December 1, 2002
by John Nicola
In Dickens’ classic novel Great Expectations the hero, Phillip Pirrip (Pip), receives significant wealth from an unknown benefactor only to lose it all through bad luck and hubris. The story ends well, however, as Pip rediscovers the importance of his early relationships and rebuilds his life.
If Pip were alive today he could easily be one of the victims of the “Millennium Equity Bubble” that we have been experiencing.
o The world’s blue chip indices are down 43% from their peaks of 2000 and yet, by any reasonable standards of value, they are still very expensive.
o The NASDAQ is giving the Nikkei Index in Japan a real run for the title of “Largest Financial Sinkhole.” The NASDAQ may win on points, considering that it has accomplished in two years what the Nikkei has taken 13 to deliver.
o Interest on GIC’s, bonds and money market funds are the lowest they have been in 40 years
o To round things out there are numerous analyses and prognostications that predict the next bubble is already upon us and it is real estate.
In this environment even the most ardent optimist could be forgiven for assuming that their retirement plans have been badly mauled.
Over the last year, we have had many meetings with our clients where they have expressed significant concerns regarding their investments: the possibility that “Lesser Expectations” will be needed and that “Freedom 55” will have to be replaced by “Freedom 85.”
The dialogue below is a compilation of some of those discussions. The concerns are real and need to be dealt with, but, as with Dickens’ novel, it can all end well.
Bob and Ellen Sanders are in their late 40s with their children almost independent. They have been working on the assumption that they could retire comfortably at age 60 on an income of $100,000 per year after tax. Their other key financial facts are:
o Current retirement savings of $750,000
o They hope to sell their professional practice for $350,000 at age 60.
We had done several retirement projections for them assuming a 7% return on their assets and 3% inflation (this means a real rate of return of 4% annually, which is a little less than a balanced portfolio of stocks and bonds would have earned over the last 100 years).
The projections showed that they needed to save $43,000 annually for the next 14 years to comfortably achieve their goals. Given their pre-tax family income is slightly in excess of $250,000 annually, this was a comfortable objective for them. What follows is a transcription of our latest review meeting with them.
BOB: John, I just finished reading your last newsletter, Back to the Future, where you predicted that it could take another 10 years for the markets to get back to where they were in 2000. I can’t tell you how wonderful that made me feel. If the returns in the market are going to be zero and money market funds are paying 2%, then exactly how exactly will we make 7% between now and age 60? If you don’t have a really good answer, then I hope you keep some Prozac in the office.
JOHN: Fair comments Bob, but you should know I am not predicting a zero percent return for the markets for the next 10 years. That would be what is required to create good value in the general equity markets. I also said that in the period from 1969 to 1982, stocks provided no net capital gains to investors. If they did not receive a high dividend, then they made very little return at all. In other words: during that period, cash flow was king, as I believe it is today.
BOB: Nevertheless, do you still think we should be assuming a 7% return on our assets in this environment? How much more will I have to save if we assume a return of 6% or worst case 3%? Or how much longer will it mean that we have to work for?
JOHN: Let’s pull up your last retirement analysis and put your new assumptions into it.
BOB: There isn’t enough Prozac in the world to make me feel good about those numbers. You might as well take me behind the barn and shoot me.
JOHN: Well, if we did that at least Ellen would be in good shape financially. You have an excellent life insurance program.
BOB: This reminds me of the plot of that movie “Double Indemnity.” I can only assume you have a more attractive option than that.
JOHN: To be serious for a moment, we do. There are a number of considerations. We should begin by looking at the big picture so we can examine how you might modify your own assumptions to make your current plan work, even if you’ve changed your view on the returns you can make from now on.
The first step would be to look at what type of assets have shown good returns in this environment and what, in our opinion, will work in the future.
Many sectors have done well over the last three years, including income trusts, mortgages, bonds, income producing real estate and certain types of annuities. In each case, they have shown very positive real rates of return over inflation.
While the markets are not cheap, there are always companies whose stocks are depressed and represent good value. In many cases, they also pay excellent dividends such as the banks, utilities, and telcos (assuming they are not WorldCom). Dividends show a commitment on the part of management to deliver a specific and ideally growing part of profits to the owners of the business.
There is a saying that claims “a rising tide lifts all boats.” With respect to markets, it explains why any company performed well in the 1990’s regardless of their hopeless business viability (remember Boo.com?). The corollary is that a falling market often takes no prisoners and the good fall with the bad. The difference is that good companies are still profitable and often pay a reliable income return to investors. They will recover and even prosper, but patience and a disciplined approach are needed to recognize those companies.
The above, notwithstanding, there are other non-investment approaches that Bob and Ellen can take to reach their financial goals, and we believe that a 4% real rate of return assumption is reasonable (e.g.: a 7% gross return with 3% inflation). However, we can lower that assumption to 3% real return (the same return that bonds have achieved over the last century or so). This is a number that Bob and Ellen can realize by putting all of their assets into a combination of bonds, GIC’s , mortgages and other conservative income producing assets. We are not suggesting that they need to do this. Rather, we are saying that we could be this conservative and still get their goals accomplished through other means.
The problem is that a drop of 1% in the investment assumption almost doubles what they need to save for retirement (savings need to increase from $43,000 per year to $83,000 per year). This is well beyond their ability. Alternatively, Bob and Ellen can work until age 66 and then meet their goals. Since we have put the idea of taking Bob out to the barn on the back burner, we need to consider real alternatives.
Here are several that will work cumulatively to put them back on their plan:
REDUCE RETIREMENT INCOME GOALS LATER IN LIFE: Bob and Ellen have said they need $100,000 per year after tax in 2002 to retire with the lifestyle they want. A significant part of that is travel and they are both very fit and active. It may be reasonable to assume that, after a certain age, they may travel less and need less (we certainly see this with many of our older clients). If they assume that they will only need $80,000 per year after tax in 2002 from age 75 on, for example, they can reduce that $83,000 per year of savings to $64,000 per year.
PART-TIME WORK AFTER AGE 60: Bob is a dentist and Ellen is a teacher. An option for one or both of them is to consider the effect of part-time work after they officially retire. Many of our clients have said they would rather be able to keep working on some basis after retirement, but on their own terms. There will be a huge labor shortage in Canada over the next 30 years and people as skilled as they are will be in great demand. Let’s assume Bob and Ellen both work 3 months a year between age 60 and 65 and earn $50,000 per year in 2002. If they do that, they can reduce their annual savings from $64,000 per year to $48,000 per year.
REVERSE MORTGAGE: Many older Canadians have decided to use a reverse mortgage to extract some of the equity of their home to enhance their current income. If Bob and Ellen received an income from a reverse mortgage at age 75 of $12,000 per year it would reduce their savings requirements now by another $6,000 per year to $42,000 annually. This is a little less than they are saving now. While, this strategy will reduce their eventual estate value, if only one of them lives to age 90, then their children will be in their 60s and are unlikely to need an estate from their parents.
LOWER TAX RATES AT RETIREMENT: When we first did their retirement projections we assumed that Bob and Ellen would have an average tax rate on their income of 20%. In other words they would really need a pretax income of $125,000 per year and then pay 20% tax ($25,000/yr.) to net $100,000 per year after tax. If we take advantage of the maximum benefits of income splitting and invest in assets whose income is not always fully taxable (such as dividend paying equities, capital gains, rental income and annuities), then we can reduce their average tax rate to 12%. We know what you think: In Canada no couple who nets $100,000 a year in income pays only 12% tax — legally. However, it can be done quite easily. If they accomplish that, they can now reduce their savings requirement to $27,000 per year and still make a 3% real rate of return.
We live in a very tough investment environment and all assumptions about wealth building and retirement need to be constantly monitored. We have built some very powerful analysis tools for our clients to assist with their planning and if you would like your own set of these tools, please ask us and we’ll send them to you; all you need is MS Excel and a little assistance.
With a little creativity, Bob will not need to go behind the barn or get Prozac. For Bob and Ellen, their “great expectations” can be met.
Maybe it’s time to review your financial plan and the assumptions you’re operating under. What is the next step for your financial peace of mind?
John Nicola is the president of Nicola Financial Group in Vancouver, BC. The company specializes in financial planning for professionals. He is a frequent lecturer at dental conferences and study programs.