Saskatchewan farmers we’ll call Burt, 59, and Martha, 57 — not their real names — are the third generation of a family who have tilled their land in southern Saskatchewan for three generations.
The farm, 1,280 acres they own and 1,500 acres they rent, supports a 70 head cow calf operation and 300 acres of wheat and flax. The operation has supported the couple and their three children for 30 years, but none of the kids want to continue farming. Burt and Martha enjoy their lives and have no plans to quit farming for at least five years. Then, they figure, they can rent the land out and retire.
The farm is incorporated. Within the corporate shell, a few oil wells with an estimated 20 years of productive life left provide royalty income of $40,000 per year.
The corporation owns 800 acres of the farm and rents additional land from the provincial government. The couple has retained 480 acres to take advantage of the lifetime capital gains exemption, which was boosted to $800,000 in the March, 2013 federal budget.
For now, Burt and Martha live modestly. Each takes a salary of $18,000 from the farming corporation. The salaries are taxable to the corporation. They build their Canada Pension Plan benefits, create room in their Registered Retirement Savings Plans, and create little taxable personal income after Saskatchewan’s basic personal exemption.
The current situation
Farm Financial Planner asked Don Forbes, head of Don Forbes Associates/Armstrong & Quaile in Carberry, Manitoba, to work with Burt and Martha.
His analysis shows the couple has done good planning — though much remains to be done to secure the farm for the future.
Looking ahead, Burt and Martha see that they will need to convert salary from the farming corporation into taxable dividend income at the same level of $1,500 per person per month. In retirement, beginning at 65, Burt can expect Canada Pension Plan benefits of $300 per month. Martha can take early CPP benefits at about $150 per month at the same time that Burt applies (2018). When each reaches 65, they can apply for Old Age Security benefits, currently $546 per month. On top of dividend income and government benefits, they can receive monthly income from their RRSPs of $900 for Burt and $750 for Martha. Martha can also receive an employment pension through a Life Income Fund of $375 per month. On top of all that, their farmland rental should produce rent of $625 per month.
Adding up the components of their retirement income, the couple should have $7,192 per month in 2013 dollars before tax. Allowing income tax at just 12 per cent in recognition of the dividend tax credit for distributions from their privately controlled corporation, they will have $6,330 after tax per month to spend, Forbes estimates.
That will leave a good deal after they cover their anticipated expenses, $3,650 per month. Their savings, about $2,680 per month, will allow them to travel, to indulge their children or to support good causes.
Creating a trust
Burt and Martha need to create a structure for the supervision of the leasing operation into which they should eventually convert the farm. They can create a family trust in their wills. A testamentary trust would take over ownership of the farm on the event of the last to die and ensure that it would operate within the trust as a business leased to operators. The trust also creates income management opportunities — it could distribute farm earnings to the three children on a periodic basis. It creates a wall against many liabilities for accidents on the farm that might generate claims against the beneficiaries. The many forms of trust agreement should be discussed with the couple’s lawyer, Forbes suggests.
The trust could be handled by a chartered bank — all the banks have trust operations. That is an expensive solution, however. Banks acting as trustees charge as much as five per cent of revenues per year, plus charges for actual work such as collecting rents, cashing cheques, paying taxes and other services.
The better solution is to have the adult children act as trustees and to use a trust company as agent. That way, the trust company or bank will charge several per cent less. The children retain full control and have the right to discharge the agent without cause. Even if the trust is run by a trust company acting in full as a fiduciary, that is, with the highest level of responsibility, the will should give the beneficiaries power to change trustees without cause. That power at least gives the children the power to shop for the best price or best practice and should, in theory, keep the trustee alert to the need to provide good service, Forbes says.
Burt and Martha already have the basis for a testamentary plan in their life insurance. Each has a $250,000 policy. The policy should be kept in force. Cash values and potential payouts within the policies have a good deal of creditor protection.
Life insurance is often seen as a poor investment, but for people who will continue to be exposed to risks of the economy through their mutual funds, it is a portfolio stabilizer, not unlike the bonds which, in fact, are the investment base of the insurance itself.
Burt and Martha have invested their registered savings in several mutual funds. The names are respectable, the records are acceptable, but the management costs are high. Over time, as any remaining penalties for early sale of funds expire or at least decline to an ordinary transactional fee level of perhaps one to two per cent of net asset value, they should migrate to exchange traded funds with mandates similar to those of the fund they now hold.
Fund picking is often seen as something like a visit to a candy store in which the investor can buy not just what one may call white bread broad index funds, such as the S&P/TSX Composite or the S&P500, but sector funds such as entertainment industry, health care and pharmaceuticals, American retailing, and so on.
This form of portfolio construction may be entertaining, but it is both inefficient and financially dangerous. The smaller the sector, such as natural resources, the more volatile it is. When it slumps, there is more incentive to sell.
The better way to construct a portfolio is by giving weight to bonds, which tend to rise when stocks fall and to broad market stock indices. Government bond interest rates are at historic lows. When rates rise, these bonds will lose value. But investment grade corporate bonds with maturities from one to five years still yield three to 4-1/2 per cent. They can be bought in laddered maturities that minimize the losses that rising interest rates will generate. Bonds can be held in a ratio related to age, so Burt and Martha might consider populating their portfolio with half or more investment grade corporate bonds. They should discuss the ratio of bonds to stocks with their investment advisor, Forbes urges.
Stock index investing eliminates single stock event risk — that chance that a bad year or an accident (think of the Japanese Tsunami and what it did to Canadian uranium stocks) can devastate a portfolio. However, most index funds are constructed top to bottom from recent winners to the also-rans. They effectively buy winners at their highs and sell losers at their lows. The broader the index, one should add, the better an index strategy works An index that is equally weighted eliminates this recent winner bias and further reduces event risk.
Burt and Martha can accomplish all of this through exchange traded funds with average management expense ratios of no more than 1/2 per cent per year, a fifth of what they are now paying. On approximately $200,000 of assets in their registered accounts, a two per cent annual fee saving would amount to $4,000. There is no tax on such savings within the RRSP. It would be equivalent to perhaps $5,000 outside of the funds even in the couple’s relatively low brackets, Forbes estimates.
“In spite of the good work this couple has done to continue the family farm, there is a new chapter in their lives — what happens to the farm when they retire and after they are gone,” Forbes says. “This is the time to make plans for the inevitable.” †