Early retirement plans need to be redesigned

Ashley Fraser/The Globe and Mail

Ted and Natalie have high-paying management positions, Ted in the private sector and Natalie in government. He is 52, she is 51. They have two children aged 18 and 21. The youngest still lives at home.

Ted has earned a good income over the past five years, averaging about $200,000 a year including commission. His base salary is $115,000. Natalie earns $118,000 a year, plus a bonus ranging from $5,000 to $25,000.

Natalie and Ted bought a rental property not long ago with a small down payment; the property barely breaks even.

Natalie recently joined her defined benefit pension plan and wonders if she should use funds from her former employer’s registered pension plan to “buy back” years of service in her new plan.

Ted, who recently had a health problem, envisions the day when they can both retire, travel a lot “while we can” and spend the winter in a warmer climate. In the short term, they want to replace one of their cars and make some renovations to their house. In the longer term, their goal is to retire in six years with a budget of $140,000 per year after tax.

We asked Matthew Ardrey, vice president and financial planner at TriDelta Financial in Toronto, to take a look at Ted and Natalie’s situation.

What the expert says

Ted and Natalie were able to pay off the mortgage on the family home, do some renovations and make other major purchases thanks to Ted’s substantial commission income and Natalie’s bonus, Ardrey says. Ted expects this extra income to drop significantly in the future, averaging around $10,000 a year each.

“Unfortunately, with the reduction in this extra income, they may not be able to pay even their short-term expenses in full,” the planner says. They have enough to pay for their big annual trip ($10,000), but may not have enough for home renovations ($25,000) or buying a car ($35,000). “If they want to pursue them, they may have to either fund them or cut spending in other areas.”

Ted saves 4% of his salary each month in his defined contribution pension plan, which the company matches. Then, he uses the rest of his RRSP rights to contribute to his group RRSP at work. He also makes a monthly contribution of $100 to his tax-free savings account. Natalie contributes $10,000 a year to her RRSP.

In addition to his CD pension, Ted also has a defined benefit pension that will pay him $26,400 a year when he retires at age 58, not indexed to inflation. Natalie has just joined her defined benefit plan and has the option to buy back service, says the planner.

If Natalie uses all of the $226,000 in her DC pension plan to buy back service with her new employer, her pension will increase from $1,000 per month to $2,500 per month, fully indexed, at her retirement age. 58 years old. “We recommend him to do so.

Natalie and Ted recently purchased a $550,000 rental property with a $500,000 mortgage on it. The property earns $2,700 per month gross and zero after fixed expenses. “It’s concerning because at best it’s cash flow neutral and if ad-hoc spending happens it’s going to be cash flow negative,” Ardrey said. In preparing his forecast, he assumes that they sell the rental property when they retire.

After adding up all the expenses and savings, the couple has a surplus that is not accounted for. They said they use the money for unexpected expenses such as car repairs. “Although this is part of the surplus, I feel there are budget leaks in their spending,” the planner says. They should work on improving their budget to get a clearer picture of their retirement needs.

If they retire at age 58 from Ted, they will receive reduced Canada Pension Plan benefits. The forecast assumes they start collecting CPP and Old Age Security at age 65. They will receive 80% of the maximum CPP benefit at age 65 plus the maximum Old Age Security benefits, subject to any clawbacks.

Their portfolio is 23% cash, 32% bonds and 45% stocks, says Ardrey. Of the stocks, 20% are Canadian, 20% American and 5% international. “With headwinds on the fixed income side due to rising interest rates, the expected return on this portfolio is 3.04%,” he says.

Inflation is now a bigger concern for portfolios than it once was and that will likely last for some time, according to the planner. “So we’re using a 3% inflation rate in this projection, which means their investments are barely keeping pace with inflation.” Worse still, the mutual funds they hold outside of their group plans have an average management expense ratio of 2.14%. In comparison, investments in group plans would be at a relatively low cost.

Taking all these variables into account, with their spending goal of $140,000 per year, they fail very early in their projection, running out of savings just 10 years after retirement, in 2038,” explains the planner. “Given this drastic shortfall, we deem this scenario unviable.”

To improve their retirement plan, Ardrey recommends that they hold less cash, increase their stock holdings and add non-traditional income-producing investments, such as private residential real estate investment trusts. “These investments offer uncorrelated and consistent returns that exceed what we expect today for fixed income securities.”

With 55% cash and fixed income, their portfolio has a built-in risk that they probably don’t recognize. “For the past 50 years or so, fixed income securities have been a safe haven to invest in,” says the planner. “That’s less the case today.” A rise in interest rates causes the price of existing bonds to fall. Inflation is also a risk for fixed income securities. “If the current rate of inflation is more rigid than expected, the real bond rate of return will continue to be negative.”

Earning better returns improves Ted and Natalie’s retirement prospects, but more is needed, he says. Ardrey submits his predictions using software known as a Monte Carlo simulation to assess the probability of success given different variables. To improve their chances of success, Ted and Natalie will either have to cut their retirement spending by about a third, to $96,000 a year, or delay their retirement for another six years, from 2028 to 2034.

“Unfortunately, there is no silver bullet to retirement planning,” says Ardrey. “If you can’t achieve your goals, it usually involves one or more of the following actions: working longer, saving more, investing better, or spending less.” This is the situation that Ted and Natalie must now manage to achieve their goals in the future. “Fortunately, they still have time to do so.”

Status of customers

The people: Ted, 52, Natalie, 51, and their children, 18 and 21

The problem: Can they afford to retire in six years with expenses of $140,000?

The plan: Take steps to improve investment returns, lower retirement expense expectations, or plan to work much longer than expected.

Gain : A clear picture of what needs to be done

Net monthly income: $15,100

Assets: Cash $2,000; his RRSP $410,000; his RRSP $235,000; his defined contribution pension $235,000; his CD pension $226,000; estimated value of his DB pension $634,000; estimated value of his DB pension $72,000; his TFSA of $17,000; registered education savings plan $27,000; residence $820,000; rental property $550,000. Total: $3.2 million

Monthly expenses: Property tax $450; water, sewer, garbage $120; home insurance $170; heating, electricity $300; maintenance, garden $260; car insurance $235; fuel $700; maintenance $275; parking, public transit $300; groceries $1,200; tutoring $400; clothing $250; gifts, charity $350; vacation, travel $1,000; other discretionary $600; meals, beverages, entertainment $1,300; personal care $200; club memberships $50; golf $25; pets $85; subscriptions $65; health care $100; communications $235; his RRSP and DC pension plan contributions of $1,440; Registered Education Savings Plan $100; his DB pension plan $1,380; his RRSP $835; his $100 TFSA. Total: $12,525. The surplus goes to incidental and unallocated expenses.

Passives: Mortgage on rental $501,590

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