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Montrealers we'll call Barry and Elaine, who are 35 and 36, respectively, have built financially complex lives. They have $1.94-million in assets, liabilities of $1.28-million, a one-year-old child, and a wish to use their net worth as backing for loans to buy more real estate. Barry, who is in the financial services industry, and Elaine, a consultant with a global management advisory company, are not unsophisticated investors. But they are troubled by their extensive obligations.
"We have lots of assets but also lots of debt," Barry explains. "The debt is not yet unmanageable, but could easily get there. We want to continue acquiring real estate assets for investment income, but are unsure of the best way to set it up."
What our expert says
Facelift asked Halifax-based financial planner Robert-Yves Mazerolle of Assante Capital Management Ltd. to speak with Barry and Elaine to assess their investment plans and their wish to achieve a balance of growth and safety. He notes that they have used their borrowing power to buy upscale real estate for their own home and for an income property. The plan has worked well for a few years -- the market price of the properties is $500,000 more than they paid for them.
Their property income covers their carrying costs and they are building up capital gains, but it has left them with net monthly income of $15,040 and total monthly expenses of $15,025. If some liabilities, such as tax and lawsuit settlements, are expensed into their income statement, they would be running in the red every month, the planner notes. Currently, the couple are living on the edge of solvency.
"Nearly half of their monthly income comes from real estate income and can be subject to drastic fluctuations should one or more of their tenants not meet their obligations or move out," the planner says.
The key to reducing the risks to the couple's investments and, indeed, to their way of life, may be to rebalance debt, Mr. Mazerolle suggests.
The first move should be to refinance the income property to 75 per cent of $625,000 market value or $468,750. That will add to the present $298,000 debt on the property, but it will free up $170,750 that can be used to pay off $169,000 of short-term debts that carry interest rates in a range from 9 to 18.5 per cent. The refinancing of the income property mortgage will cost $2,789 a month, which is an increase of only $459, compared with current payments of $2,330.
The move to increase the income property mortgage could have a tax advantage, because interest on the rental property is deductible as an expense incurred to produce income, while the short-term loans at high interest rates are for personal consumption and therefore not deductible. The refinancing should add $2,000 a month to cash flow, Mr. Mazerolle says. However, before using this strategy, the couple should check with tax experts, so that the plan will not run afoul of recent court decisions that appear to extend rules against actions that do nothing more than reduce taxes.
Barry and Elaine want to retire in their mid-fifties. That's two decades away.
They would like to have retirement income of $5,000 a month after tax in 2006 dollars. They have no company pension plans and will have to rely on Old Age Security and the Quebec Pension Plan, as well as their own savings. If they can increase their assets at 6 per cent a year before retirement, and maintain that rate of return during retirement, then the couple would need about $2-million in capital by the time they reach their mid-fifties in order to meet their goal, Mr. Mazerolle estimates.
They can reach this target by adding $20,000 a year each into their respective registered retirement savings plans for the next 21 years, assuming that their accounts grow at 6 per cent a year. Compensation for an assumed 3-per-cent average annual inflation rate would require that they add $23,590 each in every year on top of their current $164,000 RRSP balance. While the RRSP contribution limit is $18,000 for 2006 and $19,000 for 2007, it will rise to $22,000 a year in 2010 and thereafter be indexed to inflation.
For the next four years, the couple could make use of their RRSP contribution space. Later, they can make use of the higher contribution limits, as their salaries increase, Mr. Mazerolle notes. The cash for these substantial contributions can come in part from the interest and tax savings they will achieve by rebalancing their debts. It can also come from their real estate investments. There is a lot of risk in the heavy concentration Barry and Elaine have in their property portfolio, which makes up 89 per cent of their total assets.
Beginning at their intended retirement age of 55, the couple will have to depend on $5,000 a month after tax from their retirement savings. When Elaine reaches 60, she can claim a QPP annual payout of $7,095, which is the 2006 maximum of $10,135 less 0.5 per cent for each year prior to age 65 that payments begin. That sum is reduced by an estimated 30-per-cent tax rate to $414 a month on top of $5,000 from RRSP savings. When she reaches age 65, she can add the OAS payment of $5,903 a year or $344 a month after tax, for a total of $5,758 in after-tax dollars.
Barry, a year younger, will have similar entitlements one year later. At age 65, therefore, the couple will have a total of $11,516 a month after tax. These income estimates do not include any returns from the couple's real estate portfolio, Mr. Mazerolle notes. Barry and Elaine will have more than met their retirement income target.
Barry and Elaine need to get more life insurance, Mr. Mazerolle says. They currently have $500,000 in a joint term policy that pays when the first person dies and a group policy with a $130,000 death benefit on Elaine's life. They should add another $500,000-joint-and-first-to-die term life policy on each of their lives, he adds. The policy premium would be about $70 a month, he notes. The policy would pay decreasing benefits going down to zero over the next 20 years as they pay off their debts and increase their net worth, he explains. Given that their cash flow is tight, they need to ensure that they have disability coverage for each partner, he says. Elaine has disability coverage at her job and Barry should ensure that he gets, with each future job or purchase, a relatively inexpensive basic policy on his own, Mr. Mazerolle recommends.
Barry and Elaine should also maintain their registered education savings plan for their child. They need only contribute $167 a month or $2,000 a year and therefore qualify for the maximum payment from the Canada Education Savings Grant of $400 per child a year. If they continue their contributions for the next 17 years until the child begins post-secondary education, the account will total $73,000, assuming a 6-per-cent rate of return on the fund, Mr. Mazerolle says. This sum would easily support annual withdrawals of about $21,000 a year in 2006 dollars over four years "I think that Barry and Elaine will achieve their retirement objectives," Mr. Mazerolle says. Interested in a free Financial Facelift? Then drop a line to the writer at 444 Front St. W., Toronto M5V 2S9 or andrewallentuck@mts.net
Client situation
Barry, 35, and Elaine, 36, live in Montreal.
Net monthly income: $15,040.
Assets: Rental property, $625,000; home, $1,100,000; boat, $25,000; RRSPs, $164,000; stocks & cash, $15,000; car, $11,000; RESP, $2,800.
Total: $1,942,800.
Monthly expenses: Rental property mortgage, $2,330; home mortgage, $4,670; condo fees, $550; utilities & phones, $750; property taxes, $1,000; food & dining out, $700; entertainment, $400; clothing, $200; child care, $1,600; RESP, $200; car fuel, repairs & insurance, $150; home insurance, $350; life insurance, $75; charity, $100; line of credit, $350; boat maintenance, dock & insurance, $600; Visa interest, $500; savings, $515.
Total: $15,040.
Liabilities: Rental property mortgage, $298,000; home mortgage, $815,000; tax settlement, $60,000; business debt, $29,000; property taxes deferred, $11,000; claim in litigation, $25,000; boat loan, $10,000; lines of credit, $34,000.
Total: $1,282,000.
