There’s been a lot of http://www.somersoft.com/forums/showthread.php?t=19620discussion recently about retiring to live off equity - this was one thread that got hijacked.
Living off equity is great when it works, but in the proponents words a ‘disaster’ when it doesn’t. The question is how likely is it that it will work.
The main problem is volatility. Volatility is the variance from the norm. Risk is closely correlated to volatility – low risk = low volatility, high risk = high volatility. (See Against the Gods – The Remarkable Story of Risk by Peter Bernstein).
‘Living off equity’ requires drawing down from accumulated equity. This can be in the form an annuity, but can simply be an additional LOC. This drawing down of these funds for personal use is not a deductible expense – you pay tax, then you pay the interest on the borrowing – just like a PPOR.
Living off equity relies on the assets (usually IPs) increasing in value so there is sufficient equity to draw down for personal use. As we all know IPs always go up in value, usually doubling every 10 yrs or so. But this doubling is not consistent – it is volatile. E.G.
- Brisbane had 10 yrs of no growth up until 2000, then doubled over the next 3-4
- The depression in 1930 lasted over 10 yrs – then share prices got back to their previous level
- Up until the 19th century land prices hadn’t increased for 600 years.
But growth always reverts to the mean, so it’s easy to put together spreadsheets using average growth for each & every year. But then take volatility into account -
- The normal property cycle – boom, bust, stagnate over a 7-15 yr period
- Left field events eg tsunami, 9/11, global warming, banana republic, GeorgeW invading another oil rich nation, SARs, oil price – there’s been a left field event every year for the last 20.
So what’s the worst case scenario – is it 30% decline in portfolio value over 3 years followed by 10 years of no growth on average, then after that a badly timed left field event that adds a further couple of years of negative growth. Put together a spreadsheet such as this one and see how much equity & LVR buffer you need to support a worst case scenario.
Moving on from volatility, assuming a worst case scenario –
- Consider what max LVR the bank will allow you to borrow against. Remember you’ve had no job for 10 yrs and have significant interest payments and huge debts. Banks are not known for their understanding of ‘alternative’ investment structures.
- Consider how you would feel for 10+ years watching your LVR go up, equity go down, interest payments increase exponentially. Is this a high SANF ? Would you be wondering every night if property would every return to favour ?
- Credit squeeze – every year you’ll be going to the bank to ask for more cash to spend on non-investment stuff. Will the bank always come to the party – even when you’re 85.
The vast majority of financial advisers would recommend a pension that is consistent, indexed to CPI and guaranteed – ie has low volatility. Probably a risk free govt backed bond (or fund) yielding 5% ish. These are as risk free as you can get, consistent, income & capital guaranteed (but not indexed to CPI). They are immune from the vagaries of the IP/share cycle and left field events, and score well in the SANF stakes. These financial advisors are v. risk averse – they’d be sued if they recommended anything else (they also get a commission from recommending them).
OK, so living off equity is a great plan, but there are some serious potential risks – how can those risks be mitigated ?
- sell an IP if any of the above occur – but IP values are probably low when you need to sell & it’ll probably be LVR’d to the max & you’d be up for CGT & selling costs
- have a v. big buffer to start with – but this defeats the object of retiring early
- draw down only what capital gain has occurred so far – but there's a high probability of running out of capital to draw down for some of the years of retirement
The problem is that once you start down the 'living off equity' strategy and it starts to go a bit wrong (little or no growth after maybe 5yrs) - it's hard to change horses because you're getting close to the limits.
What are the alternatives –
- sell all the IPs & invest in lower risk higher yielding assets
- regard ‘living off equity’ as a last resort if other retirement income fails
- invest partially in lower risk high yielding assets (to provide a guaranteed base pension) and keep some highly geared, high growth IPs to live off equity IF growth occurs
- diversify into other asset classes, so if IP growth fails then other asset classes MAY provide the c/f or growth.
- Ensure IP +ve c/f is enough to provide a base pension (at a low tax rate) & consider any growth to be ‘the cream’ that can be drawn down.
All these alternatives reduce the volatility of the asset base, and consequently are lower risk.
Living off equity is a great way of retiring early and avoiding tax, but there are high risks that aren’t usually highlighted. Even if there is a 1% chance of ANY of the above happening then it is to great a risk for me – I place a high value my SANF for the next 50 years.
Cheers,
KJ
I’m not a financial adviser and don’t make commission from selling financial products and this is not advice – I have retired, but I don’t live off equity.
Living off equity is great when it works, but in the proponents words a ‘disaster’ when it doesn’t. The question is how likely is it that it will work.
The main problem is volatility. Volatility is the variance from the norm. Risk is closely correlated to volatility – low risk = low volatility, high risk = high volatility. (See Against the Gods – The Remarkable Story of Risk by Peter Bernstein).
‘Living off equity’ requires drawing down from accumulated equity. This can be in the form an annuity, but can simply be an additional LOC. This drawing down of these funds for personal use is not a deductible expense – you pay tax, then you pay the interest on the borrowing – just like a PPOR.
Living off equity relies on the assets (usually IPs) increasing in value so there is sufficient equity to draw down for personal use. As we all know IPs always go up in value, usually doubling every 10 yrs or so. But this doubling is not consistent – it is volatile. E.G.
- Brisbane had 10 yrs of no growth up until 2000, then doubled over the next 3-4
- The depression in 1930 lasted over 10 yrs – then share prices got back to their previous level
- Up until the 19th century land prices hadn’t increased for 600 years.
But growth always reverts to the mean, so it’s easy to put together spreadsheets using average growth for each & every year. But then take volatility into account -
- The normal property cycle – boom, bust, stagnate over a 7-15 yr period
- Left field events eg tsunami, 9/11, global warming, banana republic, GeorgeW invading another oil rich nation, SARs, oil price – there’s been a left field event every year for the last 20.
So what’s the worst case scenario – is it 30% decline in portfolio value over 3 years followed by 10 years of no growth on average, then after that a badly timed left field event that adds a further couple of years of negative growth. Put together a spreadsheet such as this one and see how much equity & LVR buffer you need to support a worst case scenario.
Moving on from volatility, assuming a worst case scenario –
- Consider what max LVR the bank will allow you to borrow against. Remember you’ve had no job for 10 yrs and have significant interest payments and huge debts. Banks are not known for their understanding of ‘alternative’ investment structures.
- Consider how you would feel for 10+ years watching your LVR go up, equity go down, interest payments increase exponentially. Is this a high SANF ? Would you be wondering every night if property would every return to favour ?
- Credit squeeze – every year you’ll be going to the bank to ask for more cash to spend on non-investment stuff. Will the bank always come to the party – even when you’re 85.
The vast majority of financial advisers would recommend a pension that is consistent, indexed to CPI and guaranteed – ie has low volatility. Probably a risk free govt backed bond (or fund) yielding 5% ish. These are as risk free as you can get, consistent, income & capital guaranteed (but not indexed to CPI). They are immune from the vagaries of the IP/share cycle and left field events, and score well in the SANF stakes. These financial advisors are v. risk averse – they’d be sued if they recommended anything else (they also get a commission from recommending them).
OK, so living off equity is a great plan, but there are some serious potential risks – how can those risks be mitigated ?
- sell an IP if any of the above occur – but IP values are probably low when you need to sell & it’ll probably be LVR’d to the max & you’d be up for CGT & selling costs
- have a v. big buffer to start with – but this defeats the object of retiring early
- draw down only what capital gain has occurred so far – but there's a high probability of running out of capital to draw down for some of the years of retirement
The problem is that once you start down the 'living off equity' strategy and it starts to go a bit wrong (little or no growth after maybe 5yrs) - it's hard to change horses because you're getting close to the limits.
What are the alternatives –
- sell all the IPs & invest in lower risk higher yielding assets
- regard ‘living off equity’ as a last resort if other retirement income fails
- invest partially in lower risk high yielding assets (to provide a guaranteed base pension) and keep some highly geared, high growth IPs to live off equity IF growth occurs
- diversify into other asset classes, so if IP growth fails then other asset classes MAY provide the c/f or growth.
- Ensure IP +ve c/f is enough to provide a base pension (at a low tax rate) & consider any growth to be ‘the cream’ that can be drawn down.
All these alternatives reduce the volatility of the asset base, and consequently are lower risk.
Living off equity is a great way of retiring early and avoiding tax, but there are high risks that aren’t usually highlighted. Even if there is a 1% chance of ANY of the above happening then it is to great a risk for me – I place a high value my SANF for the next 50 years.
Cheers,
KJ
I’m not a financial adviser and don’t make commission from selling financial products and this is not advice – I have retired, but I don’t live off equity.
