Give clients a pre-retirement financial check up

par Rosemary McCracken | September 22 2014 11:41AM

With baby boomers making up the bulk of many financial advisors’ client bases, an increasing number of your clients will probably be retiring in the coming years. Now is the time to make sure that their finances are up to the challenge that lies ahead of them.photo_web_2042A good place to start is by reviewing a client’s debt. “Many baby boomers are so comfortable with their debts that they are going into retirement with them,” said Carol Bezaire, senior vice-president, tax, estate and strategic philanthropy at Mackenzie Investments in Toronto. “Help them make plans to get debt-free.”

This is especially critical for clients who will be living on fixed incomes, added David Ablett, director, tax and estate planning, at Investors Group in Winnipeg. “Servicing debt reduces the amount of money they will have to live on. They should get rid of credit-card debt with its high interest rates. Downsizing the family home can be a strategy to pay off debt, although many baby boomers will want the same level of comfort in a ‘downsized’ home.”

Sources of income

The next step is to look at the client’s sources of retirement income. A survey conducted earlier this year by Investors Group found that many Canadians approaching retirement are unaware of what benefits they can expect from company and government pension plans. It found that 69% of Canadians approaching retirement were unaware of what the maximum monthly payouts were from the Canada Pension Plan, Quebec Pension Plan and Old Age Security; yet more than 80% of this group said they planned to use these benefits as retirement income and more than a third anticipated that this would be their primary source of income.

“Many people don’t know how much retirement income they’ll have until they actually retire,” Ablett said. “The scary cases are when people who are about to retire find their expectations are far too optimistic. In these cases, their choices may not be pleasant. They’ll need to reduce the amount they’ll spend in retirement or they’ll have to work longer.”

He added that members of company-sponsored pension plans also may not know the amount of retirement benefits that they’ll receive. “People who’ve spent 25 to 30 years at a company could be up for annual pensions of $50,000 or $60,000,” he said.

Retirement expenses

Once the client’s sources of retirement income are determined, he will need to come up with a realistic idea of the expenses he can expect to incur in retirement. Ablett suggested breaking expenses into two categories: monthly living expenses and lifestyle expenses that are important to the client such as travel and gifts to children.

“Say the client’s monthly expenses are $1,500. Do CPP, OAS and company pensions cover this?” he asked. “If there’s a gap between his monthly living expenses and his pension income, the money will have to come out of his investments. And lifestyle expenses will also have to be paid for with investment income.”

And the amount of investment income required each month will determine the withdrawal rate on the investment portfolio, said Scott Sonder, sales manager, financial planning at RBC Financial Planning in Saskatoon.

He said his team of financial planners uses a “cash-wedge strategy” to provide their clients with peace of mind in retirement. “If the client needs to draw down $30,000 to make up the shortfall in pension income, we will put $30,000 of his assets into a one-year GIC, $31,000 in a two-year GIC and $32,000 in a three-year GIC. This way, he’ll always have three years of income replacement regardless of what happens in the markets.”

Reducing the tax bite

The types of returns an investment generates are subject to different tax treatments. To reduce the tax bite on interest-bearing investments, which are taxed at the client’s marginal tax rate, Jonathan Sceeles, a financial advisor with Edward Jones in Toronto, said they should be held in tax-sheltered accounts such as registered retirement savings plans where the income can grow tax-deferred until assets are withdrawn from the plan. Growth investments such as equities can be held outside of registered plans because only 50% of the capital gains that will be realized when the investment is sold (or is deemed to have been sold) are included in the income tax calculation.

But Ablett cautioned that old rules of thumb should be examined in the light of current economic realities. “The strategy of holding interest-bearing investments in registered accounts and growth investments outside them may not be as effective today because returns on fixed income are much lower than in previous years. Perhaps the client should consider holding some equities in his RRSP because equity investments are now producing higher returns.”

Cash needs

A pre-retirement financial checkup should also mean reviewing what the client holds in his registered plan, Bezaire said. “Use an online calculator, entering the client’s cash needs, rate of return and inflation to determine if the RRSP is where is should be. But it should not surpass the client’s needs because every time he makes a withdrawal, this money will be taxed.”

Sceeles noted that clients who are approaching retirement should try to find capital to build up their non-registered accounts as a source of tax-efficient income. “They may consider downsizing their homes to free up some money or selling a vacation property if it’s not getting much use,” he said.

Ablett suggested that clients who don’t need the mandatory minimal withdrawals from their RRIFs for living expenses may want to pay the tax on that income and add it to their tax-free savings accounts to build a source of tax-free income.

TFSAs provide great flexibility in retirement and should be maximized in retirement, Bezaire said. “They are an excellent source of cash flow in retirement as withdrawals are not taxed, and if the client holds good investments in a TFSA they can grow pretty large over time.”

Dividend income is considered tax efficient because it enjoys a lower tax rate than interest income and, at some levels, capital gains. However, calculating the favourable tax rate means “grossing up” the dividend income, which will bring it closer to the OAS clawback threshold. Clawbacks to Old Age Security benefits start at net incomes of more than $71,592 for the 2014 income year.

“But splitting eligible pension income with a spouse may help keep a high-income senior below the threshold,” Bezaire said. “And the client can also hold dividend-paying investments in his TFSA, where investment income is non-taxable.”

Spousal splitting arrangements is a wonderful way to reduce the tax burden for married and common-law couples with one high-net-worth and one low-net-worth spouse, she added. “If one spouse has $100,000 in non-registered investments as well as pensions, the LNW spouse can take out a promissory demand loan to buy 50% of the HNW spouses’ investments. They will be transferred into the name of the LNW spouse who will pay 1% interested as dictated by the Canada Revenue Agency—or $500—to the HNW spouse every year, and the HNW spouse will claim the interest as income and also claim a capital gain over a five-year period.”

And when both spouses reach the age of 60, they can split their CPP benefits, she said. A spouse who is entitled to greater monthly benefits can shift part of this income into the hands of the spouse who is entitled to fewer benefits and who is in a lower tax bracket in order to lower the total family tax bill. “This will also help to ensure the HNW spouse’s income is under the OAS clawback threshold,” she added.

She noted that HNW spouses may also want to top up LNW spouses’ TFSAs. At income-tax time, she said, higher-income spouses can claim the spouses’ charitable donations and can also claim the lower-income spouse’s medical expenses.

“And don’t let clients forget the pension credit,” she added. “The first $2,000 of a defined benefit pension or RRIF income at age 65 is tax deductible.”

T-series funds and annuities can be tax-efficient income streams for clients with few estate-planning needs, Sceeles noted. “Clients will need to consider what their greater need is—tax-efficient income in their lifetimes or creating legacies after their deaths.” He added that some annuity products will guarantee a certain number of years of payout for a surviving spouse.

But for clients who do want to leave legacies, he said that bequeathing investments to the next generation in the will is one of the least tax-efficient estate-planning strategies. “Have your client consider leaving life insurance or his home to the children. The primary residence won’t be taxed but a second property, such as a cottage, will trigger a tax bite.”

As clients age, asset allocation—the distribution of his assets over the different asset classes of equities, fixed-income, cash and real estate—takes on even greater importance in order to prevent over-exposure in any one area. “In general, as clients approach retirement, 40% to 60% of their assets should be in fixed-income investments based on their risk tolerance, life expectancy and other sources of income,” Sceeles said. “But if the client has a healthy, defined-benefit pension, he may want to take on more risk with his investment portfolio than the person who is relying 100% on his investments in retirement.”

Sonder said it is usually best to keep the client in the same growth investments that he has been comfortable with in his accumulation years. “Introducing other aspects of diversity are often outside his comfort level as he gets older. With this in mind, it is usually just a matter of reducing the growth component of the portfolio as the client ages. One rule of thumb is that the age of the client should match the percentage of his portfolio in fixed-income investments.”

Curb wild spending

Sceeles cautioned against extravagances in the first years of retirement when some retirees celebrate their new-found freedom with lavish travel and expensive toys. “Withdrawal rates in the first few years of retirement can have a huge impact on how long the retirement bundle will last,” he said. “The client will need to have enough fixed income to draw upon if there is a stock market correction in these years so that he won’t have to sell his growth investments at rock-bottom prices. Before the client walks out of the door of his workplace, he will need to have a financial plan in place that is based on conservative market expectations. And if his portfolio does better than expected in the first year, he may have some bonus cash to spend.

“The tendency is often to think, ‘I’m healthy and I want to see the world while I still can,’” Sceeles added. “While it’s true that as the client grows older, he may want to do less travelling, but he may be faced with high health-care costs in these years. And his portfolio may have trouble keeping pace with inflation.”

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