Not far from Toronto, a couple we'll call Edward, 49, and Keira, 48, are living their lives conservatively, saving a fourth of their combined after-tax monthly income of $6,906. Edward, employed in sales, and Keira, a part-time civil servant, hate financial risk. They have paid down the mortgage on their $550,000 house to $41,000 at $800 per month and should eliminate it in about four years. They put their RRSP savings into balanced funds and keep $85,000 in a bank account.
"They are too cautious," suggests Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C.
In addition to their $85,000 cash, the couple has $18,000 in RRSPs and $80,000 in a defined-contribution retirement account. They are far behind where they should be on the brink of turning 50, Mr. Moran says.
Edward has $190,200 of RRSP contribution space and should take advantage of it. His taxable income for 2009 will be $97,141. If he puts $56,415 from his cash into an RRSP, he will reduce his taxable income to the top of the lowest tax bracket, at which further contributions are no longer tax-efficient. This move will generate a tax saving equal to an $18,617 tax refund that can be added to the $28,585 cash left over after the RRSP contribution. That amount, $47,202, will eliminate the mortgage and leave change, the planner explains.
Paying off the mortgage as soon as possible is a good investment of their cash, for there are no guaranteed funds or GICs available today that pay as much as the mortgage cost, which is 5.25% in after-tax dollars.
Rapid paydown of the mortgage would reduce their cash balance drastically. However, it can be rebuilt with $800 per month or $9,600 per year from money no longer being used to pay the mortgage. They can add that to their present savings of $1,700 per month to achieve monthly savings of $2,500 or $30,000 per year plus refunds of a third of RRSP contributions until the RRSP space is used up.
If Edward and Keira were to add their $30,000 of savings capacity to their RRSPs each year until their space is fully used up and, adding in expected tax refunds at $9,900 in 2011, $13,167 in 2012 and $14,425 in 2013 and future years, they will have a total of $541,670 to Edward's age 60, Mr. Moran estimates. The RRSP contributions should be to a spousal plan for Keira. Edward will get the tax deduction and, when the RRSP is converted to a RRIF or an annuity, the proceeds will be taxed in Keira's hands at a low tax rate, he suggests.
If they remain in cash and inflation runs at 3% per year, the purchasing power of their savings will have lost $100,370 to inflation after an assumed 0% return in cash. That will leave them with $457,910 in 2010 dollars. But if they can achieve a return of 5% per year, then their savings will rise to $605,600, Mr. Moran says. The payoff for taking on nominal market risk will be $147,658 in extra spending power, he estimates.
Edward and Keira have had unpleasant experiences with their investments. Their large cash position is counterproductive, for their money is being eroded by inflation. However, a pre-inflation 5% return can be had from a variety of public utility stocks and financial services companies.
In very difficult markets such as the world experienced in 2008 and 2009, most stocks tend to fall. But markets recover. In a sense, investing is an act of faith in history. It cannot be blind faith, but it can be faith in the value of owning a piece of the economy, backed by study and research, Mr. Moran notes.
The balance in deciding how much cash and how much stock to hold is low income and vulnerability to inflation vs. higher income and some risk. Edward and Keira should try to find a weighting of risk and return with which they are comfortable. Diversification through mutual funds with management fees of 1.5% or less, purchase of exchange-traded funds that emulate broad market indices would be a start. They should include some exposure to the bond market. A bond mutual fund with management fees of 1% or less or a bond ETF with government and corporate issues and with management fees below 0.5% would be useful.
Edward has a defined contribution company pension plan with a present value of $80,000. He adds $5,000 per year and the employer matches that sum. If he can grow the plan at an inflation-adjusted rate of 4% per year, it will have a value of $221,157 at his age 60 in 2010 dollars. If that money continues to grow and is withdrawn over the 31 years from his age 60 to Keira's age 90, it would provide $9,642 per year in 2010 dollars, the planner says.
Edward should qualify for 90% of maximum Canada Pension Plan benefits, currently $11,210 per year, and so receive $10,089 per year. Keira should qualify for 20% of those benefits and receive $2,242 per year. They can take their CPP pension as early as age 60, but should wait to age 65. Penalties for taking benefits before age 65 are 6% per year for each year before age 65 at which they begin. Penalties for early benefits are due to increase, however. Each should qualify for full Old Age Security benefits, currently $6,204 per year, at age 65.
Adding up their retirement income sources, the couple should have retirement savings of $605,600 at age 60 that will produce income of $26,400 per year and $9,642 from Edward's defined-contribution company pension plan for total income of $36,042 Adding in public pensions of $24,739 at age 65, they would have a total of $60,781 in 2010 dollars, Mr. Moran estimates.
Retirement at age 60 would be difficult to finance. The couple has current disbursements of $6,906 per month. But if they strip out $1,700 of monthly savings, their $800 monthly mortgage payment and cut their miscellaneous expenses down to $300 per month, their total expenses would decline to $4,106 or $49,272 per year. They cannot support those expenses at age 60, but could manage them at age 65 if they were to split pension income, make use of a zero tax rate for Keira after all exemptions are taken into account, and raise their returns from invested funds. If they maintain their huge cash position in savings, they could not sustain their present way of life in retirement, Mr. Moran suggests.
"Edward and Keira are like many people who remain shocked by what happened in the market meltdown," Mr. Moran says. "Yet if they do not invest in a diversified portfolio and accept market volatility, they will have a pinched retirement."
Toronto couple has too much unproductive cash and insufficient retirement assets
Use up RRSP room, pay down mortgage, diversify assets
A comfortable retirement the couple's income can sustain after age 65
MONTHLY AFTER-TAX INCOME $6,906
House $550,000, Employer pension $80,000, RRSPs $18,000, Car $15,000, Cash in bank $85,000
Mortgage $800, Property tax $420, Utilities, phones, cable $450, Food $835, Restaurant $375, Entertainment $222, Clothing, grooming $592, Gas & car repairs $289, Travel $80, Car & home insurance $240, Life insurance $75, Charity & gifts $123, Savings $1,700, Misc. $605
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