Financial checkup: Divorced man needs to start saving

Darren has just finished paying child/post-secondary education support of $2,000 a month and has five years of $1,000 in monthly mortgage payments left on his condominium. Because of the financial impact of these expenses, he hasn’t been contributing to his RRSP for the 12 years since his divorce, so he only has $200,000 in retirement savings. He has $200,000 in unused RRSP room.

Darren is prepared to continue living frugally until he retires at age 65 and to invest the $2,000 a month he no longer will be paying in child support and the $1,000 monthly he’ll have once his mortgage is paid off. That said, he wants a comfortable retirement with the ability to spend at least $50,000 – preferably, $60,000 – a year in today’s dollars to age 95.

Darren’s condo is worth about $500,000, with condo fees of $400 a month; he’d be happy to remain there in retirement. He doesn’t have any non-registered assets and hasn’t established a tax-free savings account (TFSA). He has been using a home-equity line of credit (HELOC) for unexpected expenses, the balance of which is at zero.

Darren doesn’t have a car; he can use public transportation and rent a car when he needs a vehicle. However, he would like to have a car in retirement and would be fine with an inexpensive, second-hand vehicle that costs less than $10,000 in today’s dollars.

the recommendations: garbens says Darren can probably manage to spend $50,000 a year in today’s dollars even with an average return on his financial assets of only 4% – a 1.5% real return, assuming annual inflation of 2.5% – after fees until he’s 85. At that point, he would have to sell the condo and live off the proceeds for the final 10 years of the plan. Garbens assumes Darren’s salary will go up by 1.5% a year and the condo will appreciate by 2% a year.

Chinniah ran two projections: one with an average annual return of 5% and the other with 7%, which work out to real returns of 2% and 4%, respectively, given his assumption of 3% annual inflation. Chinniah, wanting to be conservative, didn’t assume any increase in Darren’s salary. Chinniah points out that many people don’t get annual salary increases and that it’s also possible Darren could lose his job.

With the 4% real return, Darren could spend $50,000 a year in today’s dollars until age 95 and would still have his condo. With the 2% real return, he could spend only about $38,000 a year in today’s dollars without selling the condo. However, if Darren gets salary increases of 3% a year and saves that money, he should be able to spend at least $50,000 in today’s dollars even with a 2% real return and not have to sell his condo. If he gets laid off, he could downsize or sell the condo and use the proceeds to add to his capital base to finance the rest of his life.

Both advisors are comfortable with Darren’s ability to stick to a plan because he clearly has the discipline to save and to pay back any money he borrows.

Chinniah utilizes this ability in the plan he has developed. He recommends that Darren not only put the $2,000 a month in saved child support into his RRSP but also suggests that Darren put an additional $12,000 into that account at the end of February each year by borrowing the money from his HELOC. If he does this, it will take him about 10 years to use up all his RRSP room. Chinniah has confidence that Darren would pay back the annual HELOC loan as soon as he gets his tax rebate.

In theory, Darren could borrow more to use up his RRSP room sooner. But, Chinniah says, if Darren’s annual contributions are more than $36,000, his tax rate will go down and he won’t get as much of a rebate. Chinniah is assuming a 35%-40% rebate on the contributions.

Chinniah doesn’t recommend that Darren establish a TFSA until the mortgage is paid off. At that point, he suggests putting the $12,000 a year Darren is not spending on the mortgage into a TFSA until contributions to it are maximized.

Once Darren has used up all of his unused RRSP and TFSA room, Chinniah would have Darren continue to make maximum annual RRSP and TFSA contributions and put the rest of the money he can save into a non-registered account.

Garbens’ plan does not include borrowing for the RRSP. She recommends that Darren put the $2,000 a month in saved child support into his RRSP, starting now, and the $1,000 a month in mortgage cost savings (when they are available in five years) also into his RRSP. In Garbens’ projections, it will take “pretty much until he’s 65 to use up all the unused RRSP room.”

Once the RRSP is maximized, Garbens would have Darren establish a TFSA and put as much into it as he can until contributions to that account are maximized.

Neither advisor suggests using the TFSA as an emergency fund because Darren has the line of credit. They want to see his savings growing by as much as possible.

Darren will have to start withdrawing from his RRSP when he retires at 65. Garbens suggests Darren withdraw about $25,000 a year in today’s dollars until he’s 72, which will keep him in a low tax bracket. He’ll then have to take out the minimum required thereafter.

However, Chinniah recommends that Darren convert his RRSP to a RRIF upon retirement, which would require him to withdraw around $31,000 in today’s dollars, assuming a 2% real return, or $41,000 with a 4% real return. Chinniah’s projections indicate that if Darren defers taxes by taking less in his early retirement years, he could end up paying “a lot more” in taxes over his entire retirement, especially as he could see some of his old-age security (OAS) benefits clawed back.

Darren will need to manage his marginal tax rate in retirement, Chinniah notes. For example, if capital gains push Darren’s income up substantially in a given year, he should take the money he needs out of his TFSA rather than from his RRSP to keep the tax rate in check. This will ensure that Darren both pays lower taxes and avoids OAS clawbacks.

(Darren will be eligible for OAS at age 67 rather than 65, due to the change in age of eligibility announced in the federal budget in March. He could defer receiving OAS benefits for up to five years in exchange for higher benefits once he begins receiving OAS – this deferral will be allowed as of July 1, 2013 – but neither Garbens nor Chinniah recommend deferral because Darren will need the cash flow.)

Chinniah recommends a $50,000 critical illness (CI) insurance policy to age 75 with a return-of-premium rider. The premiums would be about $1,350 a year.

Garbens agrees that some CI insurance would be a good idea, but she thinks Darren would be better off by topping up his work-provided disability insurance with some private disability insurance because this would be less expensive than CI.

Neither advisor suggests long-term care (LTC) insurance because Darren doesn’t have the cash flow to pay the premiums without compromising his retirement income goal. If Darren needs to, both advisors say, he can sell the condo. Premiums for LTC insurance are quite expensive: Chinniah obtained a quote of $3,600 a year for a $1-million maximum benefit that provides $5,000 a month if Darren isn’t in a facility but $10,000 a month if he is in institutional care.

Darren should review and, if necessary, update his will, personal and property powers of attorney, as well as the beneficiaries of his term and accidental death insurance policies and registered accounts.

Chinniah recommends a balanced asset allocation of 60% equities/40% fixed-income for Darren, assuming he can tolerate the risk. Darren needs his assets to grow, so Chinniah would suggest geographical diversification of one-third each for Canadian, U.S. and international equities. While Darren is still working, the focus would be on growth stocks; once retired, there would be a shift to more of an income-oriented portfolio.

For the fixed-income portion, Chinniah suggests investing entirely in bonds initially. But once it looks like interest rates will start rising, he would suggest that Darren move about one-third of these assets into “quasi-bond” products, such as mortgage funds, real estate income trusts and preferred shares, to boost the yield of the portfolio.

Chinniah points out that bonds lose 5% of their value for every increase of one percentage point in the interest rate. While this loss in valuation is on paper only if the investor keeps the bond to maturity, he says, it’s “disheartening” for clients to see the value of their assets drop even if the income being generated isn’t affected.

Garbens doesn’t manage assets, so she just makes broad suggestions. She assumes a 50% equities/50% fixed-income mix in her projections, but agrees with Chinniah’s recommendation that 60% equities would be better if Darren can tolerate it. Garbens also agrees with Chinniah’s geographical breakdown for the equities portion but would prefer dividend-paying stocks.

For the fixed-income assets, Garbens recommends considering “rate-reset preferred shares” – if Darren is OK with that – because the returns are attractive and tend to be higher than for bonds. This type of preferreds often can pay 4%-5% a year. The issuer will attach terms, such as a maturity of, say, five years – at which time, the rate will be reset or the issuer can redeem the shares. The only drawback is that these shares may have less liquidity.

As a fee-only advisor, Garbens charges an hourly fee of $195. For a financial plan of this kind, the cost is likely to be $2,000-$2,500. An annual review generally costs $750 unless there are new issues to consider. For someone like Darren, a review every five years would be fine unless something material changes in his life.

Chinniah’s fee for developing and monitoring a financial plan and managing the portfolio is 1.75% of assets under management (AUM) up to $500,000 in AUM, declining as AUM increases. He normally meets with his clients twice a year.

© 2012 Investment Executive. All rights reserved.