APPLIED FINANCIAL PLANNING CERTIFICATION EXAMINATION Sample Case Scenario General Instructions This sample is provided as a resource for AFP Exam 2 candidates for them to create a financial plan around a client scenario. This sample also provides information on the depth and complexity of questions on the actual AFP Exam 2; however, this case scenario and questions should not be used as a diagnostic tool or indicator of performance on an actual AFP Exam 2. Read the case provided for Greg and Janice Bright that reflects their previous financial plan and changes to their family and financial situations beginning on page 2. Answer the questions beginning on page 7. The actual AFP Exam 2 will include space for your responses. Examples of acceptable answers are provided at the end of this document. CSI encourage candidates to answer the questions prior to reviewing the sample answers. Format Exam questions will relate to all of the following components of a financial plan: 1. Review of Current Situation and Objectives a. Family Demographics. b. Financial Goals. c. Overview of Current Finances. d. Investor Profile. e. Other Pertinent Financial Data. f. Potential Gaps. 2. Financial Management Analysis 3. Retirement Planning Analysis 4. Risk Planning/Management Analysis 5. Tax Planning Analysis 6. Asset Management Analysis 7. Estate Planning Analysis 8. Recommendations and Implementation Strategies Mathematical Calculations Candidates will be evaluated on the application of financial math and the use of financial calculators to create accurate client advice. In order to reap full marks, the steps (calculator calculations) required to arrive at conclusions must be shown. Where applicable, this requires that candidates show the process of their calculations in detail. The sample answers provided for Greg and Janice Bright illustrate this for clarity.

August 2012

Appendix Page 1

CASE SCENARIO: Greg & Janice Bright Read the case study on pages 2 to 6. Answer questions 1 to 9 beginning on page 7.

Background Greg Bright, a long-time client of financial advisor Megan Chu, informs her that he has just lost his job. Greg reports that the job loss was due to financial difficulties at the company and that several other people in different departments lost their jobs that day as well. Greg received a severance package and would like to review his existing financial plan with Megan in light of the changes to his situation. Megan asks Greg to fax the details of the package to her office so that she can review it before they meet. In the meantime, Megan tells Greg that she will review the last financial plan they completed together. They agree to meet in two days. Megan reviews the plan prior to the meeting to refresh her memory and recalls the following information: 

Greg is 53 years old; he is married to Janice and has one child. Janice is 53 years old and has not worked outside the home. They have one son, Dillon, who is 14 years old.



Janice recently completed a training course in office management in anticipation of finding a job.



They are planning for Dillon’s university education and have saved some money for that purpose. Part 1: Financial Details from Previous Financial Plan: Greg & Janice Bright

The following information is extracted from Greg’s and Janice’s financial plan, which was completed two months prior to Greg’s job loss. Financial Management 

Greg was a senior manager of a large technology firm. He earned a $120,000 annual salary and received a bonus of $30,000 last year.



The Brights live in a home valued at $600,000 that they jointly own and on which they have a $20,000 closed mortgage at an interest rate of 2.5%. They had planned to pay off the mortgage within the next two years prior to Greg’s layoff. They have taken advantage of all available lumpsum prepayment options.



Greg owns a U.S. condo valued at $100,000.



They own two cars with a combined value of $40,000.



The Brights have a $30,000 credit card debt and they make interest-only payments. Currently, the interest rate on the credit card is 28%.



They also have $26,000 in a joint bank account. They do not receive any interest on this amount.

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Appendix Page 2

Education Plan 

They are planning for Dillon’s university education and have saved some money for that purpose.



They have accumulated $45,000 in an RESP and have invested the funds in a three-year GIC earning 3%. They contribute $4,800 to the RESP each year.



University education is expected to cost $15,000/year for Dillon for three years.

Retirement Plan 

Greg had planned to retire at age 60 with a net after tax income of $40,000. At age 60, Greg would have been with the company for 25 years. However, Greg does not have a pension plan.



Greg has an RRSP, which has $70,000 invested in a Canadian balanced fund.



Greg’s annual CPP payment will be $10,000 at age 65.



To date, Janice does has not earned any CPP-eligible income.



Greg and Janice are each eligible to receive a $5,000 OAS pension.



In retirement, Greg plans to rent out the U.S. condo for C$10,000 after-tax per year.



Greg currently has $30,000 of unused RRSP contribution room, including his contribution limit in the current year.



The Brights would like to continue living in their home for as long as possible in their retirement.

Risk Management 

Greg’s employment benefits include medical and dental coverage; the company pays for 90% of his medical and dental bills.



He also has short and long-term disability coverage. The company pays the premiums for the short-term and long-term disability coverage.



Greg currently has a $120,000 group life insurance policy that is paid by his employer.



Through Greg’s company’s group plan, Janice has life insurance in the amount of $50,000 (paid for by Greg). Greg

Janice

Group Insurance Policy

Coverage: $120,000 Beneficiary: Janice Cost: Covered by Employer

Coverage; $50,000 Beneficiary: Greg Cost: Greg pays $20/month

Group Disability Insurance

Benefit: $6,000 after-tax Elimination period: 3 months Cost: Paid by employer

None

Group Medical & Dental Insurance

Benefit: Covers 90% of family medical and dental costs Cost: Paid by employer

Covered under Greg’s employer plan

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Appendix Page 3

Investment Plan 

The Brights’ asset allocation is based on their moderately aggressive investment risk tolerance.



The portfolio is expected to generate an average annual 5% compounded rate of return to retirement.



A tactical asset allocation is employed from time to time. The portfolio is currently overweight common stocks, particularly industrial and commodity stocks.

Strategy Agreement Return Objectives: 5% Risk Tolerance: Moderately Aggressive Time Horizon: 7 Years

T-bills 5% 5%

Strategic Asset Mix Bonds 40% Current Asset Mix 30%

Equities 55% 65%

Estate Plan 

Greg and Janice completed their wills 14 years ago when Dillon was born.



They are executors for each other. Each will leave everything to the other spouse.



In the event of their joint deaths, Greg’s mother, Eunice, is named as the contingent executor and guardian for Dillon. Everything is left to Dillon by way of a trust that will be managed by Eunice until Dillon reaches the age of majority. If Greg and Janice die after Dillon turns 18, he will receive the proceeds of their estate.

August 2012

Appendix Page 4

Part 2: New Information Details of Greg’s Severance Package 1. Greg has the choice between salary continuance or a lump sum payment, as follows: a) Salary continuance for 18 months, which includes benefits, with the exception of short- and long-term disability. Salary continuance will stop if Greg finds a new job. Greg would be allowed to earn up to $60,000 if he became self-employed; otherwise salary continuance would stop. Salary and benefits would stop after 18 months if Greg could not find a job. b) A lump sum pre-tax payment in the amount of $135,000. Benefits would stop immediately. He would have the option to convert the group life insurance to a private plan without the requirement of a health assessment for either himself or Janice. 2. A lump sum pre-tax bonus of $30,000 payable immediately, regardless of whether he chooses the salary continuation or the lump sum payment. Goals 

Greg has met with a lawyer who has advised him the lump-sum payout in lieu of salary continuance is the best option, given the uncertain financial state of his company. Consequently, he advised his employer of his intended choice and has received the payment, which he has invested in a redeemable GIC at 5% interest. He has also received the bonus payment which he has contributed to his RRSP.



Greg reveals that he is tired of corporate life and would like to try self-employment. He is a highly specialized engineering consultant and his skills are much in demand. He has been in touch with a firm that has offered him a one-year consulting engagement for $100,000, which will require Greg to work only 20 hours per week.



Greg informs Megan that his wife, Janice, has been diagnosed with cancer. It is too early for a prognosis. Based on the experience of a family friend who recently underwent treatment for cancer, he anticipates that medical expenses for Janice will be $5,000 per year in each of the next two years.



Greg would like to ensure that the family’s income in the coming year is sufficient to meet all of their expenses and to make contributions of $5,000 each to a TFSA account for him and Janice.



Eunice sold the family home last year for $250,000 and gifted the funds to Greg. Greg invested the funds in a GIC earning 5%. They would like to use the income generated from the investment to pay expenses now and in retirement.



The Brights would still like to pay off their mortgage in 2 years.



They would also like to ensure that they have an emergency reserve to cover 10 months of their anticipated expenses.



Greg’s mom, Eunice (81), is planning to move in with them. Eunice is in the early stages of Alzheimer’s and can still function, but is beginning to forget things. Burt, Greg’s dad, died last year of a heart attack at age 84. Eunice receives Burt’s indexed pension of $25,000 per year. The pension increases by 1% per year. In addition, Eunice receives medical and dental benefits. Greg would like to assess how this will alter his financial plan, if at all.

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Appendix Page 5

Assumptions 1. Greg will save $10,000 per year in two TFSAs for himself and Janice for seven years, commencing this year. 2. No additional contributions will be made to RRSP accounts. 3. Greg’s pre-retirement tax payable is based on his average tax rate of 35%. His pre-retirement marginal tax rate is 40% which should be used to calculate the value of tax deductions. Greg’s marginal tax rate in retirement will be 30% and his average tax rate will be 25%. 4. Janice’s pre-retirement and retirement marginal tax rate is 15%. She will not pay any taxes on her estimated income, after allowable deductions and credits. 5. Their retirement plan is based on Greg’s life expectancy to age 90. 6. The inflation rate is 0%. 7. Employer and employee CPP contributions are $2119 annually for each. 8. Greg’s CPP will be reduced by 0.6% per month for each month that he receives the pension prior to age 65. 9. Source deductions for E.I. are $732 annually. 10. Greg has received a quote of $1,400 to convert his current group insurance policies to private policies.

August 2012

Appendix Page 6

APPLIED FINANCIAL PLANNING CERTIFICATION EXAMINATION Sample Case Scenario Questions Note: Financial calculations are included in the answers in order to illustrate expectations for garnering full marks. When candidates are asked to show calculations, markers are looking for accurate process and final answer. Question 1: Client Profile Instructions: Complete the profile of the Bright family according to which you will create a financial plan in the coming year. Ensure that you consider previous and new information. Write your answer in the tables provided below. Greg

Janice

Dillon

Age: Occupation: Years in current position: Gross income: Marginal tax rate before retirement: Marginal tax rate after retirement: Average tax rate before retirement: Average tax rate after retirement:

Question 2: Gap Analysis Instructions: Identify and explain changes in each financial planning area listed below that should be addressed in revising the Brights’ financial plan. In listing the required revisions, consider the Brights’ stated goals and those that a financial planner should bring to their attention. 1. Financial Management 2. Retirement Plan 3. Risk Management 4. Investment Plan

August 2012

Appendix Page 7

Question 3: Net Worth Statement Instructions: Using the information in the case study, populate this Statement of Net Worth to enable accurate calculations of the Brights’ Total Assets, Total Liabilities and Total Net Worth. Ensure that you include previous and new information. Round amounts to the nearest dollar. Statement of Net Worth Assets

Total Assets

Liabilities

Total Liabilities Total Net Worth

August 2012

Appendix Page 8

Question 4: Cash Flow Statement Greg has asked Megan to create a projected cash flow statement for next year to determine whether he will be able to meet his projected expenses and savings goals with his self-employment earnings and other income. He would like Megan to quantify any short-fall and help him develop options to meet his goals. Instructions: Using the information in the case study, complete this Cash Flow Statement by populating each blank line with the cash flow item and amount. The statement should reflect cash flow in the 1st year of Greg’s selfemployment. Round amounts to the nearest dollar. Write your answer in the table provided. $ / Year Income

Less Expenses and Deduction

Home Mortgage

13,200

Property taxes

4,800

Utilities

6,000

Maintenance

2,000

Food

6,000

Vehicle Fuel, Maintenance, Insurance

4,800

Personal and Clothing

12,000

U.S. Condo Fees

3,300

Entertainment & Vacation

6,000

August 2012

Appendix Page 9

Question 5: Financial Management Instructions: Based on your analysis of the Brights’ net worth and cash flow statements, provide recommendations for implementing a plan to achieve their financial management and savings goals. Question 6: Retirement Analysis Question 6 includes three parts: Questions 6a, 6b and 6c. Instructions: 6a. Complete the retirement income calculation for the Brights at age 60 for the sources listed below. Assume that they can earn a 5% pre-tax rate of return on TFSA and RRSP investment preretirement, and a 5% pre-tax rate of return on all investments in retirement. Use a tax rate of 25%. Assume income is earned and withdrawals are made at the end of the year. Round your answers to the nearest dollar. Write your answer in the table provided below. Sources of the Brights’ Annual Retirement Income at age 60 After-tax Calculations Greg’s RRSP Yearly Income:

Greg & Janice’s TFSAs Yearly Income:

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Appendix Page 10

Greg’s CPP Yearly Income:

Greg & Janice’s OAS Yearly Income:

Non-registered yearly income: All investment income is taxable as interest

August 2012

Appendix Page 11

Question 6 : Retirement Analysis Instructions: 6b. Calculate the total retirement income available to the Brights. Refer to your calculations in Question 6a. Write your answer in the table provided below. Total After-Tax Income: Greg RRSP CPP OAS Non-registered Account TFSA Rental income

10,000

Total Total After-Tax Income: Janice OAS TFSA Total

Total Income: Greg & Janice

Question 6: Retirement Plan Recommendations and Implementation Instructions: 6c. Recommend three ways in which the Brights can ensure that their retirement income is adequate for their desired income needs. Refer to your retirement calculations in 6a and 6b.

August 2012

Appendix Page 12

Question 7: Tax Analysis and Estate Recommendation Question 7 includes two parts: Questions 7a and 7b. Instructions: 7a. Provide Greg with an analysis of the advantages and disadvantages of incorporating his business in comparison to sole proprietorship. In your answer, ensure that you consider the Brights’ specific situation. Instructions: 7b. Provide Greg and Janice with recommendations on how to best construct their wills to ensure that their estate is distributed according to their wishes. Ensure that you specifically address all major issues specific to their situation.

Question 8: Risk Analysis Instructions: Advise Greg on the best form of insurance in the event that he becomes disabled as a self-employed individual. Ensure that you consider the nature of his profession, his income needs and variability of income in considering suitable forms of insurance and features.

Question 9: Investment Management Instructions: Advise the Brights on the suitability of their current investment strategy given the changes in Greg’s employment and family situation, as well as their retirement goals. In your answer, you should evaluate the suitability of strategic and tactical asset allocation for their specific situation.

August 2012

Appendix Page 13

APPLIED FINANCIAL PLANNING CERTIFICATION EXAMINATION Sample Case Scenario Answers Please find below sample answers (in red) built using the information from the sample case scenario for Greg and Janice Bright. These responses are provided as possible correct responses; additional responses could be provided. Please Note: Financial calculations are included in the answers in order to illustrate expectations for garnering full marks. When candidates are asked to show calculations, markers are looking for accurate process and final answer. Question 1: Client Profile Instructions: Complete the profile of the Bright family according to which you will create a financial plan in the coming year. Ensure that you consider previous and new information. Write your answer in the table provided below. Greg

Janice

Dillon

53

53

14

Consultant

Homemaker

Student

0

14

$100,000/year

Nil

Marginal tax rate before retirement:

40%

15%

Marginal tax rate after retirement:

30%

15%

Average tax rate before retirement:

35%

0%

Average tax rate after retirement:

25%

0%

Age: Occupation: Years in current position: Gross income:

August 2012

Appendix Page 14

Question 2: Gap Analysis Instructions: Identify and explain changes in each financial planning area listed below that you must address in revising the Brights’ financial plan. In listing the required revisions, consider the Brights’ stated goals and those that a financial planner should bring to their attention. A. Financial Management 1. Added expenses: The Brights will have to incur some expenses for Janice’s medical care, and possibly Eunice’s, as well as private insurance coverage. 2. Additional income: The Brights will receive investment income from Greg’s severance and inheritance, in addition to his employment income from contract work. 3. Emergency Reserve: The Brights are in need of an emergency reserve. 

Given Greg’s intention to start his own business and Janice’s illness, an emergency reserve in excess of the usual expense coverage of 3 to 6 months is appropriate.

4. Taxation: The Brights should explore tax credits or deductions that can be transferred from Eunice to Greg. Greg may also qualify for tax deductions if he becomes self-employed and uses part of the home for business. Greg should explore tax savings opportunities if he incorporates his business. These include withdrawing income as dividends rather than salary, and income splitting by making Janice a shareholder or hiring her to work in the business. Other income splitting opportunities should be explored, such as holding the U.S. condo jointly in order to split rental income between Janice and Greg. Any transfer of assets between spouses to achieve income splitting opportunities should be done in such a way as to avoid attribution of income back to Greg. B. Retirement Plan The sources of retirement funding may change given Greg’s self-employment. 1. Greg will be responsible for his own retirement funding. i. Greg should explore retirement savings options for self-employed individuals. ii. Greg will have to make both employer and employee CPP contributions. 2. If Greg incorporates, he may be able to withdraw income in the form of dividends. While dividends are more tax efficient, they will do not qualify as RRSP-eligible income. 3. Greg must revisit his retirement date and desired retirement income, given the possible change from salaried to self-employment. 4. Greg and Janice should explore income splitting opportunities in retirement.

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Appendix Page 15

C. Risk Management 1. A capital needs analysis is required to reassess the Brights’ life insurance needs to ensure a sufficient amount of private insurance coverage. 2. Medical and health insurance needs must be reviewed in order to determine the type and amount of private insurance required, as well at eligibility criteria, in light of Greg’s desire to be self-employed and the state of Eunice and Janice’s health. 3. Greg must consider the need for professional liability insurance if he becomes self-employed. Incorporation should be explored from the point of view tax savings as well as limiting liability. 4. Additional home insurance coverage may be required if Greg works at home as a self-employed individual. D. Investment Plan 1. The Brights’ risk tolerance should be reassessed given the additional risk that Greg will incur as a self-employed individual. Given the variability of his employment income and the relatively short time to retirement, a lower volatility investment portfolio may be more suitable. 2. The asset allocation should also be reviewed to include Greg’s inheritance. 3. Additional portfolio liquidity should be considered in the short-term given the anticipated medical expenses for Janice and Eunice and the uncertain income for Greg.

August 2012

Appendix Page 16

Question 3: Net Worth Statement Instructions: Using the information in the case study, populate this Statement of Net Worth to enable accurate calculations of the Brights’ Total Assets, Total Liabilities and Total Net Worth. Ensure that you include previous and new information. Round amounts to the nearest dollar. Assets Jointly Held Bank Account RESP 3% GIC (3 Year Term) RRSP – Greg Home Jointly Held Greg’s U.S. Condo Greg’s Severance Package Greg’s inheritance 2 cars

Statement of Net Worth Liabilities Credit Cards $26,000 Interest rate is 28%

Total Assets

45,000 100,000 600,000 100,000 87,750 250,000 40,000 $1,248,750

$30,000

Closed Mortgage

20,000

Total Liabilities

$50,000

Total Net Worth

$1,198,750

Severance calculation: Lump-sum $135,000 – (1 - .35) = $87,750 after-tax RRSP calculation; $70,000 existing RRSP + $30,000 bonus contribution. Note that Greg had $30,000 in unused RRSP contribution room.

Question 4: Cash Flow Statement Greg has asked Megan to create a projected cash flow statement for next year to determine whether he will be able to meet his projected expenses and savings goals with his self-employment earnings and other income. He would like Megan to quantify any short-fall and help him develop options to meet his goals. Instructions: Using the information in the case study, complete this Cash Flow Statement by populating each blank line with the cash flow item and amount. The statement should reflect cash flow in the first year of Greg’s self-employment. Round amounts to the nearest dollar.

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Appendix Page 17

Write your answer in the table provided. $ / Year Income Greg’s self-employment income Greg’s investment income (severance package) $87,750 x 0.05 Greg’s GIC investment income (inheritance) $250,000 x .05 Total Gross Income (A)

100,000 4,388 12,500 116,888

Less Expenses and Deduction Greg’s Income Tax CPP (x 2 for self-employed) EI Premiums

40,911 4,238 732

Insurance Premiums

1,400

Medical

5,000

Credit card expense

8,400

Home Mortgage Property taxes

4,800

Utilities

6,000

Maintenance

2,000

Food

6,000

Vehicle Fuel, Maintenance, Insurance

4,800

Personal and Clothing

12,000

U.S. Condo Fees

3,300

Entertainment & Vacation

6,000

Total Expenses (C) Net Cash flow

August 2012

13,200

118,781 - 1,893

Appendix Page 18

Question 5: Financial Management Instructions: Based on your analysis of the Brights’ net worth and cash flow statements, provide recommendations for implementing a plan to achieve their financial management and savings goals. Mortgage Goal 

The Brights will be able to pay off their mortgage in 19 months if they continue to pay $1,100 per month against it.



At this point, since the mortgage balance is so low, almost all of their payments are going towards the principal.



Consequently, the elimination of the mortgage would reduce overall expenses by $13,200 per year ($1,100 X 12 months).

Expense Coverage and Savings Goals Education Funding: The Brights have already met their goal of 3 years of education funding for Dillon. No further RESP contributions are required. Emergency reserve funding: The Brights would like to ensure that they have an emergency reserve to cover 10 months of expenses. They have sufficient liquid assets to fund an emergency reserve, which include Greg’s after-tax $87,750 severance payment and $26,000 in a joint bank account Retirement Savings: The Brights do not have sufficient cash flow to make their $10,000 TFSA contribution. They have a short-fall of $1,893 after expenses. The Brights can meet their savings goals in the following ways: 1. Reduce discretionary expenses 

The two discretionary expenses are Entertainment & Vacation and Personal and Clothing.



If discretionary expenses are reduced by 50%, then the Brights would save $9,000 a year.

2. Reduce interest expense 

Use the tax rebate that will result from $30,000 RRSP contribution to pay off a portion of their credit card expense or contribute to their TFSA accounts.



Tax rebate due to the RRSP contribution = $30,000 x .40 = $12,000.



Payoff $12,000 of $30,000 credit card expense = $18,000 remaining.



Interest savings = $3,336 (12,000 x . 28).

August 2012

Appendix Page 19

Question 6: Retirement Analysis Instructions: 6a. Complete the retirement income calculation for the Brights at age 60 for the sources listed below. Assume that they can earn a 5% pre-tax rate of return on TFSA and RRSP investment preretirement, and a 5% pre-tax rate of return on all investments in retirement. Use a tax rate of 25%. Assume income is earned and withdrawals are made at the end of the year. Round your answers to the nearest dollar. Write your answer in the table provided below. Sources of the Brights’ Annual Retirement Income at age 60 After-tax Calculations Greg’s RRSP Yearly Income: 100,000

+/-

PV

5

I/Y

7

n

COMP FV

=

$140,710

This will provide a net after tax income of $6,865/year calculated as follows: $140,710

+/-

PV

0

FV

30

n

5

I/Y

COMP PMT

=

(from age 60 to age 90)

$9,153 gross income

$2,288 tax (at 25%) = $6,865 net income

August 2012

Appendix Page 20

Greg & Janice’s TFSAs Yearly Income: Future contributions to a TFSA ($5000/year/TFSA) 0

+/-

PV

5

I/Y

7

n

5,000

+/-

PMT

COMP

FV

=$40,710

This will provide an income of $2,648 /year, calculated as follows: $40,710

+/-

PV

0

FV

30

n (from age 60 to age 90)

5

I/Y

Comp PMT

$2,648

Total income from 2 TFSA’s would be $5,296. ($2,648 x 2) with no tax payable. Greg’s CPP Yearly Income: At age 65, Greg’s CPP will be approximately $10,000 per year. At age 60, CPP will be reduced by 0.6% per month, so that Greg will receive 64% of his regular pension. This is calculated as follows: $6,400/year -

$1,600 tax (at 25%)

=

$4,800 net income from CPP

August 2012

Appendix Page 21

Greg & Janice’s OAS Yearly Income: OAS is only available at age 65. Non-registered yearly income: All investment income is taxable as interest $250,000 inheritance X .05 =

$12,500 gross income

-

$3,125 tax (at 25%)

$9,375 net income

August 2012

Appendix Page 22

Question 6: Retirement Analysis Instructions: 6b. Calculate the total retirement income available to the Brights. Refer to your calculations in Question 6a. Write your answer in the table provided below. Total After-Tax Income: Greg RRSP

$6,865

CPP

4,800

OAS

0

Non-registered Account

9,375

TFSA

2,648

Rental

10,000

Total

33,688

Total After-Tax Income: Janice OAS

0

TFSA

2,648

Total

2,648

Total Income: Greg & Janice

August 2012

36,336

Appendix Page 23

Question 6(c): Retirement Plan Recommendations and Implementation Instructions: 6c. Recommend three ways in which the Brights can ensure that their retirement income is adequate for their desired income needs. Refer to your retirement calculations in 6a and 6b. The Brights will have an annual shortfall of $3,664 at age 60. 1. They can increase their rate of return by 2% by increasing their risk. 2. They can reduce their expenses by $3,664 annually between the ages of 60 and 65. After age 65, both of them will be entitled to OAS, which will eliminate the shortfall. 3. They can consider income splitting techniques, such as spousal RRSPs. Greg can also make Janice a shareholder of the business if he incorporates, allowing her to earn non-registered income in the form of dividends, or an employee, allowing her to earn RRSP-eligible income. 

If Greg hires Janice as an employee, he must pay her the same type of salary that he would pay an unrelated person for doing the same type of work. Therefore, he needs to keep documentation of the type of work she does and her hours in the event that he gets audited by the Canada Revenue Agency.

4. They can invest the inheritance in more tax-efficient income investments, such as dividend-paying stocks or real estate investment trusts (REITs). However, they must ensure that the variability of these income sources is conducive to their risk tolerance. Question 7: Tax Analysis and Estate Recommendation Instructions: 7a. Provide Greg with an analysis of the advantages and disadvantages of incorporating his business in comparison to sole proprietorship. In your answer, ensure that you consider the Brights’ specific situation. 

A key benefit of incorporation is the lower rate relative to sole proprietorship, assuming that income remains in the corporation.



A key consideration in deciding between a sole proprietorship and a corporate form of business is whether income is required to cover living expenses.



Since Greg will require all of his income to pay for living expenses in the coming year, it is not advisable for him to incorporate in the first year of business.



Eventually, when the business generates enough income, such that most of it exceeds personal expenses, it may be more tax efficient for Greg to set up a corporation.



The chief advantage of a corporation is that Greg can determine when and how income will be received.



If Greg incorporates his business, he and family members can receive a salary and/or dividends. Dividend income is more tax efficient than salary and income splitting with family members can reduce the family’s overall tax payable. However, dividends are not RRSP-eligible income.



If Greg sets up a corporation, he will have to pay legal and accounting fees for the annual corporate tax return. For a sole proprietorship, professional fees will be substantially lower.

August 2012

Appendix Page 24



Operating a corporation will limit Greg’s liability to the assets owned by the corporation, unless he gives a personal guarantee for business loans. If Greg operates a sole proprietorship, he will have unlimited liability.



Greg should consult an accountant so that he can fully appreciate what is involved in being selfemployed.

Instructions: 7b. Provide Greg and Janice with recommendations on how to best construct their wills to ensure that their estate is distributed according to their wishes. Ensure that you specifically address all major issues specific to their situation. 

The Brights need to update their contingent executors, trustee and the guardianship for Dillon, since Greg’s mother is not able to perform these functions. They should consider appointing someone who is willing and able to do the job if they both pass away at the same time. The person should be of an age to outlive the Brights.



The Brights should consider creating a trust to secure the financial care of Dillon beyond the age of majority. Typically, most young adults are not able to manage an inheritance. A testamentary trust can be created to distribute the Brights’ estate to Dillon at different ages, beyond the age of majority.



For example, some parents will leave their children 1/3 of their estate at age 21, 1/3 of their estate at 27, and the remaining balance at age 30. A trustee can be given discretion to distribute more of the estate to Dillon for important events in his life, like pursuing higher education.



In order to reduce probate fees on the estate, Greg should name Janice the direct beneficiary of his RRSP and all assets should be jointly held. Joint assets can be rolled over on a tax-deferred basis to a spouse, if the assets are transferred at the deceased spouse’s adjusted cost base.



Greg owns a U.S. condo that could be subject to inheritance tax upon your death. He should speak with a US tax specialist to confirm whether such a tax is in fact payable.

Question 8: Risk Analysis Instructions: Advise Greg on the best form of insurance in the event that he becomes disabled as a self-employed individual. Ensure that you consider the nature of his profession, his income needs and variability of income in considering suitable forms of insurance and features. 

Since Greg is a highly specialized professional, it is unlikely that he will be able to earn the same level of income in another profession.



Therefore, it is advisable for Greg to purchase “own occupation” insurance, which will pay him replacement income in the event that he is unable to perform the duties of his occupation, even if he can be employed in another capacity.



The alternative form of insurance is “any occupation”, which will only pay Greg replacement income if cannot perform the function of any occupation, not just his own.



The greater benefit of “own occupation” insurance should be weighed against the higher premiums charged for this type of insurance as compared to “any occupation” insurance.

August 2012

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

Greg might consider a relatively short elimination period due to the fact that he is the only income earner. Typically, the shorter the elimination period, the greater the insurance cost. Therefore, in determining a suitable elimination period, Greg should consider that he has an emergency reserve to cover 10 months of expenses. If he chooses a longer elimination period, he can cover his expenses with his emergency reserve until he begins to receive disability payments. Alternatively, if he chooses a short elimination period, he might not need as much of an emergency reserve, so that the excess funds can be invested at higher rates of return to achieve longer term goals.



Additional forms of business insurance that might be useful to an entrepreneur, such as business overhead and key person, are likely unsuitable for Greg since his operating expenses are minimal and he is unlikely to find someone to replace him given the specialized nature of his occupation.

Question 9: Investment Management Instructions: Advise the Brights on the suitability of their current investment strategy given the changes in Greg’s employment and family situation, as well as their retirement goals. In your answer, you should evaluate the suitability of strategic and tactical asset allocation for their specific situation. 

Strategic asset allocation would be the most suitable investment strategy for the Brights in retirement.



A strategic asset allocation mix takes into consideration the Brights’ risk tolerance and required investment return to meet their income needs.



Tactical asset allocation, which is currently used in the Brights’ portfolio, should be discontinued given the risk that it adds to the portfolio.



A tactical asset mix overweighs a specific asset class or sector in anticipation of capturing outperformance.



However, the portfolio manager’s outlook may be incorrect or take longer than anticipated to materialize, thereby increasing portfolio volatility.



Increased portfolio volatility can create permanent losses if retirement income is withdrawn from capital rather than investment income.



Given that the Brights are only 7 years away from retirement, a relatively short investment time horizon; it is advisable that the portfolio be rebalanced back to the strategic mix now to reduce portfolio volatility.



Additionally, a new risk tolerance assessment should be done to determine whether the strategic asset mix is still suitable, given the change in Greg’s employment and the short time remaining to retirement.

August 2012

Appendix Page 26