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Monday, September 26th, 2016

Money-losing rental and layoff put retirement at risk for couple in their 50s

fp0802_familyfinance_c_abSituation: Layoff and inability to find a new job plus a money-losing rental property jeopardize couple’s retirement

Strategy: Either get a new job to subsidize the rental or sell it to balance budget. Tidy up cluttered investment portfolio to reduce fees and duplicaton

At their ages of 55 and 51, Dan and Martha, have hit a series of bumps in their road to retirement. A construction manager for a large company, Dan brings home $5,250 a month. Martha, a metallurgist, was laid off from her job last year. Her employment insurance payments, $1,900 a month, just expired. She has been unable to find work in her field.  They are spending $6,127 a month to sustain their way of life, eroding savings they will need for retirement.

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Not only has their take-home income shriveled to half of what it was a year ago, they have an investment property purchased in 2012 that generates rental income insufficient to cover its mortgage and line of credit. On top of that, their two children, each in the early 20s, are in university. Their RESP has $37,000, which should be sufficient for the kids’ first degrees, for the elder child, 23, is in his last year of undergraduate studies. After that, unless the couple’s fortunes change, the kids will have to earn or borrow whatever funds they need for additional tuition or second degrees.

“I may have to work part-time to support our younger child, now in the second year of university,” Martha says. “With my layoff and the money-losing rental house, how much do I have to earn to sustain our way of life?  We still have a lot of costs with our children living at home.”

They are in a vise now, but if Dan and Martha cut expenses, stop subsidizing their money-losing rental property and cut investment costs, they will be able to have a secure retirement.

Family Finance asked Benoit Poliquin, a financial planner and chief investment officer of Exponent Investment Management Inc. in Ottawa, to work with Dan and Martha. His view assumes that Martha does not go back to work. To make their budget balance, they will have to free up $2,180 each month. In the alternative, if Martha can earn $2,500 to $2,800 a month before tax, then she can subsidize the real estate investment. However, given that the rental house is not paying its way, the simpler course is just to sell it and end the cash drain, he suggests.

The budget problem

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Financing the rental property with a mortgage and line of credit costs $2,180 a month. Property tax is $300 a month. Total costs are $2,480 and that does not include any reserve for maintenance. Yet the monthly rent the property generates is just $1,400. The total loss is therefore $1,080 a month, $12,960 a year. That amounts to 20% of Dan’s take home income.

If the mortgage, with a 25-year amortization, and line of credit are broken down into debt service cost separate from repaying capital, the numbers look better. On that basis, the rent, which is being paid by a friend of the family, covers all interest. The remainder of the payments support rising equity.

In time, the property may appreciate enough through rising equity from payments and a bull market to catch up to the loan balance. But this is speculative.  There is no guarantee that property prices will rise sufficiently to cover the debt at the time Dan and Martha want to sell. Moreover, the rental property subsidy means the couple cannot make regular contributions to their RRSPs or TFSAs.

With the rental house eliminated, the family budget will be $3,650 a month. When their children establish their own lives and incomes, the family’s $500 a month bill for running three cars will drop. Dan and Martha will be able to save perhaps $1,000 a month.

Retirement income

Dan and Martha have a complex portfolio. Their RRSP, TFSA and other accounts add up to $759,300. If they shed the rental property add $12,000 a year for 10 years to these various savings and obtain a 3% return after inflation, then the portfolio will have a value of $1,162,000 on the eve of their retirement. If paid out on an annuity model which expends all income and capital in the next 30 years, they would have annual income of $57,550 before tax, Mr. Poliquin estimates.

Dan should get an annual CPP benefit of $12,460 in 2014 dollars. He will also have an annual job pension of $21,332. Martha should receive Canada Pension Plan benefits of $10,740 a year at her age 65 and both will get Old Age Security of $6,704 at their respective ages of 65 and 67. At that point, their retirement income should add up to $115,220 a year. If eligible pensions are split, they should have a 20% tax rate. That will give them about $7,700 a month in retirement income, far more than they have now.

They might do even better if they rationalize their various portfolios.  They have 50 positions in various mutual funds, ETFs and individual stocks. There is duplication in funds which hold similar assets. There are high-cost funds as well as low-cost ETFs. Most of all, there is a management problem, for tracking four dozen stocks, bonds and indices is challenging at the least.  Martha is an active investor in her own right. It would be helpful to reduce the number of holdings and cut fees, Mr. Poliquin says. A fee reduction of just 1.5% would add $11,400 to the annual return of the portfolio.

A restructured and simpler portfolio able to provide income and a health measure of asset stability would have about 70% stocks and 30% bonds. The usual rule is to match the bond allocation to age, but with bond yields low and the probability that the three-decade-old bull bond cycle will end within a few years, cutting back on bonds in favour of stocks able to pace inflation makes sense, Mr. Poliquin says.

Eight to 10 assets, including exchange traded stock and bond funds, perhaps in new variations such as equally weighted stocks that eliminate the winner’s curse of recent high fliers taking up too much space could cover stocks while bond funds that overweight investment grade mid-term corporate issues that have some resistance to rising interest rates would be appropriate as a counterweight to the equities, Mr. Poliquin suggests. The couple could also use a professional portfolio manager for perhaps 1.0% of the value of assets under management.

“This couple has done everything right,” Mr. Poliquin says. “Their problems are Martha’s layoff and the cost of carrying their rental property.   Martha could add income from another job to keep the rental unit afloat, but that would be working to subsidize a bad investment. The alternative, which I favour, is to sell it and increase the security of their retirement cash flow. The decision is theirs, of course.”

E-mail andrew.allentuck@gmail.com for a free financial analysis.

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