Re: "Tough choices ahead for freelancer," (IE, Building Your Business, March 2013).
In a recent "financial checkup" column, the two consulting financial advisors interviewed for the piece both conclude that the client, a retiring 65-year-old female freelance journalist, can reach her income goal only by either working for another five years to age 70 or by reducing her after-tax spending by 18% to $45,000 a year from $55,000 a year. In doing so, they have overlooked one basic fact: both the client and the situation described present the perfect opportunity to take advantage of the 6%-7% cash flow yields (not rate of return) currently offered by life annuities.
This hypothetical client has $28,000 in a tax-free savings account, $250,000 in an open account, $450,000 in an RRSP and owns a mortgage-free home worth $900,000. She appears to be in good health and is prepared to downsize her residence within the next five to 10 years, and is not overly concerned about leaving an estate. Thus, it would seem that her main priority is to maximize her retirement income and financial security. The challenge, of course, is how to do this in the current low-yield and highly volatile financial environment. Both advisors felt that a traditional asset-allocation approach should provide her with the returns she needs, but there are no guarantees, and there remains a chance that she could run out of money by her early 90s.
Really? For $278,000, she could purchase a single-premium life annuity that would pay her $16,500 a year guaranteed for life, of which only $3,000 is subject to taxation due to the treatment of prescribed annuities. Her $450,000 RRSP could provide her with a life annuity of $28,300 a year, which is fully taxable. This would provide her with $44,800 of guaranteed annual income for life.
If we assume that the client will qualify for maximum Canada Pension Plan and old-age security, then her total gross income rises by another $18,500 to $63,300 a year. Given estimated taxes of $8,300 on this income, she is at 100% of her goal. Again, all of this is guaranteed income for life without even touching the equity she has in her house. These annuity-based incomes assume deferring payment for one year to allow her to prepare for retirement. She could use a secured personal line of credit to access cash should the need emerge because we just soaked up all her liquid funds by buying the annuities.
Yes, we know that the thought of surrendering your capital to insurance companies is considered heresy in some quarters and that this is the wrong time to buy them with interest rates being so low. However, consider the alternatives:
What will happen during retirement if you continue to put 50% or more of your clients' money into fixed-income investments yielding 2% or less, regardless of whether they are held directly or through mutual funds or exchange-traded funds (ETFs)? A small yield like that will destroy capital as well.
If you say that this is the wrong time to buy annuities (with interest rates being so low), you have missed the whole point. Now is the perfect time to buy annuities. How long do you think it will be before current fixed income yields go up to 6%? Until yields get up to 6%, annuities are a clear winner. Once rates climb significantly - say, 10% or higher - then you may have a good point.
Or do you? In the period rates rise from 2% to 6%, annuities are ahead. As rates rise to 10%, you are giving up the gains earned earlier. If rates do get to 10%, you are neutral. Hold up your hand if you think interest yields are going north of 10% any time soon.
Plus - and this is a very important point- how much peace of mind has the client enjoyed, safe in the knowledge she had a guaranteed monthly income for life? And should interest rates rise, what type of carnage is going to be exacted on the fixed-income ETFs, mortgage funds, preferred shares and real estate investment trusts recommended in the article? It is true that the client needs to consider carefully how she feels about surrendering her capital.
This scenario relies too heavily on asset allocation, which cannot provide the certainty of income the client requires. Clients whose portfolios are subject to withdrawals cannot survive on relative returns, especially in volatile financial environments. This is why annuities must command a greater role when preparing retirement income plans.
Bruce Cumming, CFP, RFP, FCSI
Executive director, private client group, and senior investment advisor, DundeeWealth Inc.
Peter Hanson, MBA, CFP, FCSI
Principal, Hanson Consulting
The views expressed are those of the authors and do not necessarily reflect those of DundeeWealth Inc.
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