The ‘Secret’ to Wealth Creation

Will a good financial adviser create wealth?

Many in the financial planning and wealth management industry want you to believe they hold the secret to creating wealth. They’ll guide you into the right investments. They’ll use their superior technical skills to minimise tax. And, perhaps, they’ll suggest you borrow and invest to accelerate your wealth accumulation.

Some would want you to believe they can perform the financial equivalent of alchemy. But, realistically, the best a truly competent, professional adviser can offer is to help you develop and effectively use the financial resources or capabilities you already have.

In saying this, we do not want to denigrate the value of good advice. It can be substantial, particularly compared with the damage that can result from poor advice or naïve do-it-yourself wealth management attempts. But the ability to provide that value does depend on having some good raw material to work with.

The inescapable truth is that unless you are born into riches, lucky or successfully take inordinate investment risk (either consciously or unconsciously), you are your primary source of wealth creation.

Your wealth depends on your projected surplus capital …

For most people, the further they are away from planned retirement the more likely it is that their most valuable asset is the ability to generate income from work. Either from their own direct employment or running a business that employs others.

But it is not simply their income that is most important for building wealth. Rather, it is the difference between their after-tax income and the amount they spend. This is free cash flow that can be used to purchase investments or repay borrowings.

An estimate of the lifetime value of free cash flow can be made by summing the best guesses of each year’s free cash flow (in today’s dollars) from now to your proposed retirement age.

We call this amount your “projected surplus capital”. For somebody in their 30’s or 40’s, its value may far exceed existing net investment wealth (i.e. investment and superannuation assets less borrowings).

Consider the simplified, hypothetical example of a recently qualified, 35 year old medical specialist and his family. Currently, their net worth consists entirely of the family residence worth $1.5 million. It is regarded as a lifestyle asset, rather than an investment.

Over the next 25 years to his proposed retirement at age 60, the doctor’s best guesses of the annual averages of the key inputs to the calculation of projected surplus capital are as follows:

1. Gross Practice Fees (p.a.)                        $750,000
2. Practice Expenses                                    ($250,000)
3. Net Practice Income (=(1)-(2))               $500,000
4. Net Tax Payable                                        ($150,000)
5. After Tax Income (=(3)-(4))                      $350,000
6. Spending on Lifestyle                               ($225,000)
7. Free Cash Flow (=(5)-(6)                        $125,000 p.a.

Estimate of Projected Surplus Capital = $125,000 p.a.* 25 years to retirement = $3,125,000.

This projected surplus capital, plus the value of the family residence, is the best guess of the family’s wealth in today’s dollars at the doctor’s age 60. His future wealth depends on him being able to deliver on these free cash flow expectations.

In such circumstances, a good adviser will help ensure, among other things, that:

• the doctor pays no more tax than necessary;

• as capital is realised, it is allocated between lifestyle and investment assets consistent with the family’s objectives;

• an investment strategy is implemented, designed to maximise expected return for risk taken; and

• the family’s desired lifestyle is protected in the event of a major insurable catastrophe.

There also may be valuable advice given about running the business more effectively and / or achieving a better work /life balance. But the focus of the advice is more about managing, protecting and, perhaps, enhancing wealth rather than directly creating it.

Increase projected surplus capital to create wealth …

So if wealth managers and financial planners can’t make you wealthy, what is the “secret” to wealth creation. Please keep it to yourself, but here it is:

“For people in the wealth accumulation stage of their lives, they need to be able to generate free cash flow – essentially, spend less than they earn.”

What an insight! So obvious, a huge percentage of the population misses it entirely.

And, it gets better:

“If you want to increase your wealth, then you need to find ways to increase free cash flow and, thereby, increase projected surplus capital”.

Earth shattering!

But think about it. If our doctor could increase his after-tax income by $25,000 p.a. (i.e. by 7%) and reduce his lifestyle expenditure by $25,000 p.a. (by 11%) free cash flow increases by $50,000 p.a. Projected surplus capital increases by $50,000 p.a. * 25 years = $1,250,000. An effective increase in investment wealth of 40%!

Your investment banker or stock broker will not offer you wealth creation opportunities like that. And with no investment risk and, largely, under the doctor’s control.