No one intends to spend their last dollar, so how should that unusable dollar be invested?
There are two questions that arise:
- How big must my estate be to provide me with security, flexibility and income on the day before I die? That is the money that I will never spend.
- There is money that I own now that, together with income, will be unused in my lifetime. How should I invest it?
The first question comes up regularly. Security and income and longevity make a difficult combination of inputs. Most people end up with more than they really need, but it is difficult to convince them.
An alternative is to use a life annuity to provide the income and other assets to provide the margin of error that arises with inflation, longevity and medical emergencies. People can reach an acceptable answer if they are aware of all their choices and do not rely on just the methods that worked for them in a different time. What makes sense at 50 is not appropriate at 92.
The question of how to invest what will be the last dollar is not commonly considered. Intuitively, it should not be the same way as the money I will likely spend.
I have recently looked at a portfolio that a business person in their mid-fifties holds as as a source of capital to pay taxes that become due at death. The current choice is an investment in a very large, bank offered, very conservative, balanced fund.
- The fund’s target asset mix is 80% fixed income and 20% equity.
- Its current mix is 66% fixed income, 27% equity and 7% cash.
- Over the last five years, yield is in the 4.75% to 8.63% range before management costs and taxes
- Management expense ratio (MER) is stated at 1.73% but with HST it is about 1.95%.
- There are taxable distribution each year.
Average returns over the last five years are:
- Yield 6.72%
- Taxes cost about .95%
- MER is 1.95%
- Leaving around 3.8% for the investor. Of that a bit over half of the yield is deferred and will become taxable when the investor sells the units.
MER expressed as a percentage of assets tends to mislead. As a percentage of income and growth, in the 2010 to 2014 period the expenses incurred vary between a low of 22.6% and a high of 41.4%. The average is 29% of income. MER as a percentage of income is large when income is low.
Balanced funds like this one have little chance of high yields and also a small opportunity to lose money. The 20% to 40% share of income going to the operator is normal.
Taxes at .9% of assets are about 14% of income, and represent an average tax rate of about 28%. Perversely, funds with lower yields tend to have higher annual tax rates because more of their income is highly taxed interest.
If the money is not usable during life, then ongoing costs create a material loss.
The recommendation in this case is to reposition the money to another investment class with similar investment characteristics but better long term performance. In this case the asset has a current mix 80% fixed income, 17% equity and 3% cash. The overall yield is on average about the same. There are some internal taxes paid that are about .55%. The advantage is that the management expense is just 3.64% of income (federally regulated maximum) down from 29% and personal current taxes are 0.0% down from 14% of income.
More about this alternative asset class tomorrow.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.