I’m sure you guys remember the last time I did a mailbag. It was all sorts of awesome, and you probably had to sit down and fan yourself because it gave you the vapors. Actually, now that I think about it, you guys have to do that after most every post. Anyway, I hate to break it to you, but those questions weren’t real questions from real people. I pulled them out of my ass. Oh, quit pretending to be surprised.
Good news everybody! This time, a real life person has asked me for some financial planning advice, and has given me permission to share their details online, minus any personal information. So what I’m going to do is outline her situation and what I’d recommend she do. Then, once I’m done, you guys can give your opinion in the comments section. Or not. See if I care.
Age: 76
Net Worth: $250k cash, $100k house
Approximate monthly expenses: $2500
Pension income: ~$800 per month
Risk tolerance: Low. “I don’t want to lose any money.” That’s a direct quote.
Other notes: Would like to leave an inheritance for her children.
Option 1: GICs
It becomes clear pretty quickly that Agnes here (not her real name, but lets go with that) has gotten some bad luck by needing to invest now during this low interest rate environment. Have you all seen how craptacular GIC rates are lately? The best 5 year rate I could find is from ICICI bank, (which, frankly, sounds a little like a made up institution) which is paying out 2.85%. Yawn.
I just checked 3 year GIC rates, and ICICI also leads the pack with a 2.35% rate. She’ll be getting a 0.5% to lock up her money for an extra 2 years. That’s not much of a premium to increase the term by 66%.
Obviously, if she goes this route, she’ll have to start eating away at her principle. Let’s assume we put $100k in a 5 year GIC and $100k in a 3 year GIC, leaving $50k in cash so she can withdraw without a penalty.
$100k @ 2.35% = $2,350
$100k @ 2.85% = $2,850
Total = $5,200 or $433.33 per month
Total shortfall: $2500-$800-$433.33 = $1,266.67 per month
Principle lost every year: $15,200
Our test subject is going to bleed cash pretty quickly if we do this option. After 3 years, she’ll have just $205k of her $250k nest egg left. This is probably not an ideal outcome.
Option 2: Bonds
Scenario 2 involves taking a bit more risk, and investing the portfolio entirely in Canadian bonds. Let’s assume a simple scenario and invest her in the following:
XBB (Canadian government and corporate bond index (50%) current yield: 3.2%
XCB (Canadian corporate bond index (25%) current yield: 3.9%
XLB (Canadian long term bond index) 3.7%
Total average yield: 3.5%
Option 2 gives us a little better yield, her $250,000 would spin off $8,750 per year. This decreases the annual shortfall to $11,650. Instead of taking 3 years to burn through $45k of her savings, this decreases the burn rate enough that it’ll take 4 years to burn through pretty much the same amount. That’s progress.
Option 3: Annuity/GIC combo
The best quote I could find online for an annuity for a 75 year old woman (keep in mind our subject is 76, and should be able to do slightly better) was $678.06 for a $100k investment.
Let’s assume she puts the other $100k in a 3 year GIC (2.35%) and keeps $50k in cash.
Annuity payment: $8,136.72
GIC payment: $2,350
Total: $10,486.72
Total shortfall: $9.913.28
This option works out the best for monthly cash flow, and cuts our burn rate to less than $10k a year. As is the case with annuities, she does pretty well with this option if she lives to 95. If she only makes it to 79, not so much.
Option 4: Annuity and Bonds
Finally, we have the option that’s perhaps the most risky – buying both an annuity and spreading the rest into our bond portfolio.
Bonds: $150k at 3.5% = $5,250/yearly
Annuity: $8,136.72
Total: $13,386.72
Total shortfall: $7013.28
Option 4 leaves us with the smallest shortfall yet, our test subject will only be bleeding $7,000 per year. This is good, except she’ll slowly have to sell off her bonds in order to live. Even though bonds have somewhat stable prices, many people think that bonds are massively overvalued right now. 2 out of 3 of the bond funds we picked are relatively short term in nature, but market sentiment can send them down.
Yes, if rates go up, they will be constantly replacing their old bonds with new ones that have a better coupon rate. This is good for Grandma Agnes. Except, like I mentioned earlier, the fund will undoubtedly be losing value at the same time. This is bad. She specifically stated she didn’t want to take on risk, and I don’t want to be responsible for causing some sort of heart attack when someone takes her on Google and shows her how her bond funds are doing.
Where does that leave us? Honestly, I don’t know. I’m not sure I want to be trying to explain to a 76 year old woman (who knows sweet bugger all about finance) about how giving $100k of her cash to an insurance company is a good idea. If she puts the money in GICs she’ll constantly fall short each month, but she’ll have the security of knowing that money is at the bank. Then, if she makes it another 5 years, hopefully interest rates have risen enough by then that she can actually get closer to living off the interest.
It’s your turn. What should Agnes do? You know where the comment section is.
Assuming she herself knows she’s in good health and will live a long, fruitful life, I like Option 3.
“If she puts the money in GICs she’ll constantly fall short each month, but she’ll have the security of knowing that money is at the bank.”
And the risk of running out of money. That doesn’t seem to jive with ” ‘I don’t want to lose any money.’ That’s a direct quote.”. When the two realities are choosing between guaranteed insufficient supplies of capital and putting more capital at risk to possibly avoid that, I think there’s some reasonable middle-ground that involves a bit more risk.
How about Option 5: put all $250k into an annuity. The annuity income would by 2.5*$678.06 = $1,695/month. So her total income would be $2,495/month (maybe slightly more since she’s 76 not 75, but maybe less if she needs to pay taxes). She’d by just scraping by with this option, but at least she wouldn’t run the risk of running out of money. And the $100k house could still be left as an inheritance.
I agree with putting the bulk of the cash in an annuity. I got a quote of $1,775 in monthly income for $250,000 US dollars for her at 76 years of age in an immediate annuity. She can probably do better than the quote in the article because each year has a tremendous effect on the monthly distributions and Nelson ran it on a 75 year old woman.
I’m not sure how this works in Canada, but in the US annuities are very tax efficient as it is understood that most of the money coming back to the investor is a return on principal and therefore this portion is untaxed. I would venture to guess its the same, but I’m not certain.
Now isn’t the time to be thinking about an inheritance. The home equity is a sizable inheritance.
Using this calculator:
http://www.rbcinsurance.com/annuities/payout-annuity-calculator.html
gives a monthly payout of $1,805.49 for a 76 year old female. It lists the taxable portion as only $12.35. Seems like annuities in Canada are also tax efficient.
She should invest all of her money in the development of a time machine. Then she can go back and tell her former self to save more money, so she’s not living on $800 a month at age 76.
If I went back in time, I’d go up to women, get up close to their ear like I’m about to tell them something, and whisper “I’m from the future…” OK, so I’m not a time traveler and I’ve done that lots anyway.
If this is just a quick simple solution :
How about one of the big bank monthly income funds. Like the BMO one. The one they always complain about the monthly dividend being unsustainable for about the last 6 years. The fund won’t grow in value per share much, it may even drop a little slowly but it pays out a constant $750.00 a month on $100.000. Then you don’t really touch your principle if you can live off that amount.
OR…. One of the tax advantaged funds that pays you back a lot of ROC up front to not get a tax hit until later (When you might not really be in a position to worry about it anymore)
I don’t like annuities – they are full of hidden traps and penalties if you need to get out of one early. It’s better you set yourself up with a better planned overall strategy then you can avoid one altogether.
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I like JT’s conclusion that the house should be plenty of inheritable equity (It’s not likely to go down in value no matter where it is in Canada if it is currently only valued at 100K). In terms of investment options I like what you’ve done in option 4. That being said, in terms of overall personal finance advice I have to ask where Agnes is spending that much money a month. Is her house fully paid for? Does she have a car loan? (if she does, sell the car!), debt, utilities etc? $2500 is a lot of monthly costs for a retired person. Also, I’m a little fuzzy on my Canadian pension details, but if someone is collecting CPP and OAS (which I assume Agnes is eligible for) shouldn’t they be getting more than $800? I guess maybe she doesn’t qualify for full CPP. All the same, maybe something else other than investment outcomes could be done to help meet her personal finance goals.
My take is that the problem is over-constrained. The inheritance goal, current burn rate and economic stability goal are mutually exclusive. Assuming a ~$30K cash buffer is required, $220K of annuity is insufficient. Investments that maintain principal make the situation worse, not better. I would keep $30K cash, put $220K in an annuity (or maybe 3 different ones if they’re not insured in Canada – I don’t know the details up north). Then I would take some combination of the following steps:
1) extract some (but not all?) equity from the house via a reverse mortgage to get extra income to hit $2500 a month.
2) reduce burn rate below $2500
3) make some kind of a deal with the eventual heirs that provides additional security in return for not encumbering the house via 1).
[...] a couple weeks ago, an actual person asked me for help with her finances. I’m sure you all remember. Yeah, I was shocked too. I’m not even a financial planning [...]