Giving Up a Booming Business Could Be Costly
SITUATION With early retirement, couple will lose business income
STRATEGY Work two more years, build up assets, savings
SOLUTION More security, income for retirement
In Calgary, a couple we'll call Alex, 56, and Sophie, 50, have parlayed their technical educations in engineering and finance into a successful family life in Calgary. They have two children in their early 20s -- one graduated with a technical degree, the other is working on a math degree, living at home and hoping to graduate in a few years. Mom and dad have a company that does work in geology. It grosses $250,000 a year, which pays them $10,500 a month before taxes. It retains profits of about $100,000 per year. Alex also receives a $1,450 monthly pension from previous employment, which, with a $224 monthly pension Sophie receives, gives them a monthly income of $8,794 after taxes.
With an annual family income of $146,088 before taxes, no mortgage and no other debt except a $16,000 car loan that is soon to be paid off, their financial lives would seem to be secure. But Alex and Sophie worry they have not saved enough money for retirement, which they would like to begin in 2012.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C. to work with the couple. "They are doing well for now," he says. "But they would be short of money if they retired without making essential adjustments in their finances."
If they cease work in 2012, Alex will have 89% of maximum Canada Pension Plan benefits, and Sophie 27% of maximum benefits, for total CPP benefits at age 65 of $9,898 and $2,937, respectively, or $12,835 per year. Each will be eligible for Old Age Security benefits of $6,204 per year in 2010 dollars. Alex will continue to receive his $17,428 employment pension and Sophie will receive an annual employment pension of $2,079. When both are 65, their total pensions, none of which are indexed, will be $44,750, far short of their present income.
They will have to supplement employment and public pension incomes with investment returns. Currently, they have about $460,000 in their RRSPs, $10,400 in their TFSAs and $79,900 in business and personal cash.
If Alex maxes out his RRSP contributions for 2010 and the next two years by investing $18,360 each year and obtaining a 3% return after inflation, the RRSPs will grow to $551,434 by the time Alex would like to retire, the planner estimates. With these assumptions, their RRSPs will support $25,258 per year until Sophie is 90. Their RRSP income plus pension income will total $70,008 per year, he says.
It would be preferable to pay Sophie via dividends. She would lose the salary that allows her to make RRSP contributions, but that is not much of a loss in her low tax bracket, Mr. Moran says. She would also shed the obligation as a self-employed person to pay both halves of CPP that total 9.9% of her income.
Alex and Sophie plan to downsize their home to one with a $350,000 price tag after their youngest child moves out. They will capture about $250,000 in this process, depending on selling costs, moving, etc. This money will be used to build a new cottage on the property.
The family business corporation has $75,000 in cash in retained earnings. If, for the next two years, Alex and Sophie add $100,000 in retained earnings per year, they will have $275,000 in the company and may have accumulated another $250,000 of savings. The total of present and retained earnings, personal savings and additional savings capacity that will be liberated by the end of car payments amounts to $600,000, which would support a draw of $27,482 per year for 36 years to Sophie's age 90. Their total income at age 65 would be $97,490 per year, Mr. Moran estimates.
The transition from Alex's age 58, when he would like to retire, to 65, when he will get full retirement benefits, could be challenging, but there are a couple of ways to finance it. The easiest is to average the couple's income, taking money from their cash flow estimates after age 65 to boost their income in the years before 65. This move would create a form of permanent, but non-indexed income of $74,300 per year, Mr. Moran says.
Banking On Unknowns
At some date, perhaps in a few years or after as much as a decade, Alex's elderly parents will pass away. The plan is for a family cottage with an estimated market price of $450,000, to go to Alex and Sophie. They plan to build a new cottage, which will be their primary residence. The parents may be able to use the new cottage, so the family could discuss gifting it rather than a testamentary disposition to Alex and Sophie.
Second, there is a possibility of selling the family business as a going concern.
If packaged as a Canadian controlled private corporation (CCPC), the company's shares would be eligible for a $750,000 tax deduction when sold. The company now has little value beyond Alex's expertise. But if he succeeds with a software project he is working on and if the new product develops a substantial market in its niche, sale as a CCPC would be possible.
Third, the couple may decide that being forced to live on a fixed income is not so attractive. Retirement means loss of their salaries and retained corporate earnings, ability to expense certain business-related costs and the power to grow their asset base.
The biggest unknown in these cash-flow estimates is inflation. The couple has three decades of life to look forward to. Yet their company pensions are neither indexed nor provided with survivor benefits. Their investment portfolio is divided into a variety of mutual funds with overlapping portfolios, no bonds and no evident design. It is not possible to estimate asset returns accurately three decades before they are realized. However, if Alex and Sophie can reduce management fees via a professional portfolio manager, who would charge 1.0% to 1.5% of assets under management, the couple would gain perhaps $5,000 a year in fee savings. Over a 10-year period, that would add about 12% to assets under management if nothing else changed.
Alex and Sophie could continue working to age 60 and continue to save $118,360 per year in his RRSP and the company. That would boost retirement income to $88,100 per year. Working to age 62 would boost annual income to $104,800, providing a security blanket for inflation, Mr. Moran says.
The final question for Alex and Sophie is the toughest of all to answer: What will they do with three decades of leisure?
"No one can say better than them what is the right balance of work and leisure, but quitting at the peak of one's game is not necessarily the best way," Mr. Moran says. "The parents should not confuse the end of child rearing with the end of their accomplishments. The most important answers in their case rest less on numbers than on introspection."