The capacity for the average person to retire today has changed dramatically since our parents’ generation. Many of them were able to retire on a company pension, which would enable a reasonably comfortable lifestyle for both husband and wife.
In addition, each retiring individual in 1971 had 6.6 workers contributing to the Canada Pension Plan (CPP) and Old Age Pension, which kept the coffers healthy. Today, only 4.2 people are actively contributing to each retiring individual, and in 2036 (23 years from now), there will be only 2.2 people contributing, leaving the CPP and OAS programs difficult to count on as the population ages. Furthermore, recent studies have shown that only 50% of salaried individuals in Canada have a defined benefit pension plan, with government workers making up 30%. This means 50% of salaried employees do not have a defined benefit pension plan. Only 24% of the 2.7 million Canadians self-employed workers/small business owners have a succession plan for their businesses. Many of the small business owners surveyed will simply shut down their businesses when are ready to retire.
The question remains: what are you doing to secure your retirement? Clearly, we must take our retirement into our own hands.
FINANCIAL PLANNER’S (OR BANKER’S) PLAN
Let’s examine a traditional financial planner’s (or banker’s) proposed 10-year plan.
Generally speaking, a financial planner’s (or banker’s) plan will include using the maximum amount of capital by refinancing the principal residence to 80% LTV (Loan To Value). This will free up $80K to invest.
Step 1. REFINANCE EXISTING MORTGAGE
CURRENT HOME VALUE: $500,000
REFINANCE TO 80% LTV: $400,000
ACCESSIBLE EQUITY: 80% ($100,000)= $80,000
Step 2. Use the current $50,000 in RRSP’s and add a portion of the current cash savings as follows: $30,000 into a new Tax Free Savings Account (TFSA), Registered Education Savings Plan, spousal RRSP, stocks, etc. The $20,000 balance remaining would be put in a more liquid investment for easier access in case of emergencies. This would provide $180,000 for the total investment plan, including the current RRSPs.
Step 3. Invest the $180,000 into financial instruments with a projected compound return after all fees, such as MERs (Management Expenses Ratios common on mutual funds). To increase the portfolio would be to continue to make annual RRSP contributions each year for 10 years.
The end result after 10 years of investing this way would turn the $180,000 investment into just over $372,000 and provide an annual income pf $37,292 per year at 10% interest.
This plan only accomplishes 46% of the couple’s desired 10-year “Financial Independence” plan – meaning that they will have to either extend their plans from 10 years to 25 years or earn 17% compound interest (after all fees) for 10 years straight.
USING REAL ESTATE
Step 1. Refinance the principal residence to free up $80,000 using the same calculation as the traditional plan.
Step 2. Divide the current $50,000 of savings into $30,000 for investment and $20,000 in a liquid account as a buffer. This would give us $110,000 to invest.
Step 3. By using the existing $50,000 in RRSPs for a down payment, without collapsing the RRPSs, we would have $160,000 towards down payment(s) and closing costs on real estate. This would be enough to purchase approximately $750,000 worth of real estate investment(s) using 20% down payment plus closing costs.
After 10 years of operating the income property, the property could be sold and proceeds reinvested in a more passive investment.
After 10 years, a $750,000 property would be worth approximately $1,057,000 using a 3.5% annual appreciation rate, and the mortgage balance would be down to $426,000.
By making bi-weekly mortgage payments and paying an extra $200/month (or $2,400/year) onto the mortgage, they would lower the mortgage balance by an additional $68K to only $358,000. That would total just over $600,000 after taxes and selling costs. They could then put $50,000 back into their RRSP.
With the $550,000 from the real estate proceeds, $98,000 in RRSPs, $30,000 in savings, and the extra $68,000 (from paying an additional $2,400/year mortgage payments on the investment property), they would have just over $746,000, which could produce $74,000 per year in income at just 10% interest.
The real estate plan replaces almost their entire income current income, and any borrowed money from refinance of the primary residence would be covered by the investment real estate. This plan would accomplish 91% of their $80,000 per year goal.
Furthermore, at just 3.5% annual appreciation, their $500,000 primary residence would be worth $705,000 and their $400,000 mortgage would be reduced to just under $275,000, giving them an additional $430,000 of equity – making them millionaires.
NOTE: This plan will work not only for early retirement planning but for other financial goals. For example, for young families, the same principles can apply like using it to set up an education plan for the children and can be done in addition to setting up a RESP (this is a must for those with young kids – it’s free money). With the cost of undergrad and post grad education just continuing to go up, the earnings from this plan will go a long way.