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Financial Facelift

Career change will have to wait Add to ...

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As a military officer, Tim has a steady job with a good income and a generous pension plan. Cheryl, 30, is a stay-at-home mom.

They live with their toddler in one of the few cities in Central Canada where you can still buy a house for less than $200,000.

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Yet Tim, 31, is dissatisfied with his job. He wants to do something more meaningful - a radical career change that would involve spending two years in Toronto studying.

He would emerge as a minister, with a congregation and his family around him - and a substantially reduced salary.

Cheryl, while supportive, wonders if Tim shouldn't hang in for another eight years, when his contract would be up and he'd be eligible for at least a partial pension, which they estimate would be about $36,000 a year.

"I can't see him staying for another 20 years," she says. "He's good at it, but it's not where his heart is."

Would quitting now wreck their finances?

What our expert says We asked Ian Black, planner with Macdonald Shymko & Co. Ltd. in Vancouver, to look at Tim and Cheryl's situation. Mr. Black says the long-term cost of forgoing a lifetime pension might be more than this thrifty young couple are willing to pay.

Tim and Cheryl are doing something that most people find difficult: Living within their means, Mr. Black notes. A full 25 per cent of their income is discretionary, and they are using that money to repay their mortgage nearly three times faster than they are required to.

If Tim quits the military now and the family moves to Toronto, their monthly expenses would rise by 20 per cent. They could rent out their home, which would bring in $550 after rental costs, but they would have to pay about $1,300 for an apartment in Toronto. Tim's schooling would cost $570 a month.

If they both earned $500 a month in part-time work while Tim was studying, as they plan, their income, including their home rental, would be about $1,550 a month. Mr. Black estimates their expenses would be $5,900 - including the costs of operating their two cars and continuing to cover their $900 mortgage payment - leaving a monthly shortfall of $4,350 - $104,400 over two years.

"The question is how much the shortfall might be closed," Mr. Black says. They could sell their home, eliminating the mortgage payment of $900. But then they wouldn't have the rental income, so the net gain would only be $350 a month. The $85,000 or so equity they have in their home could be invested, but this would likely mean borrowing to fund the monthly shortfall. The cost of borrowing would be as high as the return on investment, resulting in no positive change to the bottom line, he notes.

Another option would be for either or both to work more than they plan to while Tim is studying.

Either way, there will still be a shortfall that would have to be made up by borrowing or drawing on their savings.

"Regardless of the source of the funds, the household's net worth would be eroded," Mr. Black says.

But an even larger cost would be the loss of Tim's defined-benefit pension. If he were to leave the military today, Tim would be able to take with him the $42,000 of pension contributions he has made. But he would give up the pension he could begin collecting in eight years, which the couple estimates would be $36,000 a year in today's dollars.

Assuming this pension increases with the rate of inflation, the capitalized value can be roughly estimated as an annuity using a real rate of return. At age 39, in eight years, Tim would have a life expectancy of 41 years. A 41-year annuity of $36,000 starting eight years from today would have a present value of about $665,000, assuming a 3-per-cent real rate of return.

Client situation

THE PEOPLE:

Cheryl, 30, and Tim, 31

THE PROBLEM:

How to finance Tim's goal to quit his job and spend two years studying for a new career without throwing the family into the poorhouse

THE PLAN:

Tim sticks it out for another eight years until he can qualify for a reduced pension and the mortgage on the family home is paid off



THE PAYOFF:

Financial security for the family during the career change and thereafter

MONTHLY NET INCOME:

$5,352 (after income taxes, CPP, EI and pension contribution)

ASSETS:

House $180,000; savings account $11,250; savings for child's education $5,750; Tim's RRSP $6,800; Cheryl's spousal RRSP $4,200; Tim's pension contributions $42,000; two vehicles $15,000. Total: $265,000.

MONTHLY DISBURSEMENTS:

Mortgage $900; property taxes $122; home insurance $50; utilities $265; alarm system $18; food and dining out $600; clothing $83; haircuts, cosmetics, etc. $30; medical $30; leisure $75; transportation, including car insurance $425; life insurance $60; miscellaneous $882; education savings $150; savings and extra mortgage payments $1,662. Total: $5,352.

LIABILITIES:

Mortgage $95,500. Total $95,500.



Cheryl is expected to survive Tim by five years, so she would receive any survivor benefit. Assuming Cheryl receives a 60-per-cent survivor benefit, using the same 3 per cent real rate of return, a five-year annuity starting in 49 years would have a present value of $23,000. Roughly speaking, the pension has a pretax capitalized value of $688,000, when the two numbers are combined.

"The roughness of this estimate does not detract from how much this amount eclipses the receipt of the $42,000 of pension contributions," Mr. Black notes.

The decision to change careers now would likely result in a real reduction in their household's net worth of upwards of $100,000 and an additional implied reduction of more than $650,000.

Suppose Tim stays put for another eight years. At the rate the couple are repaying their mortgage, they will have it paid off in four or five years. This would be a great help because the couple would have substantially more money with which to buy a new home wherever they ended up living.

Tim and Cheryl would still have several years in which to save once the mortgage was repaid, Mr. Black notes. They could simply save money to cover the two years that Tim is attending the seminary.

Alternatively, Tim could begin making spousal RRSP contributions in order to defer taxation and have the withdrawals taxed in Cheryl's hands.

Tim's pension income would go a long way to reducing the shortfall their household would face when he enters the seminary. Longer term, the $36,000-a-year pension would be a welcome addition to the family's income.

Finally, they may wish to review Tim's disability insurance before he makes a change. Disability insurance typically has a waiting period during which the couple would need to cover their household expenses if Tim were to become disabled.

With expenses of about $4,000 a month after tax, their general savings would cover less than three months. So they could run into an issue if the waiting period was longer than that. Special to The Globe and Mail

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