Working toward a debt-free retirement

Safe as your houses in retirement? In our latest Money Makeover, Amanda Morrall looks at the integrity of a property-based savings strategy.

A South Island couple in their 50s – we'll call them Bob and Mary – have four properties between them and no dependents. In addition to their family home, worth an estimated $650,000, they have a bach (QV $210,000), and two rental properties ($375,000 and $350,000). The combined mortgages on all properties are just under $640,000. They receive less than $30,000 a year in rental income.

Bob works fulltime in law enforcement and hopes to retire at age 58 and access his work-related superannuation (estimated to be worth $500,000). His partner Mary works four days a week in the social services sector and would like to stop working at age 60 or earlier. Mary recently joined a KiwiSaver scheme which – at current contributions levels – should be worth $98,000 when she gains access to it at 65.

Together, the couple earns $166,000 (before tax) a year. Apart from the mortgages, Bob and Mary do not have any debt. Bob averages about $325 a month in savings with $7000 put aside in a term deposit. He has another $5000 in a credit union and a savings account.

With possible retirement three years away for Bob and $640,000 in outstanding debt, the couple is contemplating the sale of at least one property. They aren't sure about the timing or how they will fare in retirement if they want to maintain their current lifestyle.

The couple enjoy travelling and are planning a trip overseas in 2010. They would like to go overseas every second year in retirement.

"I feel secure knowing I've got the rental properties, so I hang on to them but I wonder, 'Is that the best?' I also have big mortgages so if I was to sell one property, it would clear up a lot of our mortgages, so would that be a better use of the money?" Mary asks.

For an expert opinion, Money Makeover consulted Fiona Woodford, a certified financial planner with Myles Wealth Management.

After crunching the numbers, Ms Woodford confirms a sale is best, and sooner than later, ideally.

Even with Bob's $500,000 superannuation money, heading into retirement carrying four mortgages is unwise, she says. "It's financially prudent to be completely debt-free at retirement. Otherwise you will have to service the debt out of your own investments. Also, the banks may not be happy for you to have debt when you no longer have any income. Plus, it'll give you some peace of mind," she said.

Using part of the superannuation payout and selling a rental property (valued at $350,000) before Bob stops working at age 58 would clear their debts in one go.

But even with their remaining three properties and Bob's super, Woodford estimates their non- property investment wealth (assuming they spend $45,500a year in retirement) would only last till Bob reaches age 67. If, at that stage, the couple sold their second rental property, it would top up their retirement war chest till 2031 when Bob reaches 78. Still, that could leave Mary (five years his junior) short.

The average life expectancy for men in New Zealand is 78 and 82 for women.

If the couple qualify for and receive New Zealand Super, it would alleviate any concern of a shortfall.

Still, Ms Woodford cautions them against assuming that superannuation is a given.

"The conservative approach [in financial planning] is to not allow for it on the basis that the Government may bring in some income or asset testing or extend the entitlement age," she advises.

But assuming the couple did receive New Zealand Super when each of them turns 70 (as opposed to the current eligibility age of 65), and provided they sold their second rental property, both Bob and Mary should have more than enough to see them through for the rest of their lives.

Without the $24,000 a year they would receive as a couple under the current New Zealand Super scheme, Bob and Mary still have a few options to extend the length of time their wealth lasts: they could sell their home or bach, they could prolong retirement or pick up part- time work later on, be more disciplined about spending, or target a higher rate of return with their investments.

Any of the above could alter the net outcome markedly, Ms Woodford stresses.

"The retirement projection model can be extremely sensitive to changing any of the variables. If you push your retirement back by two years, that can have a significant impact on the value of your wealth. It's two years' extra saving, two years' not spending from your investments, and two years' extra that your investments grow. You'd be surprised what kind of impact that could have."

And the rate of return they choose to target with their investable money is no less significant, she says.

Should they fail to receive New Zealand Super, they could compensate for that lost income stream by using an investment strategy that seeks to achieve higher returns.

Ms Woodford calculates that an 8 per cent rate of return on their investment wealth throughout retirement should give them enough money to live off till Bob turns 80.

Bob describes himself as a conservative investor by nature and says he recently switched his superannuation scheme from growth to conservative because of the current market instability.

Ms Woodford acknowledges Bob's aversion to risk and the need to tailor one's portfolio to personal risk comfort, but cautions him against knee-jerk investor behaviour. She says there are overarching factors that also come into play in financial planning.

"Never mind what is happening at the moment with the markets. The exercise that needs to be done is to establish the most appropriate investment strategy for you over the long term . . ."

For now, Ms Woodford suggests that Bob and Mary make sure their property investments, as they stand, have the greatest tax efficiency possible. "It may be more tax efficient to have the higher mortgage on one of the rental properties as opposed to your home so your home is paid off before the rest.

"It would pay to sit down and talk to an accountant about your options."

Even with optimal tax structures in place, a property-based retirement plan can still be a risky investment strategy, she warns.

"You have to look at the cashflow from property from an after-cost, after-tax perspective and you have to allow for the fact that every once in a while you might need a chunk of money to renovate or fix up the property.

"That's where property can become a bit unstuck in retirement unless you have enough of them that your rent – after tax and costs of return – is equal to or greater than spending requirements in retirement."

Another downside to building one's investment wealth entirely around property is the risk that when you need an urgent sale, it won't happen.

Property is also a barrier to lump sum withdrawals when you need cash.

"That's the problem with property is, you can't eat bits of it in retirement."

The discussion has Bob wondering whether he might not be better off "cashing up" one of the rentals tomorrow and putting the cash in the bank.

Woodford warns against pushing the sell button in haste and points out broader investment principles.

"The important thing is to match the nature of the investment with the likely term of the investment and not get into a situation where you are trying to anticipate what markets are going to do in the short term."

She says a well diversified portfolio is protection in itself during cyclical economic downturns.

"You need diversification, within asset classes, across asset classes and globally, you need to make sure you invest in high quality assets, and have appropriate levels of liquidity in investments."

And overall, investment returns in retirement should be a combination of income and capital gains, she says.

"The dangers of living off just income are: firstly, most people don't have enough capital investment where income – on its own – is high enough on an after-tax basis to cover spending requirements in retirement.

"Secondly, income will drop, if interest rates drop, which is the environment we're looking at now, and that's where a lot of people have got themselves into trouble over the last few years, where they're trying to squeeze out higher returns from their investments by going into higher interest bearing securities, which means taking higher risks.

"With interest rates dropping, if people have all their money sitting in only interest bearing securities, then they're going to be short of what they need to cover living costs in retirement and therefore will have to start eating into their capital.

"That's why it is important to have a blend of income-producing investments and capital growth investments.

The makeup of that blend depends on age, risk profile, capital and the level of spending required in retirement."

* No person or entity (including Myles Wealth Management and The Dominion Post) will be responsible or liable for any errors, omissions or inaccuracies in this article or liable to anyone for any loss, damage, injury or expense suffered or incurred as a result of reliance on the information provided and opinions expressed in the article. Disclosure documents are free and available upon request. Are you interested in being the subject of a free Money Makeover? Email: Amanda.Morrall press.co.nz

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