Securing the future

Reader alert: This is part 3 of three in a series.

In September 2010, members of the Institute of Advanced Financial Planners met in Banff, Alberta to consider the organization’s annual case study. This year’s case involved a client everyone could identify with: a fellow CFP.

This is the story of Russell, a financial planner in his mid-fifties who wants to retire. He and his wife Diane have been married for 25 years, with one son together, Terry, and a child each from a previous marriage. Diane’s daughter Melanie joined Russell’s planning practice six years ago, while Russell’s daughter Kathy operates her own health and wellness store.

In Part 1, we dealt with Russell’s soft issues: What are his actual plans for retirement? Does his wife share his vision? And how can he ensure his children are treated fairly? With this counselling out of the way, he can now set about harvesting the value he has built up in his largest asset: his financial planning practice.

In Part 2 we examined the value of Russell’s largest asset, his business. By cleaning up his book of business and segmenting his clients, he could sell RKM Planners & Wealth Advisors Inc. for up to $1.3 million.

The task at hand

Now he has to plan for his retirement income. He and Diane want to generate an after-tax income stream of $6,000 per month, which they believe will allow them to maintain both their home in Calgary and their cottage — their recreational property — in British Columbia.

The good news for Russell is his asset base is stronger than he might have suspected. His initial estimates for the value of his business were between $600,000 and $900,000, so a sale for $1.3 million will give him at least $400,000 more to work with.

Outside of the business, Russell and Diane have accumulated about $1.1 million in assets, consisting of their registered accounts, taxable investments, a real estate LP and a $300,000 loan to RKM.

According to the IAFP’s case study, RKM is worth about anywhere between $300,000 and $900,000. But Russell will be happy to know that Jim Otar, creator of the Otar Retirement Calculator, believes that RKM is undervalued.

Otar says a conservative estimate would put recurring income at 0.75% of assets (which are currently $85 million) or at about $638,000 per year.

“Using a multiplier of 2.5, we can conclude that this business is worth about $1.6 million,” Otar says. “We use the multiple of recurring income instead of the multiple of EBIT because of the size of the firm and unknown profit picture.”

Selling the practice

In total, the couple should have between $2 million (if Russell underprices RKM at $900,000) and $2.4 million (if he maximizes RKM’s value). While Russell could probably get a better price for his practice by accepting payment spread out over 10 years, he is exposed to risks. If regulators shut down the company in the third year after its sale, he will find it difficult — if not impossible — to recover the remaining payments.

Despite the impact on his net worth, Russell has already decided to sell the practice at a discount to his stepdaughter Melanie. Because she is family, he is also willing to take on the additional risk associated with spreading the sale out over 10 years.

It might be best to sell at a slight discount and have the cash in hand for deployment into his retirement income portfolio. Otar suggests a pretax income of just $85,000 will be enough to generate the desired $6,000 per month, since income splitting would allow Russell and Diane to pay an average tax rate of just 15%.

“Diane has 50% of voting shares of RKM,” Otar points out. “Being a planner, it makes sense to assume that Russell paid her an income from the company for income splitting purposes and thus created a CPP pension asset.” That allows Otar to project a combined income for the couple of about $26,000 from CPP and Old Age Security.

Russell and Diane also generate $10,000 per annum from an income property they own, and that income will rise at the rate of inflation.

To address longevity risk, Otar says Russell and Diane should base their planning around an age where the probability of survival is less than 10%. For a 56-year-old man, there is only a 5% risk of living beyond the age of 96. For Diane, the risk is 10%.

Given their $2 million asset base, generating the additional $49,000 in pretax income should be a cakewalk. But that assumes that $85,000 in pretax is a target rather than a floor.

Patricia Vigna, field marketing specialist at Desjardins Financial Security and Investments Incorporated, says Russell should aim for $130,000 in pre-tax income per annum, which would leave him with enough capital to fully fund his insurance needs within the 10 years of the business sale.

Insuring for illness

One of the problems Russell faces is that a critical illness would place his business loan at risk. The overall business could, in turn, suffer greatly, jeopardizing the jobs of his staff and Melanie.

She recommends his company fund his critical illness policy, and that he remain an employee over the course of the 10-year buyout, even if he is working a greatly reduced schedule. This is a policy that he must act on immediately, as delaying at his age could leave him uninsurable.

“Russell is reluctant to give up his control, but guess what: he doesn’t have to. He’s in the financial services industry,” Vigna says. “He can be there for the next 10 years.” Insurance, she points out, is one of the most straightforward tools for ensuring fair and equitable treatment of the other two children, Terry and Kathy.

“What is the outcome for Russell and his family if they do not look at planning for the end of life?” Vigna says. “Without planning, there won’t be a fair and equitable share; Melanie is going to have the opportunity to assume her stepfather’s business.”

Given that Russell is a financial planner himself, Vigna assumes he has structured his business so that Diane owns enough of a stake that they may each claim the $750,000 small business exemption. This structure carries its own risks. She recommends Russell draw up a shareholders’ agreement that takes into account the eventuality of his death, as well as the possibility of critical illness, disability or need for long-term care. The shareholders’ agreement would also help to settle matters in the event of a relationship breakdown and disagreement.

The shareholders’ agreement should also clearly identify insurance risks. By creating this shareholders’ agreement, the planner has packaged up all the information needed for underwriting the insurance Russell will need to achieve his goals. “The soft facts are what you use to close insurance sales: it’s the legacy, it’s the relationship with the family, it’s how he wants to be remembered, [and] it’s love of self,” says Vigna.