Our Approach – a case study

Michael and Janet Professional’s financial future ...

To help illustrate how we can help you achieve the financial future you want, it is instructive to look at the situation of Michael and Janet Professional. They are not real clients, but their circumstances and aspirations are similar to many existing clients and others that would benefit from our service.

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Some background …

As you may have guessed, Michael is a professional, perhaps a partner in a major legal or accounting firm. He is 48 and his wife Janet, who is not working, is 46.

They have three children – Jessica, aged 17, James, aged 15, and Jennifer, aged 12. All attend private schools and it is expected they will go to university, with Michael and Janet meeting the cost.

Michael is well regarded in his profession and works long hours. The family enjoys a good quality life and, by any standards, they are a high income household. Looking from the outside, it would appear that they could not possibly have worries about finance related matters.

But a nagging concern for Michael is that he is not sure for how long he can or wishes to sustain working at the current pace. The question is when will he have some choices, given that a significant change in lifestyle spending (i.e. more modest) is not a palatable option.

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Current net worth

A first step in answering this question is to obtain an understanding of Michael and Janet’s current financial position – their assets and liabilities, their expected income and expenditure for the current year and other information relating to such matters as insurance, estate planning and financial structures (e.g. superannuation funds, family trusts, companies).

The Professional family’s consolidated balance sheet is provided below:

Detailed Statement of Capital Assets & Liabilities (Current Position)

Description Michael Janet Joint Total
$ $ $ $
Superannuation Funds        
Superannuation Fund for Janet   75,000   75,000
Superannuation Fund for Michael 600,000     600,000
Sub-total 600,000 75,000 0 675,000
         
Readily Realisable Assets        
NAB Bank Account     75,000 75,000
Coles Myer Ltd   5,000   5,000
Telstra Shares     10,000 10,000
Sub-total 0 5,000 85,000 90,000
         
Land & Buildings        
Family Residence     3,000,000 3,000,000
Holiday House   600,000   600,000
Investment Unit 700,000     700,000
Sub-total 700,000 600,000 3,000,000 4,300,000
         
Other Assets        
Furniture     100,000 100,000
Janet's Jewellery   75,000   75,000
Sailing Boat 70,000     70,000
Sub-total 70,000 75,000 100,000 245,000
         
Motor Vehicles        
BMW - Michael's Car 60,000     60,000
Mercedes - 4 Wheel Drive - Janet's Car   70,000   70,000
Sub-total 60,000 70,000 0 130,000
         
Liabilities        
Michael's Amex 3,000     3,000
Holiday House Loan   275,000   275,000
Home Loan     400,000 400,000
Investment Unit Loan 300,000     300,000
Sub-total 303,000 275,000 400,000 978,000
         
Net Worth 1,127,000 550,000 2,785,000 4,462,000
         

There are a number of “issues” with this balance sheet, but our initial focus is always on “Net Investment Wealth” i.e. “Net Worth” less lifestyle assets. In the Professional’s case this is:

Net Worth   4,462,000
$
Less    
Lifestyle Assets    
  Family Residence $3,000,000  
  Holiday House $600,000  
  Other Assets $245,000  
  Motor Vehicles $130,000  
  Total Lifestyle Assets   (3,975,000)
Net Investment Wealth       487,000

 

Net Investment Wealth (“NIW”) is what the family has to live off if Michael is not working. As a rough “rule of thumb”, we assume NIW will support annual ongoing lifestyle expenditure of about 4% of the total, or $19,480 a year (in today’s dollars).

The Professional’s balance sheet is heavily focused on supporting their current lifestyle. As we will see, their net investment wealth is considerably less than what it needs to be to support their desired future lifestyle.

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Current income – "cash inflow"

Michael and Janet agree that the following represents their best estimate of likely cash inflow for the current year:

Detailed Analysis of Income (Current Position) Michael Janet
$ $
Employed Income    
XYZ Professionals – Trust Salary   75,000
XYZ Professionals Salary 775,000  
XYZ Professionals Super -38,750  
Sub-total 736,250 75,000
     
Investment Income    
NAB Bank Account Interest 1,478 1,478
Coles Myer Ltd Dividend   203
Telstra Shares Dividend 202 202
Investment Unit Rental Income 20,485  
Sub-total 22,165 1,883
     
Deductions    
Advisor (Accountant) 1,500 1,500
Gifts to Charities 5,400  
Sub-total 6,900 1,500
     
Imputation Credits    
Coles Myer Ltd Dividend (Imputation credit)   87
Telstra Shares Dividend (Imputation credit) 86 86
Sub-total 86 173
     
Total Income before deductions and rebates 758,415 76,883
     

Michael’s firm is structured to allow him to split $75,000 of income with Janet and hence reduce total taxation. Michael is currently not maximising his superannuation contributions, while Janet is not making any contributions to superannuation at all.

Based on the above income, Michael and Janet’s tax statements for the current year are as follows:

Taxation Statement (Current Position)   Michael   Janet
$ $
Total Earned Income   736,250   75,000
ADD Total Investment Income   22,165   1,883
ADD Imputation Credits   86   173
LESS Deductions   6,900   1,500
Taxable Income   751,601   75,556
         
Tax Payable        
At Tax Rate 0% on $6,000   on $6,000  
At Tax Rate 15% on $28,000 4,200 on $28,000 4,200
At Tax Rate 30% on $46,000 13,800 on $41,556 12,467
At Tax Rate 40% on $100,000 40,000 on $0  
At Tax Rate 45% on $571,601 257,220 on $0  
Sub-total   315,220   16,667
         
LESS tax offsets   86   173
Imputation Credits        
Total Income Tax Payable/(Refund Due)   315,134   16,494
         
ADD Medicare Levy   12,407    
         
Summary of Income Tax Payable/(Refund Due)   344,036   22.93%
         
Average Tax Rate   43.04%    
(Tax Payable / Total Income)        
Average Tax Rate   43.43%   23.33%
(Tax Payable / Taxable Income)        
         

Clearly, a lot of tax is being paid, but as revealed below, even after tax and Michael’s superannuation contributions, there is significant cash inflow or “net spendable income” to meet anticipated outgoings.

Calculation of Net Spendable Income (Current Position) Michael Janet Total
$ $ $
Total Earned Income 736,250 75,000 811,250
Total Investment Income 22,165 1,883 24,048
Total Tax Free Income/Tax Refunds      
Sub-total 758,415 76,883 835,298
       
LESS Income Tax payable 315,134 16,494 331,628
LESS Medicare Levy 11,274 1,133 12,407
       
Net Spendable Income      
per year 432,007 59,256 491,262
       

With almost $500,000 p.a. of available cash inflow as the fruits of Michael’s labour, both Michael and Janet feel both justified and able to live a very good quality lifestyle. Certainly, their friends and most of Michael’s colleagues appear to be living a similar lifestyle with no apparent concerns regarding their financial futures.

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Current expenditure – “cash outflow”

Michael and Janet’s first ever detailed analysis of their expected spending (for this year) shows the following:

Detailed Analysis of Expenditure (Current Position)

Housekeeping Expenses $
Family Residence Electricity 3,500
Family Residence Garden 5,000
Family Residence Gas 1,000
Family Residence Help in House 5,000
Family Residence House and Contents Insurance 1,000
Family Residence Internet 1,000
Family Residence Local Taxes 2,000
Family Residence Repairs and Renewals 15,000
Family Residence Swimming Pool Maintenance 2,000
Family Residence Telephone 1,500
Family Residence TV/Video Rental 1,000
Family Residence Water Rates 1,000
Holiday House Electricity 700
Holiday House Garden 2,000
Holiday House Land Tax 2,000
Holiday House Local Taxes 1,600
Holiday House Repairs and Renewals 4,000
Holiday House Telephone 500
Holiday House Water Rates 500
Groceries 18,000
Sub-total 68,300
   
Personal Expenses  
Christmas & Birthday Gifts 9,000
Clothing & Footwear - Janet 6,000
Clothing & Footwear - Michael 5,400
Contingency 6,000
Cost of maintaining Sailing Boat 7,200
Eating Out 9,000
Entertainment (Cinema, Theatre etc) 4,800
Gifts to Charities 5,400
Holidays 24,000
Home Entertainment 3,000
Laundry & Drycleaning 1,200
Medical Costs 3,000
Outings 3,000
Pocket Money - Janet 3,600
Pocket Money - Michael 3,600
Sports and Hobbies 6,000
Subscriptions 1,200
Wine & Spirits 4,800
Sub-total 106,200
   
Children / Grandchildren  
James Clothing and Footwear 2,000
James Education Expenses 16,640
James Other Expenses 3,000
James Pocket Money 1,000
Jennifer Clothing and Footwear 2,000
Jennifer Education Expenses 16,640
Jennifer Other Expenses 3,000
Jennifer Pocket Money 1,000
Jessica Clothing and Footwear 2,000
Jessica Education Expenses 16,640
Jessica Other Expenses 3,000
Jessica Pocket Money 1,000
Sub-total 67,920
   
Cost of Servicing Debts  
Michael's Amex 420
Holiday House Loan 27,037
Home Loan 72,512
Investment Unit Loan 21,000
Sub-total 120,969
   
Motoring Expenses  
BMW - Michael's Car Depreciation 8,000
BMW - Michael's Car Fuel & Oil 2,000
BMW - Michael's Car Insurance 1,500
BMW - Michael's Car Registration 400
BMW - Michael's Car Road Service Subscription 75
BMW - Michael's Car Servicing 1,500
Mercedes - 4 Wheel Drive - Janet's Car Depreciation 10,000
Mercedes - 4 Wheel Drive - Janet's Car Insurance 1,500
Mercedes - 4 Wheel Drive - Janet's Car Servicing 2,000
Mercedes - 4 Wheel Drive - Janet's Car Fuel & Oil 2,500
Mercedes - 4 Wheel Drive - Janet's Car Registration 400
Mercedes - 4 Wheel Drive - Janet's Car Road Service Subscription 75
Sub-total 29,950
   
Professional Fees  
Advisor (Accountant) 3,000
Sub-total 3,000
   
Insurance  
Term Policy - Janet 2,400
Health Fund - Janet 1,800
Health Fund - Michael 1,800
Sub-total 6,000
   
Total Expenditure 402,339
   
Summary of Cash Outflows (Current Position)  
  $
Housekeeping Expenses 68,300
Professional Fees 3,000
Personal Expenses 106,200
Children / Grandchildren 67,920
Cost of Servicing Debts 120,969
Motoring Expenses 29,950
Insurance 6,000
   
Total Expenditure 402,339


Excluding the “Cost of Servicing Debts”, ongoing lifestyle expenditure for the family is estimated at $281,370 a year. While the children will eventually leave home (hopefully!) and after debts have been repaid, the numbers suggest a lifestyle expenditure of about $210,000 p.a. (in today’s dollars) for Michael and Janet to maintain their current lifestyle when Michael is no longer working. Michael and Janet are a little shocked at how much they spend, because they do not feel they live a lavish lifestyle.

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Preliminary observations ...

Based on our 4% p.a. “rule of thumb” discussed earlier, lifestyle expenditive of $210,000 p.a. implies a net investment wealth requirement of $5,250,000 (again, in today’s dollars) for “financial independence” i.e. free to choose whether or not to work. With current net investment wealth of only $487,000, already at this early stage of analysis we can tell there are some issues for the Professional family.

However, all is not lost. The table below shows that provided Michael continues in his current role, sizeable cash flow surpluses are expected to be available that, together with super contributions, can be applied to increasing net investment wealth:

Inflows and Outflows (Current Position)

Description Michael's
  age 48
  $
Total Inflows 835,301
Income Tax & Medicare Levy 333,612
   
Net Inflows 501,689
   
Outflows  
Housekeeping Expenses 68,300
Professional Fees 3,000
Personal Expenses 106,200
Children / Grandchildren 67,920
Cost of Servicing Debts 120,969
Motoring Expenses 29,950
Insurance 6,000
   
Total Outflows 402,339
   

Currently, annual cash inflows exceed annual cash outflows by $99,350

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“Journey into the future”

With their existing financial situation agreed, we then take the Professionals on their “journey into the future”.

We plan for our clients to live to age 100 – longer, if requested. We ask them how they wish to be living in five years, ten years, during retirement. We ask them to think about likely once-off expenditures, such as renovations, moving house, weddings, new cars, major holidays, helping children buy a first apartment, supporting the education costs of grandchildren etc.

We ask them not to constrain themselves in their aspirations, but to also think carefully about what it is of most importance for them to achieve. Our task is to see whether those aspirations and objectives are achievable based on the way they currently organise their financial affairs and their projections of future income and expenditure.

Some suggest that it is foolish to Plan so far ahead. They say the world is far too uncertain and we have enough trouble just predicting what tomorrow will bring. We agree.

But the purpose of the projections and associated modelling is not to predict, but to see what the future looks like based on the best assumptions we can make now. If we don’t like what it looks like, the modelling provides a framework to see the huge effect that some sensible and often modest changes made now can make if implemented in a disciplined way over long periods of time.

Life consists of a series of decisions made under uncertainty. We believe that these decisions are likely to lead to better outcomes if they are well informed and proactive, rather than ill informed and reactive or, worse still, made by default or not at all due to decision making paralysis.

For Michael and Janet, key inputs into their long term planning include:

  • Michael believes he is unlikely to work in his current professional role beyond age 55 – we assume his income continues to grow at 1% p.a. above inflation until then;
  • For the period from age 55 to his projected retirement age of 65, Michael would like to take on a couple of company directorships. It is to be assumed that he is able to earn $300,000 p.a. in directors’ fees (in today’s dollars) but will not be able to split any of this with Janet;
  • It is projected that the holiday house will be sold in 12 years time, at Michael’s age 60, as the children are considered unlikely to want to holiday there once they have left home. In fact, the holiday house has already lost a lot of its appeal for teenage children;
  • An inheritance of $500,000 (in today’s dollars) is assumed to be received in twenty years time, reflecting the reality that either or both Michael and Janet will receive a meaningful sum from parents’ estates at some time in the future;
  • An amount of $200,000 (again, in today’s dollars) is to be given to each child at their age 25, to assist with purchase of an apartment; and
  • They would like to leave a significant estate for their children.

Together with many other assumptions regarding such matters as retirement lifestyle expenditure, superannuation and investment returns, and superannuation pensions, a long term cashflow is constructed. The chart below shows the cash inflows and outflows for the Professionals based on their best guesses of their desired future assuming they continue to manage their finances as they have in the past.

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Chart 1: Inflows/Outflows Chart (Current Position)

 

Things to note include:

  • The surpluses of cash inflows over outflows, while Michael continues to remain a partner of the professional firm to his age 55;
  • The large cash inflow from proceeds of the sale of the holiday house at Michael’s age 60;
  • The receipt of the inheritance at Michael’s age 68; and
  • Except for the once-off large inflows, an excess of ongoing cash outflows over ongoing cash inflows for most years after Michael’s age 55. In particular, superannuation pension income from age 65 onwards will not be sufficient to meet expected expenditure.

The issue is:

Based on the assumptions, can Michael and Janet accumulate sufficient additional Net Investment Wealth from projected cash flow surpluses to finance the projected cash flow deficits, particularly beyond Michael’s age 65 to his age 100 i.e. “will they run out of money”?

As a base case assumption, we initially consider that surplus cash flows are invested in low risk assets (e.g. bank deposits) and earn only 2% p.a. after tax. If the modelling indicates that even with this conservative investment assumption Michael and Janet would “not run out of money” by Michael’s age 100, an implication is that it is not necessary to invest surplus cash in riskier assets (e.g. shares and property) to achieve their lifestyle objectives.

The chart below addresses the “run out of money” question:

Chart 2: Cashflow Consolidation (Current Position)

 

It shows that while Net Investment Wealth rises to a little under $3 million at around Michael’s age 68, it would be completely exhausted by Michael’s age 87. The Professionals are literally “in the red” - and would need to sell lifestyle assets to meet their ongoing living costs. Certainly, the children’s inheritance is looking a bit vulnerable.

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“Out of the red” and “Into the blue”

The inference is that something has to change if the Professionals are to increase the likelihood that they will not “run out of money” and remain “in the blue”. These changes do not necessarily mean a winding back of lifestyle objectives, implicit in such alternatives as Michael working longer, Janet finding a job or reducing ongoing expenditure. These are considered last resort fall backs.

Almost without exception there are relatively painless structural changes that can be made, that reduce net tax paid and avoid unnecessary costs, by eliminating balance sheet inefficiencies.

Also, the Professionals may be comfortable taking a higher level of investment risk with their surplus funds than simply placing them in the bank, with an expected (but not guaranteed) after-tax return in excess of 2% p.a..

Serious consideration also needs to be given to whether there are any aspects of current lifestyle that are holding back financial progress, but not providing more than compensatory benefits. Psychological research shows that we tend to place a higher value on things we own than an objective market valuation would suggest. We tend to overweight the loss we expect we will feel if we sold those things. Often, third party intervention can identify these situations and initiate more rational assessments.

For example, the Professionals have considered selling the holiday house a number of times. However, it has been in the family a long time and many happy memories are attached to it. Each time market valuations have been sought, Michael and Janet have been disappointed with the feedback – "the market" just does not seem to appreciate the value that is so obvious to them.

However, the holiday house is a significant financial drain. It is rarely used, as the children would now prefer to spend weekends and holidays with their friends, rather than with the family. Regardless, it still costs $11,000 a year to maintain plus interest costs. Because the Professionals don’t wish to rent the property, maintenance costs and interest on the loan are not tax deductible. And from a purely investment viewpoint, the holiday house only exacerbates their already large and concentrated exposure to direct property (see "Foundations of Financial Economics: Diversification is Key").

But how would "the big financial picture" look if the Professionals sold the holiday house immediately and invested the proceeds in Janet’s name. Considerably better, as the revised projection remains "in the blue", as shown in the chart below:

Chart 3: Cash Flow Consolidation (Sale of Holiday House and Investment)

 

The analysis reveals that, based on the assumptions, there is a huge opportunity cost in continuing to hold the holiday house. The framework aids rational decision making. Is the emotional attachment to the holiday house worth the now explicit foregone opportunity to make significant progress toward financial independence? Overlaid on this should be our view that while purchase (or ownership) of a holiday house may be a good lifestyle decision, for most people it is usually a poor investment decision.

A number of additional strategies could be considered to enhance the Professional’s financial outlook. Together with the sale of the holiday house and some relatively conservative investment assumptions (based on the experience of the past 25 years), a Plan is developed that suggests the Professional’s financial and lifestyle objectives are now comfortably achievable, as shown below:

Chart 4: Cash Flow Consolidation (Draft Recommendations)

 

The strategies that result in the above cashflow consolidation imply a better matching of long term cashflows, as revealed in the following chart (that should be compared with Chart 1.). The projected earnings on the "peak" Net Investment Wealth of about $4.7 million at Michael’s age 68 are approximately sufficient to fully fund the Professional’s lifestyle without drawing down on capital. The children’s inheritance is looking good!

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Chart 5: Inflows/Outflows Chart (Draft Recommendations)

 

Of course, over time things will change and, perhaps, dramatically. But, provided Michael and Janet regularly review their strategies and assess their progress against what may be moving objectives, they are unlikely to have to make unexpected, significant changes to their lifestyle. They are constantly “iterating” to their desired future, rather than subjecting themselves to the risk and psychological trauma of potential massive lifestyle disruption due to a failure to look any further forward than next year’s holiday!

Some readers may have noticed that in the above discussion there was little explicit mention of investment risk and virtually nothing on investment alternatives. And that is deliberate. Iin our view, it is your objectives that drive the planning process. If these can be achieved without taking any investment risk (i.e. all surplus cash can be put “in the bank”), then taking additional risk is a choice rather than a necessity.

If objectives do not appear achievable initially, our immediate focus is on testing the status quo (e.g. does it make sense to continue to own a holiday house) and making structural changes, aimed to reduce taxes and eliminate unnecessary costs. It is only after these avenues have been exhausted and a gap between projected and desired lifestyle remains that increased investment risk is considered.

The amount of investment risk required is driven by the size of the gap that needs to be closed. This then needs to be tested against your attitude to risk. If your “need for risk” indicates a more growth oriented investment portfolio than your “attitude to risk” suggests you would be comfortable with, this serves as the basis for a very important discussion – the dilemma often described as “eat well or sleep well”. For a more detailed explanation on how we work with you to select an appropriate asset allocation, see the “The Asset allocation Decision”.

It is only after the critical asset allocation choice has been made that we give any consideration at all to specific investments. As discussed in “Our approach”, a core principle is to focus on the things you can control or influence, and not on those you can’t. When it comes to investment, this means focusing on costs, risks and taxes and not on chasing market outperformance.

For a fuller explanation of our investment philosophy, see our “Foundations of Financial Economics”. Our investment approach is based on the findings of the world’s pre-eminent researchers in financial economics and is consistent with our aim to give you the best chance of achieving your desired investment outcome, with minimum risk.

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How much is “peace of mind” worth …

What is the benefit of our strategic approach to financial planning? It is hard to put a dollar figure on it because it is different for every client.

However, the detailed analysis supporting the Professional’s case study includes the following potentially positive financial outcomes from the planning process:

  • a much improved ongoing cashflow situation, with no need for unplanned, and potentially forced, asset sales;
  • a 10% reduction in lifetime tax payable;
  • a 48% increase in the projected retirement income stream; and
  • a projected 21% improvement in the Professional’s net worth at Michael’s age 65.

Such potential enhancements do not derive from taking excessive risk but reflect the gains that can be made by taking a long term view and comprehensive account of all financial resources – assets, liabilities and the composition and timing of future cashflows.

We believe that only by taking such a "big picture" approach is it possible to build coherent, integrated strategies that most effectively use your financial resources and give you the best chance of achieving your financial objectives. The usual alternative of a concoction of short term actions in response to short term issues almost always results in outcomes that may conflict with each other and your long term objectives and expose you to more risk than necessary.

However, from the Professional’s and our clients' viewpoint, the greatest value is probably the peace of mind that comes from knowing that their financial affairs are being given the ongoing attention they deserve.

We believe you will think the smartest decision you ever made regarding your financial future is when you contact us to set up an obligation free introductory meeting to discuss how we can help you.

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