CASE STUDY INVESTMENT CHOICES AFTER MORTGAGE PAY-OFF

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1 CASE STUDY INVESTMENT CHOICES AFTER MORTGAGE PAY-OFF KNOWLEDGE EXPECTED OF: Both FPSC Level 1 Certifi cants and CFP Professionals Version 1.0.0, Updated Aaron earns $6,667 (after-tax) per month as a professor at a local university. He also earns net income of $10,000 per month in each of March and April from his income-tax return preparation business. Aaron prefers to maintain his taxpreparation business as a sole proprietorship, given the additional costs and regulatory requirements associated with incorporating his business. His major cash outfl ows include $3,000 for his monthly living expenses and $500 toward a car payment. Each year, Aaron spends $5,000 per month in July and August travelling. He carries errors and omissions insurance for his business. Aaron would like to retire in 15 years at age 60. At that time, he estimates he will be withdrawing $40,000 per year (in today s dollars) from his investments. Each February, Aaron purchases $12,000 of mutual funds via a lump sum contribution to his Registered Retirement Savings Plan (RRSP). The mutual funds include the following: $12,261 in broad-based Canadian equities, $10,675 in Canadian energy companies, $21,024 in U.S. large cap stocks, $5,734 in international equities across multiple continents, and $14,016 in Canadian government bonds. His RRSP account has grown to $63,710 and he currently has $84,000 in unused RRSP contribution room. Aaron has never contributed to a Tax-Free Savings Account (TFSA). When he switched banks almost a decade ago, Aaron set up a pre-authorized monthly transfer of $250 from his chequing account to his savings account to cover emergencies that may arise. This account has grown to $34,000. The last time Aaron renewed his mortgage, he purchased an indexlinked guaranteed investment certifi cate (GIC) using a portion of his emergency funds. Aaron felt that this was a reasonable alternative to a savings account for the potential to earn a higher rate of return. Now that he has paid off the mortgage on his $400,000 house, and has been offered tenure at the university, Aaron feels comfortable taking on additional risk to achieve greater growth on his retirement investments. He is comfortable with allocating assets during his working years in the following way: 30 percent in Canadian equities, 30 percent in U.S. equities, 15 percent in international equities, and 25 percent in fi xed-income investments. Once he retires, Aaron would prefer to have an equal split between equities and fi xed-income investments. While he likes mutual fund investments because of the professional money management they provide, Aaron worries about another market downturn similar to that of A fellow business owner recommended that Aaron consider segregated funds for the creditor protection and maturity guarantee they provide. Aaron would like to understand the advantages and risks of each investment option before making a decision. Average annual fees are two percent for mutual funds, and three percent for segregated funds. Knowledge Expectations Financial Analysis Construct a current net worth statement for Aaron. Page 1

2 Personal Net Worth for Aaron House $400,000 Total Lifestyle Assets $400,000 Non-registered savings account $34,000 Registered Retirement Savings Plan (RRSP) $63,710 Total Investable Assets $97,710 Total Assets $497,710 Total Liabilities $- Net Worth $497,710 Explain that Aaron has positive net worth, with suffi cient liquid assets for emergencies. Construct a current cash fl ow statement for Aaron. Cash Flow for Aaron Post Mortgage Payoff January February March April May June July August September October November December Annual Net salary - University Professor $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $80,004 Net income - Tax preparation business $- $- $10,000 $10,000 $- $- $- $- $- $- $- $- $20,000 Total Net Income $6,667 $6,667 $16,667 $16,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $100,004 Total Net Cash Inflows $6,667 $6,667 $16,667 $16,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $6,667 $100,004 Mortgage $- $- $- $- $- $- $- $- $- $- $- $- $- Living expenses $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $36,000 Car payment $500 $500 $500 $500 $500 $500 $500 $500 $500 $500 $500 $500 $6,000 Travel $- $- $- $- $- $- $5,000 $5,000 $- $- $- $- $10,000 Total Living Expenses $3,500 $3,500 $3,500 $3,500 $3,500 $3,500 $8,500 $8,500 $3,500 $3,500 $3,500 $3,500 $52,000 Emergency savings account $250 $250 $250 $250 $250 $250 $250 $250 $250 $250 $250 $250 $3,000 Registered Retirement Savings Plan (RRSP) $- $12,000 $- $- $- $- $- $- $- $- $- $- $12,000 Total Savings Contributions $250 $12,250 $250 $250 $250 $250 $250 $250 $250 $250 $250 $250 $15,000 Total Cash Outflows $3,750 $15,750 $3,750 $3,750 $3,750 $3,750 $8,750 $8,750 $3,750 $3,750 $3,750 $3,750 $67,000 Explain that Aaron has a net positive cash fl ow which may be used to increase his savings toward his retirement goal. Identify that the variability of Aaron s cash fl ows enables him to build up savings that he can use in months of cash fl ow defi cits. Page 2

3 Calculate that Aaron has fi xed expenses of $3,500 1 per month. Calculate that Aaron should have $21,000 2 in liquid investments set aside for emergency purposes. Explain that Aaron s current emergency fund exceeds the amount he needs to provide for six months of living expenses. Identify that Aaron may avoid paying tax on interest income from transferring his emergency savings to a TFSA. However, he may benefi t more from purchasing growth-oriented investments for retirement in that account. This is because growth-oriented investments will enable Aaron to shelter greater amounts of tax resulting from capital gains. While he may have benefi ted from using index-linked GICs to earn higher rates of return on his emergency funds, Aaron should ensure that the funds remain liquid, safe and accessible without a penalty. He may consider holding the investments in cash or a cashable GIC. Both investments will provide him with interest income while also maintaining their nominal value. Knowledge Expectations Retirement Planning Calculate that, after ensuring a suffi cient amount of assets for emergency purposes remains accessible, Aaron will have $13,000 3 remaining that he may use to save for his retirement. Explain that Aaron should contribute the excess $13,000 to his RRSP. Calculate that Aaron has surplus cash fl ow of $33,000 per year ($2,750 per month) that he may use to save for his retirement. Explain that maximizing his RRSP contributions (ahead of his TFSA contributions) will enable Aaron to pay less tax, given that his income and associated tax rate in retirement is expected to be lower than his current income and tax rate. Calculate that, after contributing $13,000 to his RRSP, Aaron will have $68,000 4 in unused RRSP contribution room. Explain that Aaron should begin saving his $2,750 in excess cash fl ow each month to his RRSP until he reaches his RRSP contribution limit. He should then contribute to his TFSA for maximum tax-deferred savings. Explain that Aaron will benefi t from dollar-cost averaging by making monthly contributions to his RRSP, as opposed to doing so in a lump sum each February. In addition to benefi ting from investing over longer periods of time, Aaron may also benefi t from reduced volatility in his portfolio. 1 $3,000 + $500 = $3,500 2 $3,500 (six months) = $21,000 3 $34,000 - $21,000 = $13,000 4 $81,000 - $13,000 = $68,000 Page 3

4 Knowledge Expectations Asset Allocation and Diversification in Investment Planning Calculate that the asset allocation of Aaron s current RRSP holdings is as follows: 36 percent 5 in Canadian equities, 33 percent 6 in U.S. equities, nine percent 7 in international equities and 22 8 percent in fi xed-income investments. Explain that Aaron s current RRSP holdings are overweight in Canadian 9 and U.S. equities, 10 while underweight in international equities 11 and fi xed-income investments. 12 Explain that being overweight in Canadian and U.S. equities creates the potential for greater volatility. Explain that Aaron should rebalance his portfolio, and return his investment holdings to his long-term asset allocation as follows: 30 percent in Canadian equities, 30 percent in U.S. equities, 15 percent in international equities and 25 percent in fi xed-income investments. Calculate that Aaron s RRSP contribution of $13, through a lump sum should be split in a way to ensure his long-term asset allocation is maintained. That said, the contribution should be split as follows: $77 14 in Canadian equities, $1, in U.S. equities, $5, in international equities, and $5, in fi xed-income investments. Explain that while Aaron s portfolio is diversifi ed across major asset classes, Aaron may benefi t from further diversifi cation within each class. Explain that a broad-based Canadian equity mutual fund generally has exposure to the energy sector. Aaron should consider selling the energy fund in favour of other broad-based Canadian equities to reduce so much concentration in energy. Explain that Aaron s current U.S. equities focus on large-cap stocks only. Diversifying further into mid-cap and small-cap stocks will reduce his portfolio s overall risk, in addition to providing greater opportunities for growth. Explain that adding funds that focus on corporate and international bonds would complement Aaron s current bond holdings. As such, they would provide greater diversifi cation, reduced risk and potential growth opportunities. 5 $22,936 / $63,710 = 36% 6 $21,024 / $63,710 = 33% 7 $5,734 / $63,710 = 9% 8 $14,016 / $63,710 = 22% 9 36% > 30% 10 33% > 30% 11 9% < 15% 12 22% < 25% 13 In many cases the following amounts may be rounded for simplicity. For example, $77 may be rounded to $0 or $100, $1,989 to $2,000, $5772 to $5,800 or even $6, ($63,710 + $13,000)(0.30) - $22,936 = $77 15 ($63,710 + $13,000)(0.30) - $21,024 = $1, ($63,710 + $13,000)(0.15) - $5,734 $5, ($63,710 + $13,000)(0.25) - $14,016 $5,162 Page 4

5 Explain that Aaron may consider switching his current selection of mutual funds to a fund of fund solution. This solution will provide diversifi cation between and within all asset classes. It will also be rebalanced by a fund manager, saving Aaron time and providing him with the confi dence that his portfolio is being managed by an investment professional according to his risk tolerance. Knowledge Expectations Investment Planning and Selection Explain that, given his long-term time horizon, comfort with fl uctuating investment values and growth objective, mutual funds and segregated funds are suitable investment choices for Aaron. Explain that Aaron s desire for professional money management, portfolio value and plans to make monthly contributions are consistent with both investment options mutual funds and segregated funds. Evaluate the factors that Aaron may consider when choosing between mutual funds and segregated funds: Time horizon: Explain that, while Aaron expects to retire in 15 years, his investment time frame is 50 years. As such, the maturity guarantee provided by segregated funds may be limited in value when compared to investing in a mutual fund. Cost: Mutual funds have the advantage of being relatively lower in cost than segregated funds. Creditor protection: As a sole proprietor, Aaron is responsible for his business-related liabilities. Segregated funds have the advantage of offering creditor protection. Given his errors and omissions insurance, the additional cost of segregated funds may not be justifi ed. Explain that mutual funds are the optimal choice for Aaron, given the time-horizon consideration, and cost and creditor protection offered on mutual funds and segregated funds. Knowledge Expectations Retirement Planning for Aaron Identify that, based on the most conservative life expectancies provided in the Projection Assumption Guidelines 18, 45-year-old Aaron should plan to live to 95. Identify that Aaron s time horizon to accumulate assets for retirement is 15 years. 19 Identify that Aaron may expect a 35-year 20 time horizon for his retirement. Calculate that $40,000 in today s dollars is equivalent to $53, in 15 years. Calculate that Aaron may expect to earn an annual gross rate of return of 5.7 percent 22 on his mutual funds until he reaches retirement, based on the return assumptions provided in the Projection Assumption Guidelines. Calculate that Aaron may expect to earn a net rate of return of 3.7 percent 23 on his mutual funds until he 18 This case study reflects Projection Assumption Guidelines published in = = N = 15; I/Y = 2%; PV = $40,000; PMT = $0. CPT FV = $53, % (0.75) (0.25) = 5.7% % - 2.0% = 3.7% Page 5

6 Calculate that Aaron may expect to earn an annual gross rate of 5.1 percent 24 on his mutual funds during his retirement, based on the return assumptions provided in the Projection Assumption Guidelines. Calculate that Aaron may expect to earn a net rate of return of 3.1 percent 25 on his mutual funds during his retirement. Calculate that Aaron will require $1,140, at age 60 to be able to withdraw $40,000 annually (in today s dollars) from his portfolio, if he uses mutual funds. Calculate that, after Aaron contributes $13,000 to his RRSP, he will have $76, invested in the portfolio. Calculate that, based on his planned contributions of $12,000 per year to his RRSP, Aaron may expect to have $367, at age 60. Explain that, based on his planned contributions of $12,000 per year, Aaron is not currently on track to meeting his retirement goal. 29 Calculate that, if Aaron contributes $2, per month to mutual funds in his registered accounts, he may expect to increase his savings by $660, to $1,027, by age 60. Explain that Aaron may not meet his retirement goal of retiring at age 60 with an annual drawdown on his registered assets of $40,000 (in today s dollars). 33 Explain that Aaron may choose to adjust his goal by: Reducing his retirement income to $36, Increasing his monthly savings by an additional $ via an expense reduction or a possible increase in income. Postponing his retirement date % (0.50) (0.50) = 5.1% % - 2.0% = 3.1% 26 N = 35; I/Y = 3.1%; PMT = $53,834.73; FV = $0. CPT PV = $1,140, $63,710 + $13,000 = $76, N = 15; I/Y = 3.7%; PV = $76,710; PMT = $12,000. CPT FV = $367, $367, < 1,140, $2,500 mortgage payment + $250 pre-authorized transfer to savings = $2, N = 15 X 12 = 180; I/Y = 3.7%; PV = $0; PMT = $2,750. CPT FV = $660, $367, , = $1,027, $1,027, < $1,140, N = 35; I/Y = 3.1%; PV = $1,027,693.39; FV = $0. CPT PMT = $48, N = 15; I/Y = 2.0%; PMT = $0; FV = $48, CPT PV = $36, N = 15 x 12 = 180; I/Y = 3.7%; PV = $0; FV = $1,140, $367, = $$772, CPT PMT = $3, $3, $2, = $ CFP, CERTIFIED FINANCIAL PLANNER and are certifi cation trademarks owned outside the U.S. by Financial Planning Standards Board Ltd. (FPSB). Financial Planning Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB. All other are registered trademarks of, unless indicated Financial Planning Standards Council. All rights reserved. Page 6