and want to leave an estate, including real estate, of $2 million in today’s dollars.



Both Allen and Takasaki think the couple’s goals are achievable, but Allen suspects they are underestimating their income requirements. This is partly because of the cost of running a second home in Florida, but also because she thinks they should take out long-term care insurance as their assets could disappear if either or both need to go into a nursing home or need extensive care at home. Allen also recommends life insurance to cover the capital gains taxes that will be payable when the estate is settled.

Takasaki disagrees about the need for long-term care insurance, arguing that if either of them became disabled, they probably wouldn’t go to Florida and could sell that house and use the income generated from the proceeds to pay for health-care costs.

Allen’s projections are based on pre-tax income requirements of $135,000 instead of $100,000. That would give them $100,000 to pay their Canadian expenses, including $10,000 for $300 a day each in long-term care insurance premiums and $5,000 for $500,000 “last to die” life insurance, plus the US$24,000 for their U.S. expenses.

Assuming a 6% nominal return after fees and 2% inflation, this would leave the couple with $2.4 million in 2041 dollars ($1.2 million in today’s dollars). Combined with the $1 million in real estate, this will meet the estate goal on a pre-tax basis and on an after-tax basis, assuming the couple takes out life insurance to cover the capital gains tax liability. Allen is assuming that the value of the real estate only increases with inflation and that there are no major capital outlays, such as major repairs or renovations on either property.

There will be capital gains taxes on the Florida home and also on the financial assets if, as Allen suggests, a “buy and hold” investment strategy is pursued. In her view, it would be reasonable to expect potential taxable capital gains of $750,000.

Takasaki’s strategy would involve more buying and selling, resulting in little capital gains on the investments when the estate is settled. As a result, he suggests a much smaller policy aimed at covering only the US$45,000 due on the capital gains that have been generated so far on the Florida home.

Allen considers life insurance to be the easiest way to cope with the capital gains tax liability. The alternative is to discuss the matter with the children and explain why the assets are being managed in a way that leaves a big tax bill.

“No one likes to write a cheque for $400,000 to the Canada Revenue Agency, no matter how much money he or she is inheriting,” she says. “The emotional impact of having to write such a cheque could cause the heirs to challenge whether their parents had planned to incur such a tax liability.”

@page_break@In Allen’s view, life insurance for the husband of $350,000 should also be considered if the wife believes that she would need the full $135,000 pre-tax income after her husband dies.

Takasaki’s projections assume a 6.5% nominal return, 2.5% inflation and pre-tax income requirements of $100,000, which would leave an estate, including real estate, of $2 million in today’s dollars after the payment of capital gains taxes on the portfolio.

Both Allen and Takasaki assume the couple will take advantage of the pension income-splitting now allowed, which Allen says will save the couple about $7,000 a year in taxes. She adds that the couple should be working with a tax advi-sor, especially concerning the cross-border Florida house asset.

Both advisors suggest the couple consider putting all the assets into a joint account with rights of survivorship, thereby avoiding the payment of capital gains until both have died and also avoiding probate fees when the first of the two partners passes away.

Neither Allen nor Takasaki suggest additional medical insurance or critical illness insurance. Allen points out that critical illness insurance covers only major specific conditions, while long-term care insurance covers a broader range of situations in which extensive care is required.

Allen notes that $300-a-day long-term care insurance would generate $72,000 a year for either the husband or wife or $144,000 if both required care. Nursing-home fees are currently around $4,000 a month in Toronto but, like all medical costs, have been rising much faster than inflation and will probably do so in the future. When calculating how much insurance to buy, it would be reasonable to assume that costs will rise 5% or even 10% a year.

Given their need for US$ income, Takasaki suggests that most of the required US$ income come from Canadian fixed-income investments that pay in US$. He further recommends that most of the fixed-income be in the wife’s name because she’s in a lower tax bracket, so she will benefit less from the dividend tax credit, given her lower investment income and lack of CPP benefits.

Allen is less concerned about specifically generating US$ income, focusing instead on the proper geographical mix in the portfolio. If currency risk is considered a problem by either the advi-sor or client, she suggests using currency hedging.

Takasaki suggests a transaction-based account because the fixed-income would be held in bonds and preferred shares — with a 50% allocation to each — that are bought and held. The average annual fee would be less than 1%.

Allen recommends a managed account, with the assets invested in a blend of capital gains tax-deferred wrap programs, pooled funds and mutual funds, given that the couple will be out of the country four months of the year. The fee would be 1.85%-2% a year.

Takasaki suggests a 50% equities/50% fixed-income portfolio, while Allen recommends 70% equities/30% fixed-income. Allen emphasizes that the first priority with any asset-allocation approach must be the clients’ tolerance for risk.

In the interests of broad geographical and sector diversification, Takasaki would recommend that 60% of the equities, or 30% of the total portfolio, be in foreign investments. These would be mostly U.S. securities, both because of the US$ income requirement and because U.S. multinationals provide international exposure.

Allen thinks appropriate geographical diversification can be achieved with about 43% of the equities or 30% of the portfolio in non-Canadian equities. This is partly because she believes prospects for Canadian stocks will remain healthy for a while. But she also feels that this mix of Canadian and foreign equities will produce sufficient sector diversification.

In Allen’s case, the foreign portion would include alternative investments amounting to about 5% of the total assets, probably in a long/short hedge fund investing in European and/or U.S. stocks. She currently favours European stocks over U.S. equities and would suggest investing two-thirds of the equities portion — excluding the alternative investments — of the portfolio in that region and only 10% of the portfolio in a dividend-paying large-cap U.S. dividend fund or pool, which would provide some US$ income.

Takasaki would suggest Cana-dian hedge funds for 10% of total assets. He would split the assets among two or three managers and strategies.

In terms of style, both favour a blend of value and growth. Allen would have somewhat more value than Takasaki, while he would tilt the style mix depending on market conditions. IE