Implications of risk profiles for living on equity
The risk profiles I have outlined above are necessarily somewhat arbitrary. You may find that you exhibit characteristics of one or more of the profiles at different times and even in relation to different asset classes. However, broadly speaking, we each fall mostly into one profile or another.
To state the obvious, your risk profile will have a direct influence on your investment strategy and thus on the outcome or result from that strategy. That is because an investor’s risk profile will dictate the investment products they choose and whether tools such as gearing can be employed. With the above risk profiles in mind, let us now consider the impact which an investor’s tolerance for risk will have on their expected outcomes using the living on equity strategy. To do so it will be helpful to have some figures to work from to quantify the different outcomes.
Financial situation prior to Living on Equity
Some of you may be looking at the pre-living on equity financial position set out above and feeling that you will never achieve this level of wealth. To you I say “aim high”! The above net worth is easily achievable over 10-15 years. But if you can’t bring yourself right now to accept that, then simply reduce the figures to get a picture of where you could end up. The principles remain the same regardless of the numbers involved.
Moderately aggressive outcome & aggressive outcome
I will deal with the moderately aggressive scenario first as presented above. The passive income produced will be as follows:
Notes:
- Although $2.05m of property is owned, $850,000 is the family home and thus is not income producing.
- Interest on the whole property portfolio of $2.05m (i.e. home plus investment properties) is calculate here on an interest-only basis for simplicity. Whilst payments on the home loan would likely be principal and interest, and thus increase this figure, the principal component would equally reduce the debt and increase equity. Thus for our purposes it evens out in the end.
Given the gross portfolio value is $3.675m, the growth on the portfolio at various rates of capital growth is as follows:
As noted in earlier articles, to be conservative I recommend no more than 2/3rds of any growth be drawdown and spent for lifestyle. The remaining third should be left undrawn for leaner growth years. Thus the total income generated from utilising living on equity with this risk profile at a 5% average capital growth rate will be a passive income of $14,637 pre-tax plus a tax free $119,437, giving a total income of $134,074. Which should, I suspect, be more than enough for most to live on, particularly given the family home is retained and largely funded here. If we were to strip out the interest on the home loan from our calculations then expenses would drop accordingly and passive income would rise. However, the income would then need to be applied to home payments so it evens out in the end.
There are a multitude of options open to an investor wishing to take a truly aggressive approach. However, in my view, when this level of income can be achieved without straying beyond the major asset classes, there is no real need to live on the edge – particularly in or near retirement.
Balanced outcome
During the
accumulation phase, the balanced investor will acquire investment properties whilst trying to keep their LVR at 65% or less. In addition, shares are acquired, but without leverage. Bear in mind that because the investor prefers to keep their LVR relatively low, they will not be value-adding with shares by drawing down equity from the properties. As mentioned, often the balanced investor will encounter serviceability problems and turn to a variety of cashflow improvement methods, including cashflow positive properties or cashbonds.
The lower leverage involved, combined with the fact that the balanced investor does not have their dollars working 6 times, will dramatically slow down their wealth creation process compared with the more efficient approach taken by an investor with a more aggressive risk profile. I anticipate it will take at least twice as long for the balanced investor to achieve the same results. Nevertheless they will eventually get there and will be able to sleep at night while doing so. The key point to note is that the sacrifice for being more conservative than is necessary is
time. Given time is a finite resource for each of us, there is a high cost for taking too conservative an approach during the accumulation phase.
As noted earlier, it is acceptable for an investor to switch to a balance approach in retirement after taking a more aggressive approach during the accumulation phase. Remember that the difference between the moderately conservative and the balanced risk categories in
retirement is that the balanced investor will not insist upon a 100% guaranteed income. It follows that the balance investor will house their liquidity in a capital growth producing asset (namely shares) despite maintaining a lower LVR. If we assume that the investor adopted a moderately aggressive approach to reach retirement the outcome is:
In the figures noted above the total portfolio value was $3.675m including an 80% LVR against the properties and 50% leverage against the shares. However, this portfolio needs to be remodelled to lower the risk profile so as to match the investor’s retirement risk profile of “balanced”. The requirements here are LVR of 50% with no debt against the shares. Thus the property portfolio remains the same namely $2.05m with debt of $1.64m. However, the share portfolio (or perhaps some cash depending on requirements) will be only $812,500 with no debt. Thus the total LVR is 57.3%, (i.e. $1.64m ÷ $3.675m). The retired balanced investor’s returns would then be as follows:
Given the gross portfolio value is $2,862,500, the growth on the portfolio at various rates of capital growth is as follows:
Thus the total income generated from utilising living on equity with this risk profile at a 5% average capital growth rate will be a passive income of $2,450 pre-tax plus a tax free $93,031 (drawing only 65% of the available growth), giving a total income of $95,481. This compares poorly to the total income generated by the investor with a greater risk tolerance – $38,593 lower per year.
Now I know that I would definitely prefer an extra $38,000+ in my pocket each year, but each to their own in accordance with their risk profile. Again, the family home is retained.
Moderately conservative outcome
I do not believe that an investor can accumulate a substantial portfolio to provide financial independence with a moderately conservative risk profile and investment strategy. To attempt to accumulate growth assets such as investment properties without borrowing is a very long and hard road. Put simply, it just takes too long to buy enough properties even if you live to be over one hundred years old! Even the variation on this theme of using only minimal borrowings and paying off your investment properties in full would leave the average investor lucky to have accumulated more than 2-3 properties over 20 years.
Thus, I will also disregard this method for accumulating an asset base to permit living off equity. However, we do need to discuss this risk profile for when an investor retires. An investor who reverts to this risk profile on retirement would generally sell some assets to pay off debt on the remainder of their portfolio so as to reach the scenario of paid off property and shares plus some surplus cash.
At this stage, the cash is then placed into a 100% guaranteed investment (such as a government bond) to give the safest return of passive income achievable. At the same time this will be supplemented by further income from rentals and dividends (which are of course uncertain due to vacancy and company performance amongst other factors). There will also be capital growth from the shares and property. It is against the growth on these assets that the moderately conservative investor will be able to live on equity. Their certain income stream will permit them to service the debt required.
Implications of being moderately conservative for living on equity
Considering the implications of being moderately conservative a bit more closely we find that either:
- the moderately conservative investor requires a much larger initial asset base to produce the living on equity income; or
- they must accept a lower income.
In the initial figures noted above the total portfolio value was $3.675m including an 80% LVR against the properties and 50% leverage against the shares. However, this debt would by definition be unacceptable to the moderately conservative investor. So therefore without leverage the total portfolio value would be $1,222,500. This portfolio would be comprised of $410,000 in unencumbered property and $812,500 in cash (not shares because the requirement is for 100% guaranteed income). Thus the asset allocation is 33.5% property and 66.5% cash.
The moderately conservative investor’s returns would then be as follows:
Notes:
- Assumes the family home is sold and the investors retain $410,000 worth of investment property whilst renting privately or in a retirement village etc.
This result pales into insignificance compared with the income levels demonstrated above for more aggressive risk profiles. Further, it assumes the family home has been sold as the net property holdings are below the $850,000 value of the home. However, it does have the benefit of having the interest income being almost two thirds guaranteed. The major sacrifice though is the diminished potential for capital growth, which is the very equity that it is proposed to live off. Remembering that there is no capital growth on the cash component of the portfolio, the capital growth potential for the property held is set out in the table below.
Again, as will be shown by the examples to follow, this compares very poorly with the results from a more risk tolerant approach.
Thus the total income generated from utilising living on equity with this risk profile at a 5% average capital growth rate will be a passive income of almost $53,000 pre-tax plus a tax free $13,325 (assuming 65% drawdown only), giving a total income of $66,250. This compares poorly to the $134,000 plus income which is possible by taking a more robust approach to investing.
A sensible variation on this approach for the moderately conservative investor (but which is still within the risk profile) would be to hold less cash/fixed interest investments and more property. This approach is justified on the basis that because no debt will be used, less of the passive income will be required for holding costs and stress testing. A better mix might then be 80% property and 20% cash/fixed interest. The returns would then be as follows:
Now this is not as good as the $52,925 produced by the 34/66 property/cash asset allocation. The compensation for this lower income is potential for greater growth, as shown by the table below.
Again choosing a 5% growth rate on the property will yield a passive income of $41,565 but a higher living off equity income of $31,785. The total income produced is $73,350. Certainly this is better than the 34/66 property/cash split but still well below the possible outcome.
Conservative outcome
As noted above, I do not believe an investor can realistically expect that they will accumulate a substantial asset base with 100% guaranteed investments. Nor is it feasible, even in retirement, to retain 100% fixed interest style investments. The buying power of the retirement income stream will eventually be seriously eroded by inflation. This is becoming an increasingly important concern as people are living longer and thus spending longer in retirement. Potentially as much time in retirement as they did in the workforce! If retirees are to enjoy a well funded retirement they cannot rely solely on income style investments without a reasonable growth component.
I mention this risk profile in the context of the living on equity strategy merely to emphasise that the strategy cannot be implemented by someone with this risk profile. In my opinion adopting this approach to risk is irrationally risk adverse for any investor who has more than a very short investing timeframe.
