Situation: Couple has means adequate for retirement spending but fears a market crash
Strategy: Evaluate graduated shift into insurance based annuities to eliminate market risk
An Alberta couple we’ll call Theo and Maureen, each 62, find themselves unexpectedly unemployed. Theo, a chemist, worked for several small companies for 40 years, then got laid off a few months ago. Maureen worked a series of part-time administrative jobs for many years but has not had a paying position for two years.
The couple has built up almost $1.1 million in financial assets, mostly in registered plans. They invested well in a series of small positions in Canadian large cap stocks, well-known mutual funds and low-fee exchange traded funds. Their spending is modest, they have no debts, yet they live in dread their investments might tumble further than they have recently into a market abyss on the scale of 2008 when senior global stock markets lost 40% to 60% of their value.
We live in fear of going through another collapse
“We live in fear of going through another collapse,” Theo says. “We want to know what we can do with the investments to minimize that risk. Our goal isn’t capital growth but safety and income.”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd., in Kelowna, B.C. to work with Theo and Maureen.
In his view, they are secure, for their allocations net of savings, about $4,000 a month, can easily be financed with drawdowns of their $207,600 in taxable securities, $70,000 in cash and $804,900 of RRSPs and TFSAs. Theo also gets $2,000 a month in Employment Insurance payments through June, 2015. As well, $207,600 of taxable large cap Canadian shares generate about $5,200 in dividends assuming a 2.5% yield. They receive $1,169 a month in combined Canada Pension Plan benefits. They began to receive benefits at 60, accepting a 36% penalty of what could have been $1,826 for the total of two benefits a month had they waited to 65. But, as Mr. Moran says, they made a choice and there is no going back to change it.
For now, their $48,000 in annual allocations net of savings can be covered with $14,028 of combined CPP payments, $24,000 a year of Theo’s EI benefits and $5,200 of taxable dividends. The total, $43,228 mostly in Theo’s hands, would leave $39,769 after average 8% income tax. They can cover the balance of expenses by drawing down their $70,000 cash at $4,000 a year and funding TFSA contributions from cash rather than from their income.
Related
Life after Employment Insurance
Theo’s $24,000 annual EI benefits will run out in June, 2015. By the time they are 64, their cash will have been reduced to $62,000, but their $291,500 of TFSAs and taxable securities will have grown at 3% a year after inflation to $309,000. If they take out just the annual income at 3% after inflation, $9,270 a year and add $14,028 combined CPP benefits, they would have total income of $23,300. They can add $12,000 a year from cash and $8,800 from their RRSPs, which, using the 3% growth after inflation assumption, will have been rising at about $21,630 a year. That’s $44,100 before tax and $40,570 after income splits and 8% average tax . They can receive Old Age Security a year later at 65 at a rate of $6,764 a year each, reducing their draw on cash to zero and on RRSPs to a negligible amount.
The $8,800 annual draw for two years from the RRSPs, which is about 1% of their present total, reduces the effective growth rate to 2% over inflation. So as they enter their 65th year, the RRSPs would have a value of about $750,000 available for RRIF payouts. During the next 30 years, the RRIFs, basing payouts on an annuity model and a 3% return after inflation would generate $37,150 a year before tax. With $14,028 CPP and $6,764 OAS per individual, their pre-tax income would be $64,700 and income after 12% average tax would be about $57,000 or $4,750 a month. Their present allocations including TFSA contributions would be largely intact.
Capital preservation
There is an argument for using taxable securities and TFSAs to preserve tax-free growth in RRSPs until payouts have to begin in their 72nd year. The low payout suggestion follows this strategy. On the other hand, tax averaging suggests payouts beginning in this case as early as age 62. In the case of Theo and Maureen, paying modest income and preserving capital merely cuts the rate of growth. Income security is a larger issue for the couple, though it would mean giving up perhaps decades of equity growth and dividends — higher than government bond interest these days.
Annuities are a conservative way of achieving asset security. They shift investment risk to an insurance company that sells the annuity contract. Current annuity rates, based on low yielding government bonds for the most part, work out to a core payout rate of just a few per cent plus return of capital less an insurance charge for the risk – from the insurance company’s point of view — that the recipients of benefits will live to be centenarians. The return of capital is not taxed. On an after-tax basis, the payout might be about 5% of capital. That beats straight Government of Canada bonds,but is hardly a grand sum.
Theo and Maureen could defer buying annuities for perhaps three to five years until interest rates have risen 1% or 2% and they are older. Rising interest rates plus reduced life expectancy would raise income from RRSPs significantly. For example, at age 70 and using a 3% growth rate, an annuity purchased for $305,000 would generate $41,800 for 25 years. In fact, the capital base for the annuity, assuming all of the RRSP was used for that purpose, would be larger. But the $4,650 growth in annual income shows the effect of diminishing life expectancy. Thus, still using the same capital base and 3% interest rate, at age 75 with 20 years of life expectancy, the annuity would pay $49,000 a year. At a higher interest rate then perhaps prevailing, say 4%, the payout would rise to $53,000 a year.
Increasing age and interest rates improve payouts, but annuity incomes are hostage to inflation. A sustained rise in the rate of inflation to 6% from its present 2%-3% level would devastate the annuities’ purchasing power. However, buying a series of annuities every five or 10 years with no more than 10% of available capital for each purchase would in effect create a ladder of contracts with rising payouts.
The actual annuity purchased from an insurance company on a joint and last-to-die basis would not necessarily have the same payout numbers in the example. But the comfort of having a guaranteed income, which effectively turns a defined contribution RRSP-based pension into a defined benefit pension little different from what such plans pay when survivor options are figured in, would solve Theo and Maureen’s concern about plunging markets. Assuris, the life insurance industry’s guarantee plan, would provide continuity of payment even if the insurer were to fail.
“I appreciate the couple’s concern about market flops,” Mr. Moran says. “However, if they continue to invest in high-quality, dividend-paying companies with rising payouts, they can focus on the long-term value of their portfolio and its ability to generate income. Given their three-decade time horizon, this is the winning strategy because dividends tend to keep pace with inflation.”
Financial Post
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Source:: National Post
