Jul 07, 2020

AR: Augmented... Retirement

With investors experiencing massive equity corrections and interest rates falling to rock bottom, an additional asset class, which may offer augmentation to your retirement plan, can be considered. In this article, we review a retirement strategy from two angles: standard and augmented.

A key goal for wealth managers is to create the proper balance of assets for our clients. For wealthy Canadians, this balance usually holds a combination of equities, debt, real estate, cash and guaranteed certificates. This asset mix has proved successful for generations and is still the bread and butter for many today. 

 

However, through the past twenty years, investors have experienced three massive equity corrections and interest rates have fallen to rock bottom. A cruel irony now sees those who once had mortgage rates near 20%, stuck with low rates for their savings. For certain clients, an additional asset class may be used to maintain cash flow and protect estate values for the next generation.

 

Consider Jack and Jill Carpenter, both 50 and reside in the province of Alberta. All of their accounts are invested in a balanced portfolio (25% Canadian equity, 35% U.S. equity and 40% Canadian bond); assigned rate of return for this asset mix is 4.58% before fees (data derived from Morningstar).

 

RRSP (combined) $700,000
TFSA (combined) $200,000
Joint Non-registered $1,000,000
Corporate Investment Account $1,000,000
Total Investment Assets $2,900,000

Jack plans on working for another 10 years and earns about $400,000 from the active business. This income is shuffled to a holding company, as required. He pays himself a salary of Yearly Maximum Pension Earnings (YMPE), approximately $60,000. He also pays dividends to both himself and Jill, who helps with admin and bookkeeping regularly, $100,000 total, increasing with inflation, each year. Jill also plans on working for another 10 years and earns $70,000/year as an employee. 

 

Lifestyle expenses are $150,000/year increasing with inflation and their TFSA contributions are maxed until retirement.

 

Standard Retirement

In a standard retirement, starting at age 60, it is estimated that their lifestyle will cost $192,013/year. The non-registered joint account grows to $1,476,527, corporate investment account is $4,803,404 and registered assets are $1,408,220. The total amount of investments at retirement are $7,688,151.

 

The couple has ample resources to meet their spending requirement and financial stability is achieved through the projection ending their 90th year. Accompanying the usual Canada Pension Plan (CPP) and Old Age Security (OAS) (limited) pensions, a balanced withdrawal from both registered and non-registered accounts and $128,000/year dividend from their holding company, which increases with inflation, results in the following balances at the end of their 90th year and assumed death:

 

 

Ending Value

Cost Base

Tax (48%)

Net to Distribute

Joint Non-registered $1,494,000 $964,000 $127,000 $1,367,000
TFSA (combined) $1,254,291 - - $1,254,291
RRIF (combined) $433,000 - $208,000 $225,000
Hold-co Investment (48.67%) $3,330,865 $2,522,496 $72,800*
Hold-co Shares $3,258,111 - $782,000**
Taxable Dividends to Estate (42.31%) $2,853,927 $1,207,000 $1,646,927
Non-taxable Distribution to Estate $404,184 - $404,184
Totals     $1,614,800 $4,897,402

* Total tax paid after accounting for refundable tax.
** We assume the estate qualifies as a graduated rate estate. Through a loss carry back provision, this gain can be avoided.

 

Augmented Retirement

Jack and Jill look down the hill and like what they see. Their heirs retain about 75% of their gross asset value and about 65% of the company asset value after tax. However, bothered by estate erosion, concerned about market volatility during retirement, and challenged by the likelihood of interest rates remaining low for their lifetime, Jack and Jill are prompted to seek additional strategies.

 

They consider one small change to their asset structure leading into retirement. The corporate account is invested with a fixed income component of Canadian bonds containing 40% of the portfolio or $400,000. The rate of return on this component is 3.16%. Jack & Jill decide to take about $26,500/year from their fixed income portfolio and invest into a participating whole life policy owned in their corporation. The policy is guaranteed to be paid up at the end of twenty years (age 70) and contributions total about $530,000. Meanwhile, the remaining market-exposed investment account at retirement has a value of $4,490,000 (compared to $4,800,000 in the standard retirement). All other account balances are identical to the standard retirement scenario.

 

As expected, the couple has ample resources to meet their spending requirement and financial stability is achieved through the projection, ending their 90th year. Jack and Jill really didn’t ever have to worry about their retirement stability. Even if they did, at the current dividend scale, there is a $1,800,000 cash value within their policy sitting in their holding company that they could access. In this insurance-based investment strategy, Jack and Jill have:

  1. Reduced their annual tax bill by avoiding the punitive passive taxation of interest income in their holding company (48.67% in Alberta).
  2. Created a tax-sheltered asset within their policy, which includes both guaranteed cash value and annually posted non-guaranteed cash value that vests immediately. Hence, this asset class cannot go down in value.
  3. Diversified their market exposure and broadened their asset classes.
  4. Generated superior wealth to benefit their estate or philanthropic desires (table below).

 

  Ending Value Cost Base Tax (48%)

Net to Distribute

Joint Non-registered $1,494,000 $964,000 $127,000 $1,367,000
TFSA (combined) $1,25,291 - - $1,254,291
RRIF (combined) $433,000 - $208,000 $225,000
Hold-co Investment (48.67%) $1,823,000 $1,376,000 $40,230* -
Hold-co Shares (includes cash value)*** $3,534,500 - $242,000** -
Death Benefit*** $2,258,000 - - -
Taxable Dividends to Estate (42.31%) $1,767,868 - $744,802 $1,023,066
Non-taxable Distribution to Estate $2,272,605 - - $2,272,605
Totals     $1,362,642** $5,899,349

* Total tax paid after accounting for refundable tax.
** We assume the estate qualifies as a graduated rate estate. Through a loss carry back provision, much of this gain may be avoided. In this example, stop-loss rules could have limited application and an estimated adjustment to total tax payable has been included.
*** Using current dividend scale rates.

 

By diversifying some of their portfolio assets within their corporation into a whole life policy, Jack and Jill have added an additional asset class to their investment portfolio and have reduced market exposure. The cash value of the policy is an alternative to fixed income investments; it grows tax-exempt with historic returns similar to a growth portfolio, yet it can’t go down in value. In the likely scenario where they don’t need the cash value before death, the policy generates a pool of over $2,000,000 that is eligible to be paid tax-free from the company to the estate. If their investment had been left in their traditional fixed income vehicle, a rate of return of 9.2% would be required to achieve the same results. Consequently, Jack and Jill are able to pay $252,000 less tax and add over $1,000,000 to benefit the people or causes they care about.

 

If you would like to discuss strategies for your own augmented retirement, we can help to ensure you’re on track. Our Portfolio Managers work closely with our Wealth Advisory Services to deepen financial strategy discussions. Fill out the form below and one of our team members will get in touch with you shortly.

 

 

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