Case Study - Retirement Plan

David and Lisa have come to you to determine if their current level of savings will be sufficient to sustain their current lifestyle (i.e., disposable income) when they retire. They have provided you with the following important information necessary to provide them advice:

David is 50 years old and his wife Lisa is 51;

They plan to retire in 10 years;

They need a plan that assumes that David lives to age 91 and Lisa until she is 96; and

They live in a small house in Toronto and plan to stay in the house during their retirement.

Financial Information

Financial information for David:

David has earned over $100,000 in each of the last 5 years and expects to be able to sustain $100,000 in take-home pay after taxes, CCP, and EI premiums for the next 10 years until his retirement.

David has no company pension and has not in the past made contributions to an RRSP. However, he has contributed $15,000 in each of the last two years to an oil and gas mutual fund which currently has a balance of $30,000.He intends to continue to save $15,000 annually until retirement.

Financial information for Lisa:

Lisa currently earns $40,000 in take-home pay after taxes, CCP, and EI premiums and expects to maintain this amount until retirement.

Lisa has contributed $2,000 to her RRSP for the last 7 years and currently has a balance of $20,000.She intends to continue to save $2,000 annually until retirement.

Lisa has an inflation-adjusted company pension of $25,000 in today's dollars that she will collect upon retirement in 10 years

Financial information for David and Lisa:

David and Lisa are currently making annual mortgage payments of $42,000 that will continue for the next 10 years after which their house will be debt-free

They are also currently paying $25,000 annually for the education their two children and will continue with this support for the next 5 years

For each of the last 5 years prior to retirement, assume David will contribute to an RRSP the additional $25,000 not paid out in school expenses.

Also assume that any tax rebate from RRSP contributions by either David or Lisa are reinvested in their RRSPs

At age 65, both David and Lisa will be eligible to collect 80% of their CCP entitlement

Case Study Requirement

You are expected to undertake calculations to provide to this couple an amount (if any) of additional savings over the next 10 years prior to retirement needed to support (in inflation-adjusted dollars) their disposable income at a level equivalent to 80% what they are currently experiencing.

These calculations will be undertaken on an EXCEL spreadsheet.The exercise will be based on:

Calculating the net present value (at the beginning of their retirement period) of net after-tax revenue and income during their retirement

The second calculation will be to compare this to the future value of all their accumulated savings available at the beginning of their retirement period.

In the event that the future value of the savingsis not sufficientto support the present value of their net retirement expenditures, you will calculate what additional annual savings needed over the next 10 years to balance these two calculations

In the event that the future value of the savingsexceedsthe present value of their net expenditures, you will calculate the reduction in annual savings that they would be able to afford over the next 10 years to balance these two calculations

Important Considerations

Assume in your analysis that the annual inflation rate over the entire pre and post retirement period is 2% and that investments they have or will make will yield a 4% return.

CPP and OAS revenue, when received at age 65, will be in inflated dollars with the claw-back (if any) based on their retirement income at that time.

Be sure in the EXCEL spreadsheet(s) that you submit that all links are included so I can follow how you carried out your calculations.

Distribution of Marks

The marking guidelines are as follows:

Calculations

Calculation of net revenue required during retirement (6 marks)

Calculation of savings available at the beginning of the retirement period (5 marks)

Calculation of additional (or reduction in) savings to balance 1. and 2. (2 marks)

1. The underlying focus of your calculations will be to first determine David and Lisa's financial position in ten years at the beginning of their retirement (the total of all their investments which have earned 4% per year). You would then compare this to the present value of what they hope to receive as disposable income during retirement, less what you estimate they will actually receive during that period.

2. Their expectation of disposable income during retirement should be what they currently are enjoying taking into account major payments they are currently making. This must be adjusted for inflation.

3. If your estimate of the cashflow during retirement is set out as an uninflated annual amount, you will have to employ a real return discount rate that considers both an inflation rate of 2% and an investment rate of 4%

4. Assume for the purpose of calculating the couples taxes that they are Ontario residences.

5. With respect to the cashflow during retirement, the NPV will be calculating the lump-sum value at the beginning of their retirement in ten years as you will be comparing this to their accumulated savings available at that time. Therefore, if you are using uninflated values and the real return discount rate (ie: a constant value over the entire retirement period) make sure the initial value is what it would be at the start of their retirement and not the value today.

6. Be careful with the assessment of the OAS and CPP income they will receive. Unlike Lisa's pension that begins in year-one and continues uninterrupted through her entire retirement, these payments for both David and Lisa are delayed. When calculating their NPV, it will need to be adjusted as it will reflect the lump-sum value not at the beginning of the retirement period but at the point when the payments commence. Also, the potential clawback of OAS payments is based on their actual income when it is received during retirement and not on their income today.

7.Assume they both decide to receive their CPP and OAS at age 65.Use the current 2020 OAS maximum monthly payment of $614 inflated by 2%.CPP cannot be precisely determined for these two individuals as it is based on lifetime employment contributions.The maximum allowable monthly payment in 2020 is $1080 and the average monthly payment is $735.Assume that at 65, each would receive a monthly payment in 2020 dollars of $908 [(1080 + 735)/2].

8. Assume that David has enough unused RRSP eligibility to be able to transfer his current mutual fund balances and also be able to contribute the additional $25,000 per year in the last five years prior to retirement when tuition payments are no longer being made.

9. The assignment requires that you include in their investments the amount of tax savings they receive over the next ten years due to their annual RRSP contributions. During this period, you will need to find the marginal tax rate (both federally and provincially) that will be used in this calculation. With respect to taxes owing during retirement, you can use the estimates presented in Table 17.1 of the text (p. 446).

9. When you have completed your analysis, you should have identified either a surplus or deficiency in accumulated savings at the beginning of the retirement period, relative to the NPV of funds needed to provide the total amount of their expected disposable income during retirement. To complete the assignment, you would then need to express this surplus as a reduction (in the event of a surplus of savings) or a required increase in the amount of annual RRSP contributions over the next ten years.

10.The intent is that he will immediately transfer the $30,000 in year 1 to an RSP and take the tax savings which he will reinvest in the RSP.He will alsoadd $15,000 per year for 10 years until retirement, reinvesting any tax savings.In the last 5 years prior to retirement, David will increase this $15,000 annual contribution to $40,000 being the additional $25,000 in funds no longer needed for his children's education.

11.Assume that during retirement, their pension income is split 50/50.Lisa will be drawing both from her RIFF and her employment pension income while David only from his RIFF.You would add these together and tax each on 50% of the total.

12.Use 2020 marginal tax rates and rather than using the text table, use 2020 actual Ontario rates.Inflate these each year into the future by 2% inflation.

Table 17.1 will attach