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Constructed-Response Questions - Part 4 - Post #06 - The CFP Examination - December 2017

Posted by John Gobeil on

The CFP Examination is the second of two exams that must be passed to obtain CFP certification. We have posted this entry to assist you in your preparation for The CFP Examination being held on Friday December 1, 2017. 

In our last Post, we reviewed the Sample Examination Item #3, Question 1. We had some suggestions for answering “List five advantages and five disadvantages of Option 4 for Todd.”

In this Post, we will review the Sample Examination Item #3, Questions 2. We have some suggestions for answering, “If Todd chooses to receive monthly pension income, which is the most appropriate option for him?”

Sample Examination Item #3

James, a CFP professional, is meeting with Todd and Nadine Paulson, both 58 years of age. Both spouses have worked for ABC Financial, a federally regulated financial institution, for many years. Although Nadine has no plans to retire before age 65, Todd, who suffered a massive heart attack six months ago, is retiring at the end of this year, at age 59. Todd has been presented with the following fully indexed RPP income options:

Option 1 – $1,960 per month with 60% survivor pension
Option 2 – $1,890 per month with 75% survivor pension
Option 3 – $1,820 per month with 100% survivor pension
Option 4 – Commuted value of $395,000 (CRA maximum transfer value of $257,000)

If Todd chooses one of the first three options, he is also eligible to receive a bridge benefit of $798 per month until age 65. With his recent health problems, Todd has thought about estate planning issues and wants to maximize any benefits paid to Nadine should he predecease her. Service Canada has confirmed that Todd will be eligible for a CPP retirement benefit of $880 per month at 65 (Nadine qualifies for the maximum amount) and an OAS benefit of $522 per month.

Todd and Nadine each have basic group life insurance coverage of one times salary, which decreases to $2,000 of coverage on retirement. However, the group health coverage will continue at an unreduced level in retirement provided the monthly pension income option has been chosen. Both Todd and Nadine have concerns about the ongoing viability of ABC Financial.

Todd describes himself as a moderate investor and has $125,000 in his RRSP. He has $38,000 in unused RRSP deduction room. To meet their current cash flow needs, Todd will require monthly after-tax income of $2,500. Taxable income up to $39,000 would carry an effective tax rate of 20%, while taxable income between $39,001 and $65,000 would result in an effective tax rate of 31%.

Sample Examination Item #3, Question 2

Having answered Question 1, you would be somewhat familiar with the client situation. However, you will now find information that is irrelevant for Question 1 becomes relevant for Question 2. So, carefully read the response instructions and the response template for question 2.

Response Instructions

If Todd chooses to receive monthly pension income, which is the most appropriate option for him? Provide a brief explanation to support your choice. (3 marks)

Response Template Question 2

Most appropriate pension option Explanation


The fact that there are 3 marks suggests that you are looking for the most appropriate option for one mark and you are looking for two reasons to support your conclusion for one mark each.

The three options all differ in terms of the amount per month and the survivor pension.

Option 1 – $1,960 per month with 60% survivor pension
Option 2 – $1,890 per month with 75% survivor pension
Option 3 – $1,820 per month with 100% survivor pension

So, the two reasons to support your conclusion are something about the amount per month and something about the percentage of the survivor pension.

Maximizing the survivor pension is always nice. So, can they get by on $1,820 per month, rather than $1,960?

Go back and read the situation highlighting relevant information as appropriate.

“Todd has thought about estate planning issues and wants to maximize any benefits paid to Nadine should he predecease her.”

“To meet their current cash flow needs, Todd will require monthly after-tax income of $2,500”.

Nadine is still working and plans to retire in 7 years. While most couples pool their finances, we have no information concerning her income and it would appear that Todd, not Todd and Nadine, needs to provide monthly after-tax income of $2,500 from his pension and other sources of funds.

So, given that option 3 has the greatest survivor benefit, could Todd provide monthly after-tax income of $2,500 from his pension and other sources of funds?

The client situation says, “Taxable income up to $39,000 would carry an effective tax rate of 20%.”

So, while having an effective tax rate of 20%, Todd could earn an after-tax income of up to $2,600 per month, calculated as:                   

  • ((taxable income threshold of $39,000 × (1 - effective tax rate)) ÷ number of months per year) ; or
  • (($39,000 × (1 – 20%)) ÷ 12).

In order to have after-tax income of $2,500 per month, Todd would need before-tax income of $3,125 per month, calculated as:

  • (target after-tax income ÷ (1 - effective tax rate)) ; or
  • ($2,500 ÷ (1 – 20%)).

“Todd suffered a massive heart attack six months ago.” Todd should be eligible for a CPP Disability Benefit of maybe $1,000 per month, which is based upon a flat-rate amount plus 75% of his CPP retirement pension.

Until attaining 65 years of age, Todd would have Option 3 with the bridge benefit, the CPP Disability Benefit and any funds that he withdraws from his RRSP.

So, Option 3 with the bridge benefit and would provide after-tax income of $2,894 per month, calculated as:

  • ((Option 3 + bridge benefit + CPP Disability Benefit) × (1 - effective tax rate)) ; or
  • (($1,820 + $798 + $1,000) × (1 – 20%)).

So, if Todd were to choose Option 3, he could generate his required monthly after-tax income of $2,500 and have the greatest amount of survivor benefit for Nadine.

Please note the following:

Your marginal tax rate (MTR) is the income tax rate that you would pay on your next dollar of taxable income.

Conversely, your marginal tax rate (MTR) is the income tax rate that you would recover from your next dollar of allowable income tax deductions.

His marginal tax rate would be 31%.

In income tax planning, your effective tax rate would be the tax rate that would apply to whatever amount of income or deduction that you might be considering.

In this case the amount of income or deduction that we are considering is $43,416 of taxable income

The question is simplistic in that it ignores the income tax credits.

Of the $43,416 if taxable income, the first $39,000 would be taxed at 20% and the next $4,416 would be taxed at 31%. Then he would get his tax credits deducted at say the 20% rate. The effective tax rate on $43,416 of taxable income, calculated as (income tax liability ÷ taxable income), would be much less than 20%.

We will go with the FPSC’s simple version. Now put this into the response template for question 2.

 Most appropriate pension option Explanation
Option 3 - $1,820 per month with 100% survivor pension.

“Todd ... wants to maximize any benefits paid to Nadine should he predecease her.” This option will maximize survivor income for Nadine.

Todd is able to achieve his income goal to provide monthly after-tax income of $2,500 from his pension and other sources of funds with this option and funds from his RRSP and CPP and OAS benefits upon attaining 65 years of age.

 

Lessons Learned

As financial planners with mathematical skills, we got kind of distracted by the phrase, “To meet their current cash flow needs, Todd will require monthly after-tax income of $2,500”.

The solution just says, “With the bridge benefit, his RRSP and government benefits, he can meet his income goal with this payment amount.”

So, we should keep it simple.

Next Post

In the next Post, we will review the Sample Examination Item #3, Question 3. We have some suggestions for answering, “What annual rate of return would Todd have to earn on his total registered investments to meet this goal?”

Effectiveness of our study aids

We always appreciate feedback on the effectiveness of our study aids. Together, we can continue to have the best study aids available.

John Gobeil, BSc, CFP®
David Gobeil, CPA, CA, CFP®

Certified Financial Planner® and CFP® are certification marks owned outside the U.S. by the Financial Planning Standards Board Ltd. The Financial Planners Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB.


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