FIRE-d Up For Retirement

Oliver and Cecilia, ages 47 and 45, live in Vancouver. Oliver recently left his full-time IT job with a salary of $115,000, while Cecilia is working as an administrative assistant earning $35,000 per year. They own their Vancouver home outright, and estimate they’d walk away with $800,000 if they sold it now. Their current invested assets are relatively modest – totalling $260,000 between their RRSPs and TFSAs. However, they have no debt.

Like many Canadian families, their experience during the COVID-19 global pandemic has them re-thinking their life plans.

The Proposal
When it feels safe to travel globally, they’re hoping to leverage what they call “geographic arbitrage” to temporarily live in a low-cost tropical location while retaining Canadian residency for tax and health-care purposes. In the right location, they estimate they could get by on after-tax income of $45,000 per year ($3,750 per month).

Until their Canada Pension Plan and Old Age Security benefits start in 18 and 20 years, respectively (or earlier if they opt to take a reduced amount of CPP before age 65), they’d need to rely entirely on their portfolio to support their required income needs, as neither of them have employer pensions.

Oliver has researched the tax treatment of Canadian dividends and believes he and Cecilia could generate their desired yearly income from their portfolio without paying any federal or provincial income taxes. To achieve this objective, he’s planning to allocate all of their non-registered portfolio to just one asset class – publicly listed, Canadian dividend-paying stocks. At dividend yields of 6% per year, he calculates that their $800,000 would give them $48,000 in yearly tax-free income.

What Does A Planner Think?
They’ve come to Michael Deepwell, TEP, CPA, CA, CFP®, CLU, of accounting and advice-only financial planning firm Lamp Financial for advice. Would their existing assets and proposed all-dividends investment plan allow them to implement a “FIRE” – Financial Independence, Retire Early – plan, and retire now?

“While Oliver and Cecilia’s plan seems appealingly simple, there’s more to consider as they plan for financial independence, especially the next 18 to 20 years,” comments Deepwell. “As a planner, my role is to identify potential sources of risk in a highly-concentrated plan such as the one they’re proposing, and then suggest strategies to address those risks. I see some smoke alarms on the horizon.”

For Deepwell, these risks include sequence of returns, longevity, and investment concentration risk.

Counterproposal
After reviewing Oliver and Cecilia’s assets and goals, Deepwell proposes a revised strategy that he believes reduces the risk inherent in their initial plans

-Establish a Cash Reserve. Deepwell suggests the couple set aside a portion of the proceeds from the house sale for the next three to five years of spending – from $135,000 to $225,000 – in risk-free, laddered GICs held inside their TFSAs and RRSPs. This tactic is designed to create stability and combat any sequence of return risk, which is the risk that negative portfolio returns early in retirement significantly impact their portfolio in the long-run.

-Make the Most of Registered Account. He then recommends the couple use their available $120,000 of RRSP room for tax-deferred investment growth in their RRSPs, including Oliver creating a Spousal RRSP for Cecilia to equalize their RRSP assets while spreading the RRSP deductions over several years to reduce their taxable income.

-Diversify. If they set aside five years of desired income and use up their available RRSP contribution room, this leaves the couple with $455,000 of their initial $800,000 from the sale of their home. Deepwell recommends they adopt a more diversified portfolio than their initial proposal of 100% Canadian dividend-paying equities. This way, they can gain diversified exposure to U.S. and global equities and to fixed income in their RRSPs and TFSAs. By holding U.S. equities in their RRSPs (but not TFSAs) they can avoid the 15% withholding taxes on U.S. dividends from U.S. issuers. Deepwell assumes a 4% after-fees return.

-Initially Use Mix of RRSP Withdrawals and Non-Registered Dividend Income. Deepwell suggests for the next 10 years, Oliver and Cecilia each withdraw $12,500 from their respective RRSPs while structuring their non-registered portfolio to generate eligible dividend income of about $10,000 each. Excess income can be contributed to their TFSAs and the carried-forward RRSP deduction can reduce any taxable income. The RRSP withdrawals and dividend income would meet their desired after-tax spending needs and, thanks to the basic tax credit and the dividend tax credit, won’t require them to pay income tax.

-Meet longer-term income needs from non-registered portfolio until CPP and OAS benefits kick in. Once their RRSPs are exhausted, Oliver and Cecilia can increase withdrawals from their non-registered funds before Oliver’s age 65 when his OAS and CPP benefits start, followed by Cecilia’s OAS and CPP two years later.

Following this plan, Deepwell estimates that the couple’s non-registered funds will still have funds past age 102. They have about a 10% probability of surviving past age 101, according to FP Canada’s Projection Assumption Guidelines. “Longevity risk is a significant concern,” says Deepwell, “as they may spend more than 50% of their lives in the decumulation phase over the next 50-plus years.”

The couple will also have their TFSA accounts past age 65, which will remain tax-free when withdrawn over the remainder of their lifetimes without clawing back their OAS and any Guaranteed Income Supplement benefits.

Smoke Alarms for a FIRE-y Plan
“As enthusiasts of the ‘Financial Independence, Retire Early’ or ‘FIRE’ movement, Oliver and Cecilia are eyeing the windfall from the appreciation on their principal residence and wondering if they can ‘quit the rat race’ and enjoy life in a low-cost, global location,” Deepwell comments. “By shifting from the accumulation to decumulation phase at their current ages, they are giving up a substantial amount of human capital – my back-of-the-envelope calculations suggest Oliver alone is foregoing nearly $2 million of future earnings. They should consider if that value is worth giving up for their next phase of life.”

“Their initial all-dividends plan hides a significant amount of embedded risk,” he adds. “My role as a planner is to install enough smoke alarms in their financial plans so that if anything goes wrong, they are able to continue on without too much disruption.”

“If they follow the significantly revised path I’ve proposed, they would still meet their goals and potentially have a larger pool of funds to draw upon later in life, or pass on to their loved ones. All in all, they would pay minimal, if any, income taxes over their lifetimes, yet achieve sufficient income to fund their lifestyle – and they’d have a growing TFSA as a fallback to cover major bills or medical expenses.”

Deepwell adds one final note of caution to Oliver and Cecilia’s plans: “Their retirement strategy hinges on their Canadian tax residency. They will need to maintain significant residential ties to Canada on an ongoing basis as they travel the world. In their case, this could be through a permanent home or accommodations in Canada, whether rented or owned, as well as maintaining substantial personal, social and economic ties to Canada. It would be a question of fact if they meet the criteria.”