Tax Smart Retirement Funding – Asset Mix Decisions

I met with clients recently who are nearing retirement. They are each 62 and I will refer to them as Kelly and Molly. As we were engaging in some good discussion Molly said to me, “Should we be lowering our equity weighting at retirement?”

This is a very good question that I hear often. Shifting gears from the accumulation to the de-accumulation mode and no longer having employment income to fall back on can be daunting. “Once we stop working we can’t go back,” she said.

I referred to the financial plan that we drafted and have been updating annually. In their case they will benefit from a small private pension that is indexed, full Canada Pension Plan (CPP), and Old Age Security (OAS)— all starting at 65. They do not have any other annuity income. Their house is owned out right and they do not hold any other real estate. Their health is fine, and they are the same age. These two points are always important factors in a retirement plan.

They have Registered Retirement Savings Plans (RRSPs), fully funded Tax-Free Savings Accounts (TFSAs), and a non-registered account with an accrued capital gain. They report the investment income equally, as they both contributed equally to the account over the years.

It is not a priority to leave a large estate to their two children, although they would like to leave something. They explained that they covered their university educations, and now fund their grandchildren’s Registered Education Savings Plans (RESPs) each year. They do not carry life insurance as they are self-insured at this point and it is not a priority for them to carry it as an estate-planning solution.

We have been able to estimate what their annual spending requirement is for basic and discretionary expenditures. We have also built-in an allowance for vehicle replacement, gifts, and home repairs such as a new roof, etc. Longevity risk is of concern to many and with it the possibility of assisted care and the associated costs. We factor in the odds that one of the spouses could live well into his/her 90s.

My updated cash flow analysis indicates that they will need to draw a certain percentage of their overall portfolio (withdrawal rate) from retirement on. CPP and OAS don’t kick in until 65 so they will need to draw more from their investments until that point. My cash flow forecast illustrates that at 72, when their RRSPs are converted to Registered Retirement Income Funds (RRIFs), the minimum required annual withdrawal will push them into a much higher marginal tax bracket. We will therefore want to consider drawing some funds out of the RRSPs before the mandatory age of 72 to use up their lower tax brackets. This we will monitor annually.

We noted that their withdrawal rate is low— in fact it is in line with their income yield from interest and dividends, before including capital gains income. They can essentially draw the income with little dependence on the principal. Kelly then piped up and said, “What about the effects of inflation?” True, their annual expenses will increase by inflation and this will lead to a greater draw down requirement. Strategies to hedge against inflation will need to be built in. For instance, short-term bond ladders, reset preferred shares, and dividend growth common stocks are good solutions for managing inflation.

Given that their drawdown requirement is not significant, they could choose two routes. One is to maintain the equity weighting with solid dividend-paying common stocks. This enhanced income stream would allow for even greater preservation of capital. The other is a sleep-easy solution where they reign in on equities and build in more bonds and Guaranteed Investment Certificates (GICs). In doing this they forfeit the potential for a higher return for a smoother ride.

Molly expressed some further concerns. The first concern is the impact a declining equity market might have in the early stages of retirement. To manage this, we will want to keep an amount in cash and short-term bonds/GICs that will cover the required drawdown for a two to three-year period. Of course, we would still expect that even in a down market, companies with strong balance sheets will continue to pay their dividends. It comes down to a tradeoff between rate of return need and rate of return want.

Her other concern is what transpires at age 72 when they must withdraw from their RRIFs. Simply put, we will need to ensure that we have sufficient liquidity to manage the annual withdrawal requirement either at the minimum amount or greater as factored into our annual cash flow plan at that time. Cash flow planning should be reviewed annually to consider factors including expenditure requirements, changes to tax legislation, and portfolio performance.

A comprehensive financial plan should play a key role in the construction of the investment portfolio.

Ross McShane, CPA, CGA, CFP, RFP, CIM, Vice President, Financial Planning Doherty & Associates, Ottawa, ON 613.238.6727 ross.mcshane@doherty.ca www.doherty.ca