A couple we’ll call Roger and Martha, both 29, farm in southern Manitoba. They have combined income of $160,000 a year based on Martha’s town job, which pays $90,000 a year, and Roger’s work on his family farm and his own part-time farm operation for which he draws $70,000 a year. Life is good for the couple, but they are looking ahead to financial independence on their own farm and, eventually, a secure retirement income. For now, they rent an older home in town at a very reasonable rate, but they know it is not a permanent arrangement. They are currently saving for a new home on their farmland.
Farm Financial Planner asked Don Forbes and Erik Forbes of Don Forbes Associates/Armstrong & Quaile in Carberry, Man., to work with Roger and Martha.
Roger and Martha farm 320 acres which they own with a $330,000 mortgage. The mortgage requires payments of $20,360 annually, of which the first $12,360 — interest — is deductible as a cost of their business.
If they expand by buying additional farmland, it would be useful for them to form an operating company to do the actual farming, but they should retain the land outside of the operating company in order to be eligible for the Qualified Farmland Capital Gains Tax Credit, Don Forbes says. That will be $800,000 per person, up from $750,000, beginning in 2014.
Martha’s off-farm job is secure, but lenders often require mortgage life coverage. If they borrow funds to expand their farm, banks may insist on it. However, mortgage life coverage purchased from chartered banks and other lenders tends to be expensive and disadvantageous. The insurance covers the lender’s interest yet allows in most cases no remainder for the insured’s surviving family after the lender’s interest is paid. If the couple decide to build a home of their own and use mortgage financing, it is all the more likely that the lender would insist they have mortgage term life insurance.
Banks have a record of doing their underwriting after a claim — that is, a death — and in some cases denying payment, claiming that the insured misstated a fact about his or her health. Questions are complex and, say critics, they induce misstatements. Roger and Martha can compare the cost of mortgage life with a policy of similar value purchased from an independent insurer and agent outside of the bank. The cost and coverage differences may be astonishing, Don Forbes says.
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With adequate insurance coverage in hand, the lender may also perceive lower risk in the mortgage and adjust the rate accordingly. It’s a bargaining point at the least. Roger should be able to get a one million dollar, nonsmoking 10-year level term policy from an independent agent for $46 a month, Martha for $33 a month for similar coverage.
Future cash flow
Investment projections suggest that Roger and Martha will be able to grow their net worth in off-farm investments from $333,900 this year at a rate of 12 to 15 per cent based on three per cent inflation and the remainder from contributions to taxable, RRSP and TFSA accounts and returns.
Assuming that these projections work out, at age 63, when Roger and Martha figure they may retire, they would have their farming business, their house, and financial assets of approximately $6 million in future dollars — that is, present dollars inflated to higher value in 2049.
That capital, generating five per cent per year, including three per cent inflation, would provide a constant income stream of $300,000 a year. They could add Canada Pension Plan benefits, currently a maximum of $12,460 a year at age 65, inflated to levels in 36 years, which would then total $36,110. Old Age Security, currently $6,620 a year — which, inflating at three per cent a year, will be $20,400 when each is 67 — would probably be lost to the clawback, which is now triggered at taxable income of $71,592. That would produce total annual non-farm income of $336,110 in future dollars at their age 67.
If Roger and Martha maintain their mortgage and its payments, their equity in their present farm would grow to 100 per cent by time the mortgage is paid off at the couple’s age 54. Allowing for three per cent annual increase in price, essentially an inflation adjustment, at the couple’s age 63 at the beginning of retirement the property would have a value of $1.55 million. Were they to sell at that time and obtain a three return after inflation, the farm capital would generate $46,500 a year.
If Martha retains her town job and gets two per cent annual pay increases for the next 34 years, she would have final job income of about $130,000. If her defined benefit pension is set at two per cent of her final income, $2,600, times her years of service, which would be about 40, she would have annual pension income of $104,000.
Adding up all income from their farm capital, Martha’s job, off-farm investments, and government pensions, the couple would have a total of $486,600 before tax or $292,000 after income splits and 40 per cent average tax. The couple’s present budget for living and savings, a total of $84,900, consists of $48,000 expenses and $36,900 in their TFSA and RRSP accounts. At retirement in future dollars and with no further retirement savings, their annual cost of living would decline to $139,100 a year. Farm income could add to this sum, but if generated within a farming corporation, it could be retained by the company or paid out as dividends as required. However, even without that income, their expenses would be covered. Moreover, mortgages with terms as long as 30 years incurred before their mid-30s would probably be paid off. Their disposable income in retirement would be likely to rise, Erik Forbes says.
Projections are just that. There is no guarantee that Martha will keep her job, that the farm will prosper, or even that inflation will remain at or below three per cent for the next three to four decades. However, to create a buffer for the winds of change, the couple should diversify their non-farm assets.
It is a common rule of thumb that people’s portfolios should include a share of bonds equal to their age. Thus at 63, when their retirement will begin, they would have 37 per cent stocks and the remaining 63 per cent in government and corporate bonds. They should invert the allocations to 63 per cent stocks and 37 per cent bonds. If inflation were to rise appreciably from today’s low single digit levels to a mid-single digit level, many bonds would lose substantial value. Stocks would presumably gain value, for inflation is a driver of the prices businesses charge and ultimately of their earnings.
Mutual funds with fees of no more than 1.5 per cent for their stocks and 0.6 per cent for the bonds they should have as a backstop for their portfolios would be suitable investments. If they elect to learn about capital markets, they could migrate to exchange traded funds which, typically, are replicas of various indices such as the S&P/TSX Composite, the American S&P 500 Composite, and various global indices. That move would cut their fees dramatically, though they might still need professional guidance.
“Roger and Martha can look forward to a prosperous future,” Don Forbes says. “If they pay down their mortgages faithfully, grow their farm and off-farm investments, maintain life insurance for their debts and diversified non-financial assets, then our projections should work out.“ †