Situation?Couple with average income has done a good job preparing for retirement but are bogged down by a real estate play
Strategy Sell their stake in a property they have no control of, diversify investments, work another five years to build a cushion
In B.C.?s lower mainland, a couple we?ll call Sam, 59, and Matilda, 64, are thinking about retirement, wondering if their combination of Sam?s pension, CPP and OAS plus whatever they can get from their net financial assets will support them. They have take home income of $4,142 a month and they live in a lovely bungalow overlooking a bay filled with sailboats.
It?s worth $737,000, a result of high prices in B.C.?s robust real estate market.
Sam has worked for two decades for a local construction company, Matilda for a home repair store. Their children are grown and their liabilities, a total of $112,000, are related to investments, so their interest cost, which is modest at today?s rates, is tax-deductible.
If the B.C. property market were to crash, a lot of their wealth would be wiped out
Their fortune is mostly made up of their house and consumes the bulk of their net worth.?If they are to strengthen their finances, they have to build up other assets.
Matilda still works four days a week, though she has no company pension plan.?Sam admits to being baffled by financial markets and the discipline needed to understand them. ?If I retire too early, it may be a mistake with not enough income coming in and prices going up,? Sam explains. ?When can we retire safely??
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Sam and Matilda.
The couple has done a good job of getting ready to retire, he says. ?The problem is the weight of real estate in their asset mix. The solution is to manage the risk that it entails. If the B.C. property market were to crash, a lot of their wealth would be wiped out. So what they have to do is to take control of their assets and, thereby, a measure of their destiny.?
Planning retirement income
Their retirement income at Sam?s age 65 will consist of his $1,302 company pension, his $1,013 monthly Canada Pension Plan benefit, Matilda?s $533 present CPP benefit, and two Old Age Security benefits of $546 each. That will provide a pension income of $3,940 a month or $47,280 a year.
If Sam works to age 65 and continues to save $660 a month or $7,920 a year and grows $520,000 present net financial assets and savings at 3% over the rate of inflation, it would become approximately $650,000 at his age 65. Paid out over 25 years, it would support annual investment income of $37,635. Added to pension income, the couple would have $85,915 pre-tax annual income or, after pension splitting and 20% average income tax, $5,660 a month, more than enough to support present spending of $3,482, which is current spending less retirement savings.
If Sam were to retire at 60, as he has considered, his $12,150 CPP at age 65 would be reduced to $7,776 a year, a cut of $4,374 a year. Their investment income would be $27,000 a year rather than the $37,635 based on elimination of capital by his age 90. The pre-tax income reduction resulting from reduced CPP and investment income caused by taking early retirement would therefore be about $15,000 a year. They would still be able to cover their present costs and, as B.C. allows, they could defer payment of their $287 a month property tax until sale of their house, but they would have given up their margin of safety and much of their financial security, Mr. Moran says. ?Their income would be down, their long-term risk of running out of money would be up. This is not a good solution.?
Reducing portfolio risk
In the next five years, there is a good deal the couple can do to improve the prospects for a durable and fairly prosperous retirement, the planner notes. The strategy has to be to reduce the proportion of real estate in their portfolio. Part of that is selling their 10% interest in the apartment building. Part is raising the value of assets other than real estate.
Sam and Matilda own their home and have no liabilities other than a couple of business-related loans. That should make for a secure retirement. Yet 60% of their net worth is in their house. The weight of their dependence on local real estate is actually higher, for they have a 10% interest worth $120,000 in an apartment building not far from their home.?The building pays almost no income over interest and operating cost and is therefore a speculative investment. Added to their house, it means 67% of their net worth is in the real estate market. Worse, their 10% stake gives them no control. They have the risks of ownership but cannot manage expenses. Strategically, it is not a good place to be.
Sam should sell his 10% share of the apartment building, Mr. Moran suggests. If he can get his price, $120,000, he can then pay off the $34,000 loan balance he carries at 3% a year. Sam also has a $78,000 loan that was taken out to buy non-registered mutual funds. It also costs 3% a year. The after-tax cost of the loans at present is about 2% a year in Sam?s bracket, but rates will rise one day. The loans can be paid off with the remainder of money left from settling the real estate loan.?The property sale will cut real estate as a fraction of the couple?s portfolio, eliminate debt and exposure to future interest rate increases and make more cash available for investment in financial assets. Their income will not be changed, but they will have eliminated leverage and cut their total financial risk, Mr. Moran notes.
?Sam and Matilda have used their personal discipline to live modestly and save steadily,? Mr. Moran says. ?What they need to do now is to reduce the fairly large risks they are carrying in a building they cannot control and in loans they could pay with little effort. Those are two moves that will immensely increase the security of their retirement.?
Financial Post
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