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This article was published 8/8/2014 (1103 days ago), so information in it may no longer be current.
Gilbert and Nina have a cash-flow problem. It's the kind of money dilemma a lot of folks would like to have.
They have paid off their mortgage. They save and pay their bills and at the end of every month, they have surplus cash. Even after topping up their RRSPs annually to the tune of $8,000, they have about another $8,000 left over.
And they're wondering how best to make use of it.
"Now that we're done with our mortgage, what should we do with the extra money?" asks Nina, who like her husband is a teacher in her early 40s.
The couple have about $167,000 in RRSPs all invested in equities using a mix of passive- and active-management strategies. They also have about $23,000 in TFSAs in general savings accounts, as well as another $26,000 in unregistered money sitting in savings. On top of that, they've saved about $23,000 in three separate RESP accounts for their children.
Right now, however, saving for their children's education isn't a priority.
Instead, they're wondering whether they should invest their additional cash flow for retirement, or use it to buy a bigger home or maybe even an income property.
Moreover, they're wondering if they should ramp down the risk in their investment portfolio. Gilbert's an aggressive investor, but Nina has an appetite for moderate risk. Yet at the moment, all their investments in their RRSPs are in equities.
"We've heard when we hit around 40 that we should focus more on GICs, so we're wondering what to do," she said.
They're also concerned about continuing to invest in their RRSP, worrying it could lead to them paying higher taxes once they retire.
"Our pensions are so high, and people say it's best not to have too many RRSPs, so that's another one of our many questions."
As a result, Nina and Gilbert are looking for advice to give them the biggest bang for their surplus bucks.
Senior wealth consultant with Assiniboine Credit Union Uri Kraut says Nina and Gilbert first and foremost need to take a closer look at the structure of their investment portfolio before they make any decisions with further savings.
The big red flag here is the risk profile of their portfolio.
"The current portfolio has no fixed income, which means that they are both essentially speculators as even an aggressive investor would have some fixed income -- maybe 10 to 20 per cent to be able to buy when the stock markets are down," said the certified financial planner.
In Nina's case, her investments are as much as 40 per cent overweight in equities for her moderate-risk profile.
While their current asset allocation has rewarded them in recent years because we're in the midst of a bull market, all their investments are highly correlated to the stock market's performance.
"Given the time frames until retirement and the horribly low-interest-rate environment, I understand the temptation to not have fixed-income investments, but this asset class has many roles in an investment strategy," he said.
"The role of fixed income is not simply to have safe money; it is actually to have an inversely correlated asset in the portfolio."
Typically, when stock markets do well, bonds don't, so investors avoid buying them -- and seemingly for good reason. They offer a low return on investment, and bonds are vulnerable to interest-rate hikes because when rates rise, bonds' value goes down.
Yet Kraut suggests buying bonds when they're out of favour -- provided they're of high quality and short in duration -- provides some benefits.
For one, when we enter a bear stock market, bonds will tend to increase in value as investors seek their safety. So if Nina and Gilbert buy bonds now, when the stock market is booming, there's a good chance the bond allocation will increase when their equity holdings fall in value.
Moreover, they can then sell a portion of their bond portfolio when the stock market does eventually cool and buy into equities when stock prices are low. This is the kind of "buy-low, sell-high" strategy often talked about by investors, but rarely carried out in practice.
Of course, they could always opt for GICs over bonds if they're concerned by interest-rate risk. But compared with GICs, bonds offer liquidity if they need money quickly to invest in equities or for other uses. In contrast, GICs are often locked in for a few years to get a higher rate -- albeit three per cent a year is hardly a "higher rate."
Nina and Gilbert also must re-examine their investment strategy that is a hybrid inactive and passive management styles because this structure is likely counterproductive and causing underperformance.
"If active managers add value, it is likely because they are helping "under-risk" the portfolio," he said. In other words, they may not out-perform bull markets, but good managers find undervalued stocks of good companies that do well in bear markets, so they tend to outperform the markets when times are tough.
Ironically, an allocation to bonds in their portfolio could provide the same de-risking to an arguably greater effect.
"I would certainly recommend a comprehensive portfolio review and to use fixed income, not portfolio managers to reduce risk."
As for what to do with their additional cash, one strategy is maximizing RESP contributions. While they stated that's not a priority, the federal grant top-up of 20 per cent on RESP contributions up to $2,500 annually per child is hard to beat.
"In a low-return environment like we are in, that seems virtually unbeatable."
Their children likely could also use the help. Factoring in inflation, tuition may cost all three children as much as $73,000.
Based on their current savings trajectory, they're likely to have $40,000 of that cost covered. But if they maximize contributions for the next five years, which they can afford, they will receive $5,400 in grants while making $27,000 in contributions.
Then there are the other priorities. Kraut says purchasing a bigger home is prudent, if that's what they need. If they're merely doing it to have a larger asset, it may not be a wise decision. Real estate is like fixed income in that when interest rates rise, prices fall.
"The possible decline in value on that home and the likelihood of an extended period of rising interest rates over the next 10-plus years will likely make real estate a highly unfavourable investment," he said.
"They may want to measure that risk against other options that provide a known benefit -- like making an easy $5,000 by putting money in to an RESP."
When it comes to retirement savings, Nina and Gilbert should continue maximizing their RRSPs even though they both have good pensions.
"Understanding their tax brackets in retirement is crucial when determining to contribute to RSPs."
Based on their expected pensions, CPP and OAS, they should have a marginal tax rate in retirement in the middle of the 34.75 per cent bracket. Given their current marginal tax rates are 39.4 per cent, contributions to RRSPs will provide them with long-term tax savings of four per cent because the money when withdrawn should be taxed at about 35 per cent.
Any additional savings left over can be invested for the long term in TFSAs, and once those are maximized, they can invest in non-registered accounts.
Having said all this, Nina and Gilbert will only really need their RRSPs for income if they retire at 55. Once they're both in receipt of CPP and OAS, they will be accumulating wealth -- to the tune of more than $2 million by their 90s. So their biggest concern is not having enough money for the future, but ensuring they are setting themselves up to manage their money to preserve wealth.
"At this stage, managing wealth is about the small things: ensuring you squeeze the value out of RESPs and realizing the tax advantages," Kraut said. "None of these are one-off home runs, but each is a key step in turning their savings and some solid, free cash-flow into a strong and healthy retirement and a lasting legacy for your children."