“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive consults registered financial planners Christine Butchart, senior financial planning advisor and branch manager with Assante Wealth Management (Canada) Ltd. in Hillsburgh, Ont., and David Cox with IPC Investment Corp. in Edmonton.

The Scenario: a 45-year-old man has had a business for the past five years distributing office furniture in Calgary. He believes the business is now firmly established and expects it will continue to do well for another 20 years. The business is incorporated, with the man having 80% of the shares and his 40-year-old wife the remaining 20%. Both are directors of the company.

The husband is paid $150,000 a year, which is sufficient to cover the expenses of his family. The wife runs the office, which is in the couple’s home, and keeps the books, for which she receives $15,000 a year. In each of the past two years, the business has produced an average profit of $50,000; the husband believes it will generate at least that much a year in today’s dollars in the future.

The couple have two children, ages six and eight.

The husband has $300,000 in an RRSP (split 50/50 in fixed-income and equities) and the wife has $50,000 in an RRSP (all fixed-income), saved in the 10 years she worked before the children were born. Both maximize their RRSP contributions. They also have about $15,000 in a joint savings account that comes from the unspent portion of the wife’s earnings. They have chosen conservative investments so far because they wanted financial security while establishing the business; that strategy is not indicative of their general approach to investing.

The couple have no RESPs set up for their children. The husband has $90,000 in disability insurance, and there is term insurance of $1 million for the husband and $500,000 for the wife. The only other asset is the family home, which is worth $800,000 and on which there is a mortgage of $300,000, down from $350,000 when they bought the house seven years ago.

The couple have done no estate planning and have simple wills that leave their assets to each other and then the children. They have powers of attorney for both finances and medical decisions that appoint each other. They have appointed close friends who have children of similar ages as guardians and backup guardians.

The couple’s annual income goal is $90,000 after taxes, in today’s dollars, until age 95. If they can afford to, they would like the children to attend private schools for their secondary education. They also plan to pay for the children’s university education. They estimate that private school will cost about $20,000 a year in today’s dollars for each child; university, $15,000 a year for each child. They would like to leave an estate of $750,000 for each child, in today’s dollars.



The Recommendations: These goals are not achievable, given the current structure of the business. But a few changes could make the goals viable. There are two options. Cox suggests that the husband take $100,000 of his $150,000 in annual compensation in the form of a dividend, which would qualify for the dividend tax credit and save about $25,000 in taxes.

Butchart agrees that this would lower the personal tax load. But she thinks the couple would be better off if the company were to set up an individual pension plan in about five years. Contributions to an IPP are determined by earned income, so they will be higher if the husband continues to receive the higher salary.

In addition, the wife should be paid more for her services; her current salary is very low for the work she does. Butchart suggests $45,000, with the husband’s compensation lowered to leave their combined take at $165,000.

The wife could then increase her RRSP contributions, as well as build up non-registered assets.

Cox agrees with this concept, but says the business can afford to pay the wife $30,000 while leaving the husband at $150,000.

Cox also recommends that the husband split his RRSP contributions, with some money going into his RRSP and some into a spousal plan. He should also pay as much of the household expenses as possible, allowing the wife to save. This would lower their overall tax bill in retirement.

@page_break@If all this is done, the couple should be able to afford private-school fees for four years for each child, Cox says, provided they get an average 6.5% return on their investments after taxes.

Butchart is not so sure. It depends on whether their annual income goal is indeed $90,000 after taxes in today’s dollars; annual income of $60,000 would give them the same disposable income in retirement as they currently have, as there would no mortgage payments or RRSP contributions. Butchart’s projections assume an average annual return of only 4.7% after fees. Her policy is to be very conservative about return assumptions so that the surprises are all on the upside.

Butchart is assuming 3% inflation, while Cox assumes 2.5%.

Cox recommends that the business buy a $2-million inflation-indexed, joint first-to-die full life insurance policy for the husband and wife. Cox notes that coverage will be needed beyond age 65 for several reasons, including replacing assets that might be used to pay for long-term care or unexpected medical expenses. “The importance of permanent insurance coverage cannot be overstated,” he says.

Butchart suggests increasing the husband’s term insurance to $2 million from $1 million, with a term to age 100.

Both advisors also suggest critical illness insurance. Cox recommends it for both husband and wife; Butchart for the husband only. CI insurance generally costs $3,000 a year for each $100,000 in lump-sum coverage; $500,000 in coverage would cost $15,000, for a non-smoker in normal health. Neither advisor suggests long-term care insurance, preferring the couple self-insure by building assets.

Cox notes that if the husband is ill for an extended period, his business may disappear as competitors take on his clients. He suggests the husband look into setting up a “goodwill arrangement” with someone else in the business whereby they would service each other’s clients if either became ill.

The business could also set up a small group medical and dental insurance policy, covering the husband, wife and children. Out-of-country medical coverage when travelling on vacation or business is even more important, Cox says: “Medical expenses can be catastrophic and are always unexpected.”

Cox also suggests the business lease the vehicle the husband uses and pay the home-office expenses, if this is not already the case.

RESPs, which include government grants, are a no-brainer in this situation and should be established immediately. The couple should make both current and catch-up contributions to qualify for the highest grants.

Both Butchart and Cox suggest that the trustees who would be in charge of the children’s money in the event that both parents die before the children are independent be different from the guardians. “People who are good at looking after children,” Cox says, “aren’t necessarily good at looking after money.”

Having an independent trustee also ensures that there are no questions about what is spent, including reimbursement of out-of-pocket expenses related to taking care of two extra children and capital required for any “special needs.”

Butchart also suggests that the couple consider graduated capital disbursement for the children, such as 10% at age 21, 25% at age 25 and the rest at age 30. This gives the children time to learn about money before they have control of all of it.

When it comes to how the capital is invested, Cox suggests 35% in fixed-income and 65% in equities. Butchart recommends a 30%/70% split. Both recommend that about 60% of the portfolio, or 40% of the total, be non-Canadian, to take advantage of the much greater choice and lower volatility available with global investments.

Butchart would go up to 10% of total exposure to emerging markets, sector and specialty funds, while Cox would leave these investment decisions to the managers chosen. Neither advisor recommends alternative assets — too risky.

Both advisors recommend managed money. Cox would recommend putting the assets in two programs, with one strategic and the other more tactical, to take advantage of momentum and trading opportunities. He notes that such programs have a mixture of styles. Cox would also tend to put more money into the program with the higher equity component when the equities are undervalued and less when they are overvalued.

Cox also notes that if there is concern about the possibility of bankruptcy at some point, the couple’s personal investments should be put into segregated funds to protect them from seizure by creditors.

Butchart suggests mutual funds for the couple. She favours a value tilt; although long-term returns on value and growth tend to be similar, there is less volatility with a value style. She does, however, say that whenever there is the prospect of a significant market correction, she would suggest taking some of the money out of the funds and putting them into indexed exchange-traded funds to take advantage of the general run-up in prices when recovery kicks in.

For the fixed-income portion, Butchart recommends a bond ladder with some ETFs, which would help keep costs down.

Neither Butchart nor Cox would charge the couple a fee for investing the money, provided the funds pay service fees to advisors. Butchart charges nothing to develop a plan that she will implement, but she charges between $1,500 and $4,000 if she won’t be involved in the implementation. Cox charges $125 for the initial interview and $375 for completion of the plan. IE