The Dangers of Using Equity to Fund Retirement

Steve,

How about a danger of NOT using equity to fund retirement:

1. Paying way too much tax on your income. By living off equity you can get away with paying “tax” at the prevailing cost of capital.

But I recognise that its not for everyone, and that your asset strategy and structure can either be conducive to this or not. You need a “growth” asset structure and not an “income” asset structure for it to be viable and appropriate.

Cheers,
Michael.

Steve
By the looks of your comments in the newsletter you really haven’t run the numbers properly to give a balanced view of how to use equity for retirement, you have just used the throw away line to build some hype and stuck together some loose facts to try an prop it up. Maybe if you got someone to help you run the numbers you might give a more balanced view to your readers rather than a silly cooked goose analogy.
For sure in the scenario where a person only invests in one property and does this just before retirement you are in a pickle, but the same is true if you were trying to rely on a positive cashflow.
I can’t imagine anyone reading your newsletter would be aiming at anything less than a portfolio of property to retire on over a number of years well before retiring. Given that assumption you must surely realise that with the benefit of great leverage the benefits of capital growth far outweigh paying for the loss of tax deductions in retirement. This is not even factoring in the growth of rent in the portfolio that bring the cashflow back closer to neutral.
Lets take a quick snapshot, assume over 7 years you have acquired a $1mill portfolio. If your porfolio is growing at 7% (10 year doubling average) then it will grow by $70k say you have to pay $20k to cover the neg cashflow in the portfolio (no tax rebate) and you drew down $50k to live on you have a neutral equity position. Ofcourse you LVR needs to be below 70% hence ensuring that people don’t leave this strategy too late.
$50k is also post tax dollars so equivalent to $70k if you earned that in rent or other taxable income.
Because of the size of the asset the growth in equity is going to far outstrip the growth of the non-deductable debt. So why mislead people like this?

creating wealth with property

You made some good points Rob. Also Steve,I thought your inclusion of keeping an ongoing monitored budget (allowing 10% for the unexpected) was an important point.
Cheers,
Gatsby.

“Sometimes the hardest thing to do in life is often the best thing to do.”

Borginvestor,

You miss the point that drawing down equity does not reduce your year ending net equity. The approach is based on drawing equity “in arrears” from the growth in your portfolio. You should never draw more than its growth or you would reduce your net position.

In fact you should never draw more than growth less CPI indexation so that your true “buying power” of your net equity is preserved over time.

Overall, living off equity is a relatively simple concept but it is outside the comfort zone of a lot of people. Most people would rather live off surplus “income” from the structure and not surplus “growth”.

Read that last bit again, its the key point (particularly that word “surplus” in both options)…

Cheers,
Michael.

PS. If someone can tell me how to attach a file then I’ll link a little 20k spreadsheet here which nicely illustrates the impact of the different LOI vs LOE strategies.

Michael

For me the problem with Living of Equity is what happens if the unexpected happen ( well maybe not unexpected by some )

To draw down equity you are assuming that the way the banking system will allow you access to you equity in terms of increasing the equity you can access . I would hate to be at 70 when there’s a recession, prices gone down for a few years ( that does happen ) and the banks decide that the latest fade of Living of equity has got them nervous , so they not only decide to revalue all my properties down, but decrease the LVR that they’re prepared to lend me. Interest rates go up so I’m caught in a personal perfect finacial storm.

I can’t sell because the markets gone to the crapper , and even if I could sell , because I’ve drawn down my available equity , It’s got to the point where all of the funds I’d have available after sale are going to pay for the CGT , which now no longer has a 50 % rebate.

Also because I’ve been claiming depreciation off all my properties ( and the depreciation you claim is taken of the capital base cost when working out CGT ) , the capital base cost of my properties is lower , so my capital gains tax is even higher.

I’m stuffed.

I think there is a place for living off equity , but to use it as a plan for retirement ( unless you’re loaded with a very low LVR ) is too risky.
To talk about doing it with LVR’s of around 80 % which is suggested by some , leaves no margin for error if there’s a prolonged downturn or change in the playing field. After all we’ve just had the longest boom for a long term , who’s to say we won’t have a prolonged down turn.

Change in banking practice ? I can remember as a young Doctor a few years ago ( around 1984… sheese …) being knocked back for a loan on an entry level unit in Homebush west , because I hadn’t had the required deposit save up for the preceeding 2 years ( or something like that ). Rolf / Simon where were you then ….

See Change

I think all the supporters of living off equty are totally missing the point. It must be assumed that to draw down on equity to ‘live on’ (non-deductible) occurs only when the person borrowing ‘NEEDS the extra money’. There is no other reason to do it. I am referring to LIVING off equity and NOT INVESTING off equity. It may also be assumed that these people do not have sufficient income from alternate sources.

A good example is the current climate. Regardless of how careful anyone has been and only drawing down ‘in arrears’, how does the person who NEEDS money to live get money in times of zero or negative growth???

Let’s assume they don’t have access to any more funds from anywhere else… the question now turns to how are they supposed to make the repayments on all the borrowings that have been increasing at the rate of equity growth each year when they run out of the last draw down?

Living off equity is the most ridiculoue thing I have ever heard of for people who actually need the money to live on.

Investing off equity is much more sensible and generating a healthy ongoing income that will maintain or even increase quality of life is far more beneficial and sustainable with a much lower level of risk!

TMA

Recently i have been in discussions with Gaydens Lawyers (Sydney) regarding the new senior living policy (old + 55).

It is interesting to note that currently 77% of all retirees still live at home with no mortgage and little cash, i mean unhappy and struggling.

New structures today enable these people to use their equity to survive until death, sad as that may seem.

I have said many times before on this site that the problem is our financial fundermental education. This situation is going to get worse in the future unless Australians control their spending habbits.

95% of people live beyond their means, credit card debt over 30bil, interest free store accounts, debt to equity ratios increasing etc etc.

These forums provide an insight for the minority of people who want to change. But because the majority won’t face the facts we will have to pay for the miserable sods in the future, i know lets increase the taxes on the rich and property investors to fund them!!

resiwealth

I think people need to adopt a more flexible approach to their investing. eg Gear up to high LVR’s when the market is about to take off, then cash up some properties , and lower your LVR when the market is peaking , or has peaked . In my experience the property market moves slowly enough to enable one to do this, though you may have to accept 5-10 % below the peak price when you sell.

This can give you a smaller but genuinely cash flow positive portfolio, which you can use to fund purchases in the next cycle , and so on.,

See Change