A couple we’ll call Henry, who is 68, and his wife Julia, who is 66, are in transition from active farming to retirement. They farmed 720 acres in Manitoba for the last fifty years. Julia worked in off-farm businesses until she retired last year.
Their farm, 720 acres with mixed grains and a few cows, varied in profitability over the years. They are receiving Old Age Security, Canada Pension Plan benefits and income from their RRSPs. Those pension flows add up to $30,800 per year. On top of that, they have farm income of $40,000 per year, which they split evenly, including household related benefits that are taxable and that add up to $1,000 per month. Their total income including pensions and operating income therefore add up to $70,800 per year.
They plan to pass the farm on to their 37-year old son, who we’ll call Matt. They want to leave a legacy for their two daughters who we’ll call Olivia and Andrea, who are in their early 40s.
Henry and Julia decided to use the services of farm financial expert Don Forbes, head of Don Forbes &Associates/Armstrong &Quaile of Carberry, Man.
“The problems they face are to arrange the transition of the farm, increasing their retirement income, and funding the gift for Olivia and Andrea,” Forbes says.
The farm transition requires valuing the property. Recently, the farm was assessed at $406,000 in comparison to a purchase price of $72,000. The capital gain is therefore $334,000. The capital gain should be exempt from tax as a Qualified Eligible Farm Property Tax Credit that provides for a $750,000-per-person credit.
Henry and Julia will keep the current cash value of the capital gain, but, Forbes notes, they can boost the market value if they can find examples of nearby land that has sold for more than their assumed value of $700 per acre. If they can reasonably and honestly boost the value, then Matt can take over the farm with a higher book value.
Just going on the basis that the farm is worth $406,000 and taking off its long term debt of $12,000, they have a net value of $394,000. Although the farm is to be “given” to Matt, it won’t be free, Forbes cautions. He is obligated to provide goods and services including heat and light, to pay land taxes, to pay for insurance and to provide maintenance to the family home for as long as the parents want to live there.
The current estimated cost to Matt is $1,000 per month. If a life insurance company were approached to provide this cash flow, they would want $170,000 as an initial commitment. If he were to assign this sum as the net present value of the costs for supporting the parents, the farm as transferred would have a notional or theoretical value as a legacy of $394,000 less $170,000, or $224,000, Forbes says.
LIFE INSURANCE AS A LEGACY
They can create a legacy for the two daughters by purchasing a joint and last-to-die life insurance policy that will pay them $300,000 when the parents have passed away. A $300,000 life policy would cost them $11,024 per year for 10 years, after which the policy would be fully paid. Alternatively, they can pay $5,282 per year until the death of the last parent. The proceeds would be split between the daughters when the time arrives, Forbes says.
EVALUATING RRSP HOLDINGS
There are other things that Henry and Julia can do to boost their retirement income. They should review their $120,000 RRSP portfolio. Currently, it holds a baker’s dozen of growth funds that are both volatile and inappropriate for folks who need income in retirement and who cannot afford major investment losses.
The funds should be culled, perhaps on the basis of costs. The most expensive funds, with management fees, often called the Management Expense Ratio, over 2.5 per cent can be dumped in favour of funds with lower fees. Fund performance can’t be predicted, but a decade of MERs at 2.5 per cent will take 25 per cent of portfolio value away from the couple.
Before selling any funds, it is essential to ensure that backload fees are not at the high end of the six per cent to seven per cent range for early bailouts. If they are, it is best to wait a few years until penalties fall to two per cent or less. At that level, the fees become just frictional costs like stockbroker commissions.
The reformed portfolio should have 70 per cent bonds and 30 per cent stocks. The bond portfolio should be in the form of government bonds that revert to cash at maturity and that have zero default risk or exchange traded bond funds that hold government or investment grade corporate bonds in maturities of one to five years. When interest rates rise, all outstanding bonds will lose value. But short ladders will allow maturing bonds to roll into higher yields, thus preserving most of the value of the fund. Moreover, bond ETFs have MERs that are a tenth of those charged on managed equity funds and an eighteenth of those on managed bond funds. Cost controls on management fees are vital, for bonds, which have current yields of about four per cent to six per cent, should not sacrifice a third or more of their annual income to managers and investment dealers.
TRANSITIONING THE FARM
The current plan is for Matt to take over the farm at the conclusion of the 2010 harvest. Henry and Julia still have all of last year’s crop and this year’s harvest to market over the next three years. The net profitability will be quite high on these sales, for they will have limited expenses to offset the gross proceeds.
The couple’s farm income, now $40,000 per year, will drop away and they will be dependent on government pensions and their own retirement savings. They can compensate for loss of farm income by withdrawing money from their taxable savings accounts and by beginning a program of withdrawals from her Registered Retirement Income Funds.
Once the current grain inventory is sold, they can make up for the $40,000 shortfall by taking $19,040 from taxable cash, and $5,916 from their registered savings. That’s a compensating cash flow of $24,956. Added to $23,293 of estimated future CPP and OAS benefits, they will have $58,249 before tax. But the tax on much of this money, which will include return of capital from bank accounts, GICs and investment funds, will be minimal. If their lifestyle expenses decline, as often happens in retirement, they will have sufficient disposable income to maintain themselves in the style to which they are accustomed, Forbes says.
Henry and Julia can make the transition from what amounts to a plan to retire today to actual retirement with relative ease because they have no significant debts and no plans to spend money they do not have. The insurance they may buy can create a legacy for Olivia and Andrea. When Henry and Julie die, regardless of the amount of premiums paid to date, the policy will pay death benefits in full.
Henry and Julia will also benefit from what is likely to be declining income taxes. If they use up their non-registered savings and then draw down their registered savings, their taxable income will decline and pull down taxes payable from an estimated $9,000 in 2010 to $3,650 in 2017 to $850 in 2018. Thereafter, personal tax credits will reduce their income taxes to nominal or zero amounts, Forbes explains.
“My plan for Henry and Julia is conservative,” Forbes says. “Life insurance guarantees the legacy for the daughters, the valuation and tax plan assures that Matt gets the farm, and the investment plan makes it easy for the couple to retire with customary spending power. It’s not complicated, but they will have to see their lawyer for the paperwork and their accountant to ensure that they comply with the rules.”
AndrewAllentuckisauthorofWhenCanI Retire?PlanningYourFinancialLifeAfterWork, publishedlastyearbyVikingCanada