Vi and Victor are in their mid-40s with two children, ages 8 and 10. A couple of years ago, Victor switched careers, landing a government job complete with indexed pension. Vi is in sales, so her income is volatile. Together, they bring in nearly $300,000 a year.
They have a house in Toronto with a mortgage that has 23 years left to run on the amortization.
Victor wonders whether they will be able to retire when he is 60 and Vi is 58 with $120,000 a year after tax. He’s concerned about the uncertainty of Vi’s income, and whether she may have to keep working longer.
To help things along financially, Victor took his broker’s advice and embarked on what is called a “Smith Manoeuvre.” In this arrangement, as Victor makes principal payments against the mortgage, he borrows the same amount on a line of credit used to buy investments, thereby making the interest tax deductible. Over time, the non-deductible house mortgage falls in value while the loan increases. Ideally, the value of the investments grows more than the outstanding debt.
“Once the mortgage is paid off, these mutual fund investments will be converted into some other form of investments to support our retirement,” Victor writes in an e-mail. “What do you think of our use of a Smith Manoeuvre?”
We asked Warren MacKenzie, a principal at HighView Financial Group in Toronto, an investment counselling firm, to look at Vi and Victor’s situation.
What the expert says
Victor and Vi wonder if they will have enough to educate their children and still be on track to retire by the time he is 60, Mr. MacKenzie says. “Their financial plan shows they are definitely on track, but they need to see the numbers before they have enough confidence to relax and enjoy life,” he adds.
Their savings and the principal repayment on their debt amounts to over $4,000 a month, so by the time Victor is 60 they are forecast to have a home worth $2.6-million (assuming it appreciates in value at the rate of inflation) and an investment portfolio (RRSP and non-RRSP) of about $1.8-million.
“They can achieve this if they earn an average of 5 per cent a year on their investment portfolio,” Mr. MacKenzie says. They should be in a “goals-based” portfolio – one that is designed to earn 5 per cent a year with the least possible amount of risk, he says.
Because of their investment strategy, though, “they are taking much more risk than necessary,” the planner says. Victor’s RRSP portfolio is invested 100 per cent in equity mutual funds. In addition, he has increased his home mortgage to raise additional funds to invest in a non-RRSP portfolio which is also 100 per cent in equities. (Borrowing to invest in bonds would not make sense with bond yields so low.)
“Victor started this strategy after the last market crash (in 2008), and it has worked out well as the market has recovered,” Mr. MacKenzie says. Because a portion of their mortgage is being used to purchase non-registered investments, the interest on that portion of the mortgage is deductible for income-tax purposes.
By using the Smith Manoeuvre strategy, they add to the amount of their loan each month. “Victor is under the impression that this is the way to get the largest tax break while allowing him to pay off his non-deductible mortgage more quickly,” the planner says.
“However, for someone with a well-paid government job and an indexed pension, there is no huge advantage in using the Smith Manoeuvre, because he could borrow the same amount by using a regular line of credit or a margin account with his brokerage firm,” he says. The interest on the debt that is created for investment purposes will be deductible whether Victor borrows through a mortgage with the home as collateral or whether he borrows on a margin account with the stocks as collateral.
“The important question should be: How much investment risk are they willing to take to achieve their financial goals?” Without the investment loan, their net worth is expected to be less (about $4-million instead of $4.4-million) by the time they retire, at which time Victor will receive an indexed pension (reduced because he is taking it at the age of 60, rather than 65) of about $31,000 a year.
In their first full year of retirement, when they have both quit working, they will need cash flow of about $175,000 a year before tax to meet their spending goal. This will come from Victor’s pension ($31,000), RRSP withdrawals ($40,000) and about $104,000 from their non-registered portfolio, which is estimated to be worth about $800,000 at that time, the planner says. With a return of 5 per cent a year, the $104,000 withdrawal will be about $40,000 from income generated and about $64,000 from capital.
Once they are both drawing Canada Pension Plan and Old Age Security benefits, they will need $45,000 a year from their investment portfolio. With annual savings and a growth rate of 5 per cent, the portfolio should be worth $1.8-million by that time, so drawing $45,000 a year will be no problem, the planner says.
“Victor should understand that when interest rates go higher, this may drive down the price of homes in Toronto,” the planner says. If the next market crash happens at the same time, Victor and Vi would find their two biggest assets have fallen in value. If, by then, they have quit working, they would end up with a large mortgage on their home and would have to cut their lifestyle spending.
The people: Victor, 47, Vi, 45, and their two children
The problem: Are they on track to retire when Victor is 60 and Vi is 58 with cash flow of $120,000 a year after tax? Does it make sense to use the Smith Manoeuvre?
The plan: Devise a goals-based investment strategy that shows how much they will have to save and earn. They may find they don’t need to borrow at all. If they want to borrow, consider a straight investment loan, which would allow them to build a balanced portfolio.
The payoff: A simplified financial map to retirement with much less risk.
Monthly net income (variable): $14,500
Assets: Cash $3,000; his non-registered mutual funds $184,000; her TFSA $1,000; his RRSP $382,000; her RRSP $193,000; estimated present value of his DB pension plan $130,000; RESP $72,700; residence $2,000,000. Total: $2.96-million
Monthly distributions: Mortgage $3,410; property tax $850; home insurance $360; utilities, security $600; maintenance $50; fuel $300; insurance, parking $300; groceries $1,200; child care $80; line of credit $250; charitable $160; clubs $1,500; grooming $100; dining, drinks, entertainment $250; pets $100; other personal $1,000; life insurance $100; cellphones $300; Internet, TV $110; RRSPs $1,000; RESP $415; TFSAs $500; pension plan contribution $830. Total: $13,765. Surplus: $735
Liabilities: Residence mortgage $775,000; line of credit $3,900; investment loan $198,000. Total: $976,900
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