Canny View: Be realistic when it comes to your finances

There are rough waters if you've got a few million. Photo / Supplied

It is no secret interest rates are low. Have ten grand in the bank? If you are lucky with a "high-interest" account, at the end of the year, you'll have made $200 and that's before the taxman and inflation come calling.

For those with a small amount who can't get their head around the concept of risk, it's dire straits.

We're also told there are rough waters if you've got a few million. This is from a recent article in The Australian by a financial adviser:

I recently met a new client – a divorcee with two teenage sons – who, on the face of things, appeared to have no financial worries. She has $6.5m in total assets, including a family home with no mortgage, and requires, she says, $120,000 a year to live on. Surely not a problem.

However, when we dug into her asset base, things were a lot different from what they appeared.

Her principal residence in inner Melbourne is unencumbered and valued at $1.5m. Her investment portfolio totals $5m, of which $3.5m is tied up in residential investment properties which, although they have appreciated in value, deliver little income.

The remaining $1.5m is spread across equities and fixed interest, which averages a yield of about 4 per cent per annum, producing $56,000.

The article later notes her total income from all her investments was $70,000. So only $14,000 was generated by the $3.5m in residential real estate.

Unfortunately, the debt status of the residential properties was not mentioned in the article. To receive only $14,000 from $3.5m in real estate suggests either a valuation error or unmentioned debts eating a chunk of cash flow.

Even without the full picture, throw in council rates, insurance, Government imposed costs (insulation and heating), unruly tenants & potential body corporate fees, as well as maintenance it's easy to see why residential real estate isn't a great cash flow proposition.

A casual observer might say it's a bit rich to complain you can't make enough money from such a portfolio: why not sell some real estate and move on?

It turns out the adviser in this scenario noted his recommendation was to part with residential properties, which the lady loathes to do.

People want solutions that sit within the walls they've already built in their mind. Another example to say financial advice is about managing emotions and behaviour.

Return requires risk. Always has, always will. $120,000 is an ambitious income target, but not with $5m to potentially deliver it. Her big problem is terrible portfolio construction, not that interest rates aren't higher.

So, we created a model portfolio based on her current scenario – a 50/50 portfolio (half growth, half defensive assets) with her existing liquid assets of $1.5m in equities and fixed interest.

At the end of every year, we'll draw $120,000. We will analyse the portfolio performance over the last two decades (2000-09 and 2010-19) and see if the portfolio can withstand the market events over a long period and still deliver the desired income. This scenario takes no account of tax on the income draws or inflation.

First, 2000-09. Income is drawn at the end of every year.

The portfolio generally fluctuates in a range between $1.6 and $1.3 million, until the financial crisis (2008-09) where it hits a low of $1.04 million. The recovery took it to $1.25 million before the final draw of $120,000 took it back to $1.134 million.

Could be better, but throughout the time period, a high-income demand is met while encountering a once in a lifetime financial crisis.

In the 2010s the portfolio fared better. The portfolio balance generally remained between $1.4m and $1.6m for the whole decade.

After the final draw in 2019, the balance was $1.423m, not bad after pulling out $1.2m in income. As noted, the income demand for the size of this portfolio is significant. Too large in reality. It's flirting with danger.

But if we double the portfolio to $3 million, the outcome is much different. Both portfolios were able to better withstand market volatility due to their size vs the income requirements. Both finish each decade (2000-09 & 2010-19) with a higher balance after drawing $1.2 million.

Nick Stewart

This is a basic analysis, not accounting for other variables, but there are some conclusions to draw.

Advice is important. An adviser can model these scenarios to a higher level of detail accounting for tax, inflation and the structure of where the assets are held. When drawing the income, advisers are better able to assess where to most efficiently draw the money from, taking account of capital gains discounts etc.

Utilise assets that support your goals. If the goal is income, hold assets that produce income or can be liquidated in short order. No point agonising over the real estate. Especially if it did its job and made money.

Financial markets have proven incredibly resilient in providing returns to investors over long-time frames, but they can't work miracles.

Best to understand what a portfolio is likely to withstand and what income draws it can safely handle. As we've seen $120,000 a year looks pretty good from $3 million, but at $1.5 million it begins to struggle.

No dilemma for millionaires. They'll be just fine.

Nick Stewart is an Authorised Financial Advisers and CEO at Stewart Group, A Hawke's Bay-based CEFEX certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, Wealth Management, Risk Insurance & KiwiSaver solutions.

This article is prepared in association with Mancell Financial Group, Australia. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz