Couple Should Add Risk to Vocabulary

ANDREW ALLENTUCK

In Alberta, a couple we'll call Phil and Elizabeth are working hard to adapt to the Canadian way of life. A physician trained abroad, Elizabeth, 42, pulls down $120,000 a year. Phil, 45, works in a related field and makes $90,000 a year.

They would appear to have succeeded in adapting to their new country. They have a house with an estimated value of $730,000 and are keeping $135,000 in cash and guaranteed investment certificates. But there are problems with their financial life.

They took risks in leaving their country, and now they are risk averters in the extreme. They keep their registered retirement savings plans in GICs earning 4 per cent a year and their taxable investments in bank accounts at 3.5 per cent a year.

They have no registered education savings plan for their two children, ages 15 and 12.

"We have been in Canada for only six years," Phil explains. "But we want to send our kids to university and plan retirement. Will we be able to afford to do that?"

What our expert says:

Facelift asked Derek Moran, a registered financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Phil and Elizabeth.

"There are challenges," Mr. Moran explains. "Phil simply will not take risks with investments. He has suffered equity losses and doesn't want to repeat them."

The most conservative investment strategy would be for the couple to pay off their $65,000 mortgage balance as fast as possible with their $5,635 monthly savings. Once the mortgage is discharged, they will be able to save $7,875 a month.

In the next three years, Elizabeth's income should rise to $170,000 a year. For now, assuming that Elizabeth puts $20,000 a year into her RRSP and that Phil puts $12,600 into his RRSP, that the couple expands their portfolio to include assets that can generate returns of 6 per cent a year and that inflation runs at 3 per cent a year, then at Phil's age 60, they will have $679,000 in 2008 dollars in their RRSP. At his age 65, they would have $965,470. However, if they stick with their GICs earning 4 per cent a year, they would have $767,700 at age 65, Mr. Moran estimates.

After their mortgage is paid off, they will be able to save $2,717 a month in the RRSPs and to put $5,158 into cash investments. If these taxable funds were to generate 2 per cent a year after taxes and inflation, the portfolio would rise to $1,091,800 at Phil's age 60 and $1,534,000 at his age 65. If the couple sticks with GICs and makes a zero return after taxes and inflation, they will have a total portfolio equal to their initial savings plus inflation in 2008 dollars. The after-tax result could actually be negative, depending on interest rates, tax rates and inflation, the planner notes.

Not only do Phil and Elizabeth have high tax exposure on their earned incomes, they also fail to take full advantage of RRSP contribution room. Their situation is made worse by their preference for GICs, which are very safe but have low returns. In the end, they add to their tax problems by adding fully taxed interest income to their fully taxed professional incomes.

Given the couple's preference for staying in cash, the course of least resistance is to pay down their mortgage. The 4 per cent they earn on GICs leaves 2.56 per cent after tax, and is actually a negative return once Alberta's brisk rate of inflation is taken in account, Mr. Moran says. If they pay down their $65,000 mortgage balance, they will "earn" the 4.35 per cent they pay in interest. For Phil and Elizabeth, this is a relatively attractive way to use their cash, he adds.

The rest of their savings can be used to fill the couple's RRSP space. Phil has $25,000 of available contribution room. Elizabeth has $19,000 of space. The contributions, even if left in cash within the accounts, would produce tax deductions of $8,000 and $6,840, respectively.

The next move should be to incorporate their separate professional incomes. They each generate high cash savings after they pay their living expenses. They could each have a company that would earn income, then pay out salaries. The salaries would be set to maximize their RRSP contributions. Money retained in the company would be taxed at just 14.5 per cent in Alberta. They would have 85.5 per cent of original, undistributed corporate income to invest. It is a better deal than investing the money after they have paid personal tax that leaves them with only 60 to 70 per cent of their pretax income, Mr. Moran says.

When retained earnings are eventually paid out, they will be taxed as Canadian-source dividends subject to lower taxes than ordinary earned income. Deferral of personal taxes for many years effectively makes it possible to earn money on what can be regarded as the government's money, Mr. Moran notes.

It's rather late to start a registered education savings plan for the kids, but Phil and Elizabeth could set up a family trust and pay out earnings from the corporations to be taxed in the hands of the children. This plan requires that the children be 18 years old. They are likely to be in a zero tax bracket.

The family trust makes use of postponed contributions from existing savings. There are no annual contribution limits either, though the downside of the plan is that there is no Canada Education Savings Grant boost each year to parental contributions. However, tax savings more than offset the grant, Mr. Moran notes.

If Phil works to age 65, he can expect 61.3 per cent of the maximum Canada Pension Plan payment of $6,354 a year and $5,079 if he works to age 60. Elizabeth would receive the same ratio and get $3,737 at age 60 and $6,603 at age 65. They will receive Old Age Security at age 65 based on being in Canada for 25 years out of the 40 needed to qualify for full OAS benefits. Under revised rules, that would give Phil 25/40 of the maximum of $6,028 a year, and Elizabeth 28/40 of $6,028 a year. That works out to $3,768 and $4,220 respectively.

If the couple sticks with GICs for all of their investments, their retirement income would be about $59,800 at age 60. If they expand their portfolio to half bonds and half stocks and generate a 6-per-cent annual return and retire at age 60, they can expect retirement income of $70,300. If they retire at age 65, their income would be $87,300 if they remain fully invested in GICs and $103,600 if they use the half-bond, half-stock portfolio, the planner calculates.

"This couple has the discipline to save and to build significant retirement savings," Mr. Moran says. "Their problem is to overcome their fear of loss in capital markets. They may have some losses if they buy stocks and fixed-income assets, but they are certain to have losses of purchasing power if they stick with their present investments in GICs."


Client Situation

The Couple

Health professionals who emigrated to Canada in 2001.

The Problem

Inflation losses and low returns induced by risk aversion.

The Plan

Restructure business income and investments to reduce taxes, diversify portfolio to increase returns.

The Payoff

More money for retirement and children's education

Net Monthly Income

$13,334.

Assets

House $730,000, RRSPs (GICs) $35,000, cash $100,000. Total: $865,000.

Monthly Expenses

Mortgage $ 2,240, property tax $350, Utilities & phones & cable $300, food $800, entertainment $100, clothing $150, car fuel & repairs $350, travel $1,000, car & home insurance $275, life insurance $250, car lease $384, charity $1,400, miscellaneous $100, savings $5,635, Total: $13,334.

Liabilities

Mortgage $65,000.

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