Starting over on your own

BY AMANDA MORRALL

Separation and divorce can exact a high price financially. In our latest MoneyMakeover we examine one man's efforts  to rebuild and grow his wealth.

Brad is a 27-year-old professional living and working in Christchurch. He earns $107,000 a year, before taxes, from his job and a small business he owns. Two years ago, he separated from his partner and they split up the assets. Brad ended up buying his partner out of her share of a house and a rental property they owned together. He carries mortgages on both. Despite the financial setback, Brad feels that he is doing OK but wants to know what, if anything, he could be doing better. Given his high debt load, he wonders whether the rental property is actually a "productive investment" or a liability. Apart from a two- month trip overseas (for which he has put aside $15,000) and some landscaping (approximate value $10,000) he would like to do on his house , he does not have any major financial wants. His main goal is to make the most of his assets in order to grow his wealth. Given his age and status as a single person, he says he isn't scared of sacrificing and working harder provided "it pays off in the end".

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Here's how his situation breaks down:

Income: $107,000 per year before tax

Rental revenue: $16,500 per year

Assets:

Home: $440,000

Rental property: $270,000

Bike & car: $12,500

Business: $2000

Liabilities:

Mortgage on house: $304,000

Mortgage on rental: $263,000

Hire purchase: $4000

Savings:

Holiday fund: $15,000

KiwiSaver: $8000

Superlife: $20,000

Insurances:

Income protection: $35,000 cover per year

Health: basic cover paid for by employer

Death: $214,000

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For an expert opinion, MoneyMakeover consulted certified financial planners James Smith with Bradley Nuttall Limited and Fiona Woodford with Myles Wealth Management.

James Smith

Brad is a young guy who seems to know what he wants out of life. Despite being just shy of his 28th birthday he has made a good start to his professional career and put in place a savings plan; if he can stick to this it will provide financial security down the track.

He has also demonstrated an appetite for taking on risk (according to a risk profile questionnaire completed for this exercise). This is not a bad thing and can assist with wealth creation. However, Brad needs to make sure he safeguards his good start and his future financial progress by taking the time to properly assess both the risks and rewards.

Income and Expenditure

Brad's gross income of $107,000 per year equates to approximately $76,000 after tax. His budget calculations were a little fuzzy in terms of where his income goes. This is not an uncommon problem for a 27-year-old, but does highlight the need to try to stay on top of any spending and to develop an appreciation of where it all goes.

Property and Gearing

Brad has about $136,000 of equity in his main home, plus a rental property worth $270,000 which has a mortgage of $263,000. The rental income is around $16,500 per year, but with rates of $1900 per year and mortgage principal and interest repayments of $21,000 per year there is a shortfall of around $6400 each year that Brad will need to fund from income.

Whilst this level of gearing (97 per cent) involves risk, it does force Brad to save regularly by making up the shortfall. Provided he can keep up with the current repayment schedule the rental property should be debt-free by 2036 (Brad's 53rd birthday).

Superannuation and KiwiSaver

Brad was a little unclear on the details but it does appear that he has 14 per cent of his earnings (personal and employer contributions) going into a combination of KiwiSaver and Superannuation. If we add in the tax credits from Government that are going to KiwiSaver, this amounts to regular savings of $15,000 per year.

Retirement

If we assume Brad continues to save at his present levels and his growth strategy generates a return of 4 per cent per year net of tax, fees and inflation, then at age 55 he will have a fund in today's terms of around $850,000 (Young readers should note well the benefit shown here of starting to save early).

If we bring in the rental property and assume the capital value grows at, say, 2 per cent per year (again net of tax, fees and inflation) then by Brad's 55th birthday this will be worth a further $470,000.

Obviously, there a fair amount of uncertainty with projecting this far into the future. Provided Brad can stick to his current savings programme he will accumulate a strong asset base by his mid- 50s and be in a position to reduce his working hours - or even contemplate retirement.

Balancing the risks

Brad should congratulate himself on the good start he has made. However, he would be well advised to give proper consideration to reviewing the risks to his long term plans.

Brad has little need for any additional life cover at this stage but still has exposure to certain "living risks", such as long-term disablement or a major illness. If these occurred they would impact negatively on his ability to save and meet living expenses.

At a minimum, I would recommend that Brad increase his current income protection cover so that he would receive 50 per cent to 75 per cent of his current income in the event that he is unable to work. I would also recommend that the policy be based on his inability to follow his "own occupation". Also, any claim benefits should be payable until age 65 and should increase each year so that they keep pace with inflation.

Given the shortfall on his rental, Brad would be wise to build a decent cash reserve. As a minimum I would recommend $10,000, but closer to $15,000 would be better.

A Family Trust would provide another layer of protection for Brad, including claims under the Property Relationships Act. I would therefore recommend he seek the services of a good lawyer and ask them to outline the potential costs and benefits of setting up a trust.

Fiona Woodford

You have done well, Brad, given your age, to be on track for achieving your retirement goals, although you are very reliant on the income and benefits from your current employment.

Based on KiwiSaver contributions of 2 per cent each from you and your employer, SuperLife contributions of 5 per cent from you and 4 per cent from your employer, and after tax returns of 5 per cent per year, the estimated future value of your KiwiSaver will be $852,000 (65) and your Superlife $1060,000 (60). Assuming your rental property is debt-free by age 60 and inflation adjusting the value at 2.5 per cent per year, the estimated future value of this could be, say, $610,000. Therefore you should build up sufficient funds enabling you to retire at age 60, with $60,000 per year (in today's dollars) to live off for 20 years.

There are three main issues to consider. Firstly, nearly 60 per cent of your total income repays debt. With interest rates expected to increase, so too will debt repayments, meaning less income to save and live off. You are currently contributing $700 per month towards the rental mortgage repayments, but should the property be vacant for any period of time, this will quickly have a negative cashflow impact. The current yield on the property is 4.6 per cent (excluding debt), and given the shortfall required to service this, further thought should go into whether there are better investment alternatives.

Secondly, because of your high level of retirement savings and debt repayment, your spare funds for other goals, such as landscaping your home and regular travel, are limited. You could consider reducing your Superlife contributions down to 5 per cent (which is the calculation used above) to build up funds outside of retirement savings. You should set up an emergency fund of three months worth of expenses in an on-call bank account. Once achieved, further savings can be accumulated in income investments to cover short and medium term goals.

Thirdly, you only have income protection of $35,000 per year net, which in the event of a claim would only cover debt repayments on your home, with little left to live off. Although you have life insurance, Trauma and TPD cover may be preferable given the main risk you face is illness or injury preventing you from working. We strongly recommend you have a complete analysis of the risks you face carried out by an insurance specialist.

Given that your relationship status (single with no dependents) could change at any time, it is important to review the ownership of your assets to protect them from future claims. This will include the consideration of a trust, wills, property relationship agreements, and Enduring Powers of Attorney.

It would be very useful at this stage to have a formal financial plan prepared by a qualified adviser to evaluate how much of your income should be diverted to retirement savings, debt repayment and other lifestyle goals. An assessment should also be made as to whether you continue with the rental property investment. It is important to meet regularly with your financial and legal advisers to adapt your financial plan for changing circumstances.

No person or entity 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 for Bradley Nuttall's James Smith and Myles Wealth Management's Fiona Woodford are free and available upon request.

Are you interested in being the subject of a free MoneyMakeover? Send your details to: amanda.morrall@press.co.nz

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