Disability and preserving assets

Last year, Andrew converted a $240,000 term-life insurance policy into a universal life policy, which will be fully paid in 14 years with annual deposits of $14,000 and which also allows for additional deposits. He wants the $240,000 used for a charitable legacy.

Andrew expects to inherit more than $1 million (in today’s dollars) from his parents, probably in about 10 years. Andrew’s 69-year-old mother’s life expectancy is only three years; however, his 73-year-old father, although overweight, is in good health and likely to live for another 10 years.

Andrew’s parents have a $1.7- million investment portfolio and a mortgage-free house worth $200,000. Andrew’s father has a pension and also is adding about $20,000 a year to his portfolio. Andrew has a sister who has a net worth of $3 million and will help Andrew financially if necessary.

Andrew’s retirement income goal is $5,000 a month, after taxes, in today’s dollars. He also wants to ensure his assets are protected from creditors because of possible malpractice claims during periods when he is able to work.

the recommendations: Both Garbens and O’Brien say Andrew has more than enough in assets to meet his retirement income goal, even if he doesn’t work again. But this assumes he inherits the $1 million within 10 years and doesn’t need expensive home-based or institutional care.

The $1 million is essential to generate sufficient income once Andrew is 65 and the disability insurance benefit ceases. That inheritance looks pretty solid, but a major stock market meltdown could significantly reduce what Andrew gets.

Nor can Andrew be sure he won’t need expensive care. Although the medical experts don’t think his currently undiagnosed condition will require such care, they could be wrong. Andrew also could develop other medical problems requiring home-based or institutional care. And, however solid and supportive Andrew believes his relationship with his sister to be, he can’t be sure of her help until he gets it.

Andrew needs a plan that gives him maximum flexibility and the greatest potential cash flow.

« This case is a lesson in the benefits of early planning, » O’Brien says. Andrew was well advised to purchase disability insurance, O’Brien adds, especially a policy that allows increases in the premium and benefits without additional testing.

Andrew also was well advised to buy term insurance that could be converted to universal life and which allows for additional deposits without medical tests.

O’Brien recommends that Andrew consider whether to continue the annual deposits of $14,000 for a further 10 years after the life policy becomes fully funded. Not only is the income tax-sheltered, but Andrew can borrow against the policy, thereby generating additional tax-free income. As long as Andrew manages his drawdowns from the policy to ensure the size of the death benefit is not impaired, he will achieve his goal of leaving a charitable legacy. Another plus about additional deposits in the life policy is that these assets are creditorproof.

Garbens also sees the advantages to additional life insurance deposits, but she is hesitant about recommending it because she’s concerned about « putting a lot of eggs in one basket. » She’d prefer that Andrew keep the life policy at $240,000 and diversify the rest of his assets.

Both financial advisors think Andrew should make the maximum RRSP contributions whenever he’s working but withdraw from the RRSP when he’s not working – a strategy O’Brien calls « RRSP meltdown. »

Because Andrew’s disability benefits are tax-free, he will have little taxable income when he’s not working. So, he could take about $20,000 a year out of his RRSP and pay only $2,000 or so in taxes. Andrew should discuss with his accountant exactly how much should be withdrawn from the RRSP in the non-working years.

Andrew could withdraw even more from his RRSP if he gets the disability tax credit, which was worth $7,546 in 2012. Both advisors strongly recommend that Andrew apply for this credit.

He should also apply for the Canada Pension Plan (CPP) disability benefit pension, which pays up to $1,212 a month until age 65; then, at that point, his regular CPP benefit, whose current maximum is $1,102, will kick in.

Reducing Andrew’s RRSP assets also would help to ensure that the minimum withdrawal from any registered retirement income fund (RRIF) he establishes will be low enough to avoid old-age security (OAS) clawbacks. This could be an issue, given the anticipated $1-million inheritance.

Both Garbens and O’Brien suggest Andrew establish a RRIF by age 65 so he can withdraw $2,000 a year. That would be tax-free, given the annual $2,000 pension income deduction. The advisors note that Andrew doesn’t have to put all his RRSP assets into a RRIF until age 71.

However, Garbens adds, there could be benefits to Andrew establishing a RRIF and putting a substantial portion of his RRSP assets into it in the near future. There’s no age limit on establishing a RRIF, and the earlier he put assets into one, the lower the minimum withdrawal.

This is another way to minimize taxable income in retirement, one that is particularly applicable to those expecting a substantial inheritance that could trigger OAS clawbacks.

Garbens also suggests that if Andrew goes back to work, he consider incorporating his business. Not only are corporations taxed at a lower rate than individuals, but he could leave most of his earnings in the corporation, convert his RRSP assets into a RRIF and live on the RRIF withdrawals. Once Andrew is retired, he could start taking annual dividends from the corporation.

Both advisors strongly recommend that Andrew continue to make maximum TFSA contributions, given the tax benefits.

Both advisors also suggest Andrew consider a prescribed annuity when he turns 65. This would provide a continuous flow of income at minimal tax rates, given that most of the income in prescribed annuities is « return of capital » (ROC).

If Andrew decides on an annuity, the amount he chooses should reflect prevailing interest rates at that time – and determine the income the annuity will generate – when he’s 65. O’Brien notes that the longer Andrew waits to buy an annuity, the shorter his life expectancy will be at the time and, thus, the higher the potential cash flow will be.

Neither advisor is enthusiastic about segregated funds. Although these funds offer creditor protection, Garbens and O’Brien both feel there are better ways for Andrew to protect his assets from potential creditors, given the high cost of seg funds.

The best way to protect Andrew’s inheritance from creditors, the advisors suggest, would be for Andrew’s parents to bequeath their money to Andrew using a testamentary trust. This would minimize the overall taxes paid on the income from the trust investments because trusts are taxed as a separate entity.

RRSP and RRIF assets also are creditorproof, which means only his non-registered account and his TFSA would be vulnerable.

As a single person, Andrew doesn’t need complicated estate planning. However, Garbens suggests that Andrew consider a « living will » that provides for more contingencies than is usual in medical powers of attorneys.

Both Garbens and O’Brien suggest a 50% fixed-income/50% equities asset mix that will become more defensive as Andrew gets older.

O’Brien, who manages money for high net-worth families, favours individual securities with broad geographical and sectoral diversification for the equities. In Andrew’s case, O’Brien would recommend 20% of the total portfolio be in Canadian equities, 18% in U.S. equities, 10% in international equities and 2% in hedge funds.

For the fixed-income portions, O’Brien suggests 28% in rate-reset preferred shares, 9% in principal-protected structured notes and 13% in exchange-traded funds (for which distributions are considered ROC).

O’Brien adds that while the recharacterization of distributions in the latter vehicle will be eventually phased out in accordance with the March 2013 budget, she would use them for as long as possible. She assumes an average annual return after fees of 6% and inflation of 2.5%.

Garbens doesn’t manage money, so she offers only broad guidelines for investments. In this case, her suggestions would be in line with O’Brien’s recommendations. However, Garbens doesn’t make recommendations regarding either hedge funds or structured notes. She uses an average annual return of 5% and inflation of 3% in her projections.

O’Brien charges 1%-2% of assets – depending on the level of assets and the complexity of the client’s affairs – to create a financial plan of this kind.

Garbens would charge $3,500-$4,500 to prepare a full estate, tax and retirement financial plan.