Is This Couple's Financial Vision an Impossible Dream
In B.C. a couple we’ll call Max and Portia, 28 and 27, are trying to plan their financial future. They bring home a total of $6,880 a month from their high-tech jobs, but Portia wants to take sabbaticals to travel more and Max wants to try out a new career. They also want substantial investment income — $1,000 a month by their mid-30s. All that, plus early retirement well before 65.
What is standing in their way is not just the problem of earning enough money to do all that, but more than half a million dollars of debt.
They have already made big career switches, Max from running a theatrical company for four years, Portia from several years in pharmacy management. Their jobs, their incomes and their present high rate of savings can build a solid retirement, though not necessarily an early one.
They are frugal, no doubt. They rent cars rather than own one, spend little on luxuries and travel little. But giving up future income and jobs in which they are thriving for the unknown is a risk to their fortune, says Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C.
Max and Portia have to come to terms with the fact that they cannot ignore their large debts or risk incomes for relaxed living just as they come into middle age. With no pensions provided by their companies, they have to plan for their later lives and carry the full risk of building their finances. Though they want the rewards of successful careers soon and then to retire in comfort well before 65, it won’t work.
“What is standing in their way is not just the problem of earning enough money to do all that, but more than half a million dollars of debt mostly incurred to buy their own home and a rental condo which, in fact, barely pays its own way,” Mr. Moran explains.
So far, Max and Portia have made a big bet on real estate. A $265,000 rental condo is their largest investment. It has a $228,775 mortgage with 26 years left on its amortization. Without capital repayment on the 25-year mortgage, interest alone is $410 a month. Condo fees and taxes add $277 for total carrying costs of $687. It generates $1,050 rent, so their total return is $363 a month or $4,356 a year. That’s a 12% return on their equity — not bad, but vulnerable to rising interest rates. If they have to roll over their 3.0% mortgage at 4.0%, which is still historically cheap, they will lose their margin of profit. No one doubts that interest rates will rise and a 1% jump is easily in the cards, Mr. Moran says.
Rather than take all the risks that go with being landlords — such as vacancy, tenant damage, and the inevitable rise in interest rates — they could sell, harvest their about $23,000 of equity after 5% selling costs, and use the cash to pay off most of a $27,000 student loan outstanding at 4.5%.
If they choose not to use the cash to pay off the loan, then, at $500 a month, it will be repaid in five years. Their home mortgage would still have 24½ years to run.
They can also use tax breaks to generate future income. They already put $16,080 into RRSPs each year. That produces a $4,500 tax refund in their brackets. They can shift $8,908 currently in their Tax-Free Savings Accounts to their RRSPs and add $6,600 cash to RRSPs to fill up most of their $20,000 of contribution room. The total contributions from TFSAs and cash, $15,508, would generate about $4,187 in additional tax refunds. After the student loan is repaid, they could allocate the $500 a month to the RRSPs.
They can leverage their high savings rate, about 25% of after-tax income, to grow their present $23,725 of RRSPs. The return, including fresh RRSP contributions at $1,345 a month plus $500 a month liberated from student loan repayment, would grow to $1,561,000 in 32 years when Max and Portia will be 60 and 59, respectively. At 3% a year, at which the payout rate equals the portfolio growth rate, this sum would generate $46,830 a year before tax.
If they choose jobs for fun … their ability to have a secure retirement will be at risk
Their reality at present is that debts are almost 90% of their assets. To support a $1,000 monthly investment income, they would have to have $400,000 capital generating a 3% return after inflation. They can’t do that in seven years with their present incomes and the need to pay down debt. Moreover, if Max changes jobs or Portia takes lots of time off for travel, sacrificing income and perhaps career advancement, their financial outlook would dim.
“It is not possible in any reasonable scenario, especially if they impair their incomes with sabbaticals or risky job switches,” Mr. Moran says.
If they choose to retire when Max is 60, their potential investment income, $46,830 a year, would be about $3,300 a month after 15% average tax. Their living expenses and savings, currently $6,880 a month, would decline to just $1,700 a month if they eliminated all debt repayment and savings. They would have their bills paid and have substantial discretionary income as a margin for safety, investment or travel. Their theoretical surplus, about $1,600 a month, would have flowered in their 50s, the result of compounding, sustained income and frugality.
At age 65, each can draw Canada Pension Plan benefits which, if they work full time in their jobs, will be $12,150 a year less a potential reduction for ceasing work before 65. At 67, each will qualify for full Old Age Security, currently $6,553 a year, for total government pensions of $37,406. Their savings would continue to generate $46,830 for total income of about $84,250 a year or, after pension splitting and 20% average tax, about $5,600 a month for spending, all in 2013 dollars. It would be a secure retirement with many options for travel or other pleasures.
“Max and Portia are disciplined savers, but that alone does not assure financial success,” Mr. Moran says. “If they shun the risk of changing jobs and stick to what they know, they can have a comfortable retirement. If they choose jobs for fun and take significant income reductions and long sabbaticals, their ability to have a secure retirement will be at risk. Reduced earnings could also eat away at one of their most important indexed pensions — the Canada Pension Plan. They need to recognize the risks that their plans entail.”
(C) 2013 The Financial Post, Used by Permission