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financial facelift

Diana and DominicTijana Martin/The Globe and Mail

To better understand the FIRE movement – financial independence, retire early – consider Diana and Dominic, a couple in their early 30s with one child and another on the way.

With no windfalls, pension plans or help from their parents, Dominic, 34, and Diana, 31, boast a net worth – assets minus liabilities – of $2.17-million. “Through a series of real estate and stock market investments, we were able to grow our net worth to over $500,000 in our 20s,” Diana writes in an e-mail. While they were both still working, they started a successful business on the side, “and as such we were able to save almost all of the income in our corporation,” Diana adds.

She recalls the hardships that beset her parents. “Seeing them struggle is what pushed me to work so hard on becoming financially literate/stable/free,” Diana writes. Today Diana’s business easily brings in more than $100,000 a year. Dominic manages the investments and takes care of their daughter. Their goal is for Diana to be “work optional” in a year or two, with a spending target of $100,000 a year after tax when they have fully retired.

“How do we protect our assets against inflation?” Diana asks. Does it make sense to move to a less-expensive locale where they can buy a larger home and rent out their city home, keeping it as an inflation hedge? What should their allocation be to real estate and stocks and bonds, “and how do you determine what is safe?” Should they keep a large cash reserve in the event of a downturn? Or would it be better to invest in dividend-paying stocks to avoid having to sell in a downturn?

We asked Warren MacKenzie, head of financial planning at Optimize Wealth Management in Toronto, to look at Dominic and Diana’s situation.

What the expert says

Diana and Dominic want to be in a position where they can work at jobs they enjoy, and work because they want to work rather than because they need to, Mr. MacKenzie says. “They also know that children grow up quickly so they are allowing themselves a healthy balance between work and family.”

Diana and Dominic can reasonably expect to live for another 50 years and no financial plan can reliably predict that far into the future, the planner says. “However, if we conservatively assume that in the future, their real rate of return on investments will be 3 per cent (a return of 5 per cent with 2 per cent inflation), their financial plan shows that by age 40, they could reduce their employment income by 50 per cent, work part-time until age 60, and still leave an estate for their heirs,” he says. Over the past few years, their investment portfolio has averaged a return of more than 10 per cent.

“Their success can be attributed to being frugal, setting a financial independence goal, being knowledgeable about their investing options, and starting a successful small business,” Mr. MacKenzie says. Dominic and Diana’s portfolio consists of equity exchange-traded funds, private mortgage investment corporations (MICs), and private real estate investment trusts.

Fifty-two per cent of their entire portfolio is invested in one MIC that in turn invests in a well-diversified pool of first and second mortgages. The loan-to-value ratio is 70 per cent and no mortgages are for more than $100,000. The MIC has delivered a 10-per-cent annual rate of return for the past five years, the planner says.

About 12 per cent of their investment portfolio is in a private REIT that invests in residential apartment buildings and has some international diversification, Mr. MacKenzie says. “This REIT has averaged over 10 per cent per annum for the past 10 years and will provide the inflation protection that they are looking for.” The remainder of their portfolio is invested in well-diversified stock ETFs.

There are a number of things that they can do in order to improve their situation, the planner says.

Given that the stock market is near its all-time high – and that they are concerned about a downturn – they could sell their stocks and use the funds to pay off the non-deductible mortgage on their home, he says. When the market weakens, they could remortgage their home and put the entire proceeds directly back into the market. “After doing this, they would have the same level of debt and about the same-sized stock portfolio, but the interest on their mortgage would be tax deductible.” Interest on money borrowed to invest can be deducted for tax purposes.

As well, they should share the housekeeping and child-rearing duties so that they can both work in their business, the planner says. By paying themselves roughly equal salaries, their average rate of tax will be lower, and it will also give each of them earnings on which Canada Pension Plan contributions can be made. “This will mean that in the future they can both receive CPP benefits.”

Although they are financially secure today, if either one of them had a fatal accident, their financial situation would change drastically, Mr. MacKenzie says. He recommends they each purchase at least $1-million of term insurance. “They should also immediately update their wills.”

They have significant TFSA contribution room and they should use any surplus funds to top up their TFSA accounts.

They also need to keep their financial plan updated so they can make the appropriate adjustments if the long-term forecast changes and indicates a potential problem, the planner says.

Diana and Dominic are worried about inflation, but their stock investments, personal real estate and REITs will help protect them against rising prices. “But their best protection will come from being self-employed and being able to increase their billing rate.”

As to moving and renting out their existing home, the decision would involve both emotional and financial factors, the planner says. “Because of their financial success, this decision should be based primarily on whether they think they’ll be happier by moving to a small town.”

Diana and Dominic ask about safety and liquidity in case of a market downturn. Their portfolio is overweighted in private REITs and MICs, both of which lack liquidity and are not without risk. As well, it is overweighted to Canadian assets, the planner says. “It is not as easy to sell as a portfolio of blue-chip stocks and government bonds.” However, as long as one or the other is working, they do not need a high level of liquidity.

Diana and Dominic started investing about 10 years ago so their only experience is investing in a secular bull market, Mr. MacKenzie says. “But sooner or later we’ll experience a bear market and they’re wise to be prepared for this,” he adds. “When this happens, we can expect growth stocks to fall more rapidly than dividend-paying stocks, and both will fall more than fixed-income investments.”

Client situation

The people: Dominic, 34; Diana, 31; and their daughter, 2

The problem: Have they amassed enough wealth to work only when they want to? How can they protect their assets against inflation? What investments are safe?

The plan: Consider selling stocks to pay off their non-deductible home mortgage. Then, after a market downturn, refinance and use the money to invest, making the loan interest deductible. Share in the running of the company so they may be able to split their income. Buy term insurance.

The payoff: Income-tax efficiency, financial security, and confidence that they can be “work-optional” by age 40.

Monthly net income: $8,500

Assets: Business cash account $50,000; emergency fund $30,000; ETFs $675,000; her TFSA $10,000; her RRSP $100,000; his pension plan $25,000; MICs and REITs $750,000; residence $1.1-million. Total: $2.74-million

Monthly outlays: Mortgage $2,600; property tax $300; water, sewer, garbage $120; home insurance $100; electricity, heat $270; maintenance $200; vehicle lease $650; car insurance $170; fuel $150; groceries $650; child care $850; clothing $150; dining, drinks, entertainment $400; personal care $100; pets $50; subscriptions $50; vitamins $25; communications $300; RESP $400. Total: $7,535

Liabilities: Home mortgage $570,000

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Some details may be changed to protect the privacy of the persons profiled.

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