Questions by Martin Hawes

So, you're about to retire??

Retirement is one of the big developmental stages that we face in life – going from full-time work to reliance on your investment capital for your income is difficult! For most of our lives we have a nice steady income from work or business and now we have to depend on the vagaries of the markets to buy the groceries. More than that, whatever investment strategy that we have had while in work will no longer be suitable – you have to change a lot of things when you go into retirement; however the change of investment strategy is often the big one.

It is important that you think through your investment plan and get the basics right. Most important is that you get asset allocation right: the amounts that you will have in shares, bonds, property and cash will determine your investment performance more than anything else – this will drive the returns that you get and the volatility that you will experience. You also have to decide how much of the investment process you are going to do as investment management will also determine whether you have good investing and a happy retirement.

Retirement is also a time when you should review all of the other areas of your finances: tax, insurances, wills, trusts, income and expenditure etc.

Wondering what to do with all those savings?

There is over $100 billion in savings in New Zealand banks. While most of these are probably earning interest, some of them will not be. In any event, much of this money could be earning better returns than being stuck in a bank for years.

Bank deposits have their place: they are relatively safe and the returns that they give usually mean that after tax they maintain their real (after inflation) value. However, for most people they are not a long-term investment strategy and sooner or later you have to start to consider other options.

So, you're serious about building wealth?

To state the obvious: having wealth is a good thing. It gives choices, allows you to do things and look after the people you love. There is no easy way to wealth; however there are some things that you can do which will give you the financial success that you want. The first thing is to set goals for your finances: having a goal for your “freedom figure” gives you the direction that you need.

Then we need to decide what vehicle you are going to use to create wealth: a business? Property? Income from work? Investments? Working out what you need to live your life as you wish with financial freedom and, then working out how to create that wealth is the first step for those who are serious about becoming wealthy.

So what do you do now you've sold the business?

The chances are you have worked hard for a big part of your adult life to build a business or to farm successfully. Selling it (business or farm) is the payoff – now you have the freedom to do the things that you have always wanted. Change may be difficult and starting to invest in things that you do not know much about certainly will be. You may continue to work in some capacity or you may start to define and describe yourself as an investor – with the sale of the business you ought to have the ability to choose the life that you want.

Wondering what to do with that little nestegg?

There is over $100 billion in savings in New Zealand banks. While most of these are probably earning interest, some of them will not be. In any event, much of this money could be earning better returns than being stuck in a bank for years.

Bank deposits have their place: they are relatively safe and the returns that they give usually mean that after tax they maintain their real (after inflation) value. However, for most people they are not a long-term investment strategy and sooner or later you have to start to consider other options.

Need to start thinking about a financial plan?

It does not matter what your age or stage: a plan for your finances so that you can live the life that you want is important. A plan gives you direction: if you know where you are going, it is much easier to work out the things that you have to do to get there. Financially, you are going on a journey whether you have planned to or not: you can be sure that in, say, 10 years you will be in a different place form where you are not. These 10 years will pass but the key question is whether your financial position will be the place you want to be

A financial plan should look first at where you are at now and then you need to decide where you want to be in the future (your goals). The plan will then bridge the gap between your current situation and your desired future one. As a part of this, the plan should look at all the main financial issues: tax, insurance, debt reduction, wills, trusts, succession, investment, income and expenditure. Ultimately, you need to set your direction to end up in the financial place that will let you live the life that you want.

How do I reduce my debt?

There are many ways to reduce debt but the two main ones are: ensuring that you have the lowest interest rate possible and using as much of your income as you can to debt repayments. When you look at the numbers, these two things reduce what you owe faster than anything else. Have a look at the article below …

Sunday Star Times Article from September 2012
The mortgage by numbers

If there was just one thing that you could concentrate on to really improve your wealth, it would be the mortgage. Reducing your mortgage costs can mean that you save tens of thousands of dollars – an opportunity, almost like no other in finance, to transfer a great deal money from the bank to yourself.

This is because for most of us the mortgage is such a lot of money and is paid for over a great deal of time. That makes a mortgage expensive: for example, if you take out a mortgage of $300,000 over 25 years at 6%, you would pay the lender a total of $279,871 in interest. When you see a cost like that, you should know that there would be savings to be made. And there are.

The first thing to understand about mortgages is the size of the commitment that you are making when you sign up to it. When you agree to the above mortgage, you are committing yourself to paying interest of $279,871 and also to giving the lender its capital back. Your total commitment is, therefore, to pay $579,871 over 25 years. That is such a commitment that you need to be sure that you are getting the right deal or, if necessary, to take some advice – after all, this is likely to be your greatest financial commitment.

Reducing the cost of a mortgage is best measured by the total amount of interest that you will pay over the course of the loan: that total interest amount of $279, 871 should be firmly in your sights, and you should be doing the numbers to lower that figure.
There are two main things that you can do to reduce the amount of interest that you pay. The first is to get the lowest interest rate possible and, second, to apply as much money as you can to debt reduction. Both of these sound obvious, but as I show below, what may seem a small reduction of the interest rate or a small increase of the payments on the mortgage can make big differences to the total amount of interest you will pay on the loan.

My first example concerns someone who is able to budget better and find an extra $250 per month (a little over $50 per week) that can be applied to the mortgage instead of being spent. If you can make the budget a little tighter so that you can apply $250 per month to the mortgage, your total interest bill falls to $208, 616 – that’s an interest saving of $71,255.

The second example is about someone who shops around and/or negotiates hard to get a lower interest rate – they get 5.5% instead of 6%. This is fairly easily done – banks are very negotiable at the moment and if you run your eye down a mortgage rate table you will see plenty of variance between rates. Achieving a rate of 5.5% instead of 6% and assuming that the payments are kept at $1932 per month will mean that total interest will come down to $225,473 (a saving of $54,398).

These are good but if you put them together you really get some savings. Assume that house owners not only managed to find an extra $250 per month for the mortgage so that they were able to pay $2182 per month but also hunted around to get that lower interest rate of 5.5%. Now their total interest is $175,367 – a saving of $104,504.

So, potentially there is over $100,000 on the table for doing two things: first you have to spend less so that you can increase you mortgage payments and, second, you have to be prepared to shop around, switch lenders and negotiate hard. This is an area where a little eventually becomes a lot (whether small extra payments or small decreases in the interest rate).

This current time of low mortgage interest rates should be considered a golden opportunity for those who are serious about getting ahead: not because they have more money to spend while interest rates are low, but because they can use this time to get rid of big chunks of dead-weight debt. This is a time to keep your monthly mortgage payments up and not be tempted to lower them when interest rates are low.

How much do I need for retirement?

This is one of the big financial questions: we all need to set a goal for our “freedom figure’, but just how much do we need to be able to enjoy our retirement? The answer is complicate and there are many variables come into play. Certainly, you can work out what you need but you have to make a range of assumption for things like whether you will work a bit in retirement, what house you will live in, what will you get from NZ Super, what will investment returns be, inheritances ….

Sunday Star Times September 2012
Retirement Income Goal

A recent survey has found that around 50% of us are worried that we will not reach our retirement goals. To me, this poses a big question: have people established the right goals – have they been able to calculate the correct amount of capital that they need to get the desired income?

It is easy enough to work out how much income over and above NZ Super that we need in retirement: we simply do a budget for our expenditure and deduct the amount that we will get from NZ Super – what is left over needs to be funded from somewhere else: either from continuing work, or from the returns on investment capital.

The amount of investment capital that you will need to make up the deficit is dependent on two things: first, the returns that you will get on your investments and, second, what you want to leave to the children by way of inheritances.

The amount of returns that you get on your investment capital always depends on the amount of risk that you are prepared to tolerate. Investors in retirement will want to keep their risks fairly low: very few in retirement will take greater risk than that of a Balanced investor – moving into a growth profile is likely to see too much volatility.

Balanced investors have 50% of their portfolios in shares and property and the rest in cash and bonds. Actuaries have measured the performance of such portfolios over long periods of time and have found that they should expect 8% returns before tax and fees. This does not mean that they will get these returns year in year out – there will be volatility and the retired investor will have to cope with that (if they cannot cope, they should accept lower returns and become Conservative or even Defensive investors).
This return of 8% will be taxed which will bring it down to about 6% and there are likely to be fees payable to advisers, brokers, managers etc. which will further lower returns. It reasonable to expect a return of 5.5% after tax and fees. That would mean that for each $100,000 of investment capital you have, you would get $5,500 per annum or $105 per week.

However, this does not allow for inflation – the $105 per week that you get when you first retire in 2012 will gradually reduce in spending power and be worth a great deal less in, say, 2032. If you want to maintain your capital and your spending power in real terms, you will need to add back the amount of inflation – assuming an inflation rate of 2%, the 5.5% return reduces to 3.5% and your spendable income to $67 per week for each $100,000.

The second factor is the inheritances that you want to leave. Many people are happy to plan to leave just the house to their children, spending all of their investment capital to go out on the last dollar. In a practical sense, this is not easy as most of us do not know how long we are going to live and, of course, we do not want the money to run out before we do.

Although, average life expectancy means that we need our money to last about 20 years, most of us will be careful (some might say hopeful) and plan for making it last 30 years.

Assuming 30 years, ignoring inflation and working on investment returns of 5.5% p.a., each $100,000 of investment capital ought to be able to give you income of $6,900 p.a. or $132 per week. Again, inflation will erode the spending power of this $132 per week, however, there are people who do not worry about this as they plan to spend less as they get further into retirement and are less active.

Although you can give basic rules of thumb for how much capital you need, when it comes to the detail the calculations are specific to the individual and not necessarily easy. Moreover, there will be changes throughout retirement as markets become volatile or inflation rises and falls. Nevertheless, I think one of the most useful things that you can do in finance is to set a goal for the amount of investment capital that you will need in retirement – it may not work out neatly and perfectly, but it does give direction and something worthwhile to aim at.

Now you’ve paid off the mortgage …

The financial plan is easy when you have a mortgage – you put everything that you have into the mortgage, paying it off as quickly as you can with the least possible cost. When you have made the last payment to the bank, it is time to celebrate: open a bottle of good wine and enjoy the idea of being debt-free.

However, now things do get a bit more complicated: you ought to continue to have a surplus (you are no longer spending money on the mortgage) but what are going to do with this money. The simple answer is to save and invest it, to start to build your wealth by adding asset instead of subtracting liabilities. However:  what assets are you going to buy? How are you going to invest? How much of the investment process do you want to do? When your debt is gone and you start to invest you should develop  strategy so that your investments make a happy fit with your life.