Deconstructing wealth

Luxury cars, glittering jewels and cozy cottages build a formidable illusion of wealth. But these hallmarks of conspicuous consumption don’t always add up to high net worth. This harsh reality jolts many possession-rich and cash-poor folks when their advisors tally assets against liabilities, and reach grim conclusions about future cash flows.

“People tend to assign arbitrary numbers to illiquid assets, and believe they’re worth a lot,” says Calgary based Nicholas Miazek, manager of financial planning at T.E. Wealth. When drawing up a net-worth statement, he makes a point of dividing the two and showing people what they can actually spend.

If clients won’t liquidate assets like primary residences or cottages, Miazek takes them off the table when making net-worth determinations, and helps them plan for alternative sources of income.

Some advisors assume clients will liquidate their properties halfway into retirement, downsize, and invest the resulting cash, “but most people aren’t inclined to move down the property ladder,” says Miazek. “If they’re selling a $500,000 home in the suburbs, they’re most likely buying a half-million dollar condo downtown.”

Homework for your clients

Ask clients to bring along copies of the following documents to the intitial meeting:

• Last year’s income-tax notice of assessment
• Employer-sponsored pension plan statement
• List of assets (including ownership and amount)
• List of liabilities (including ownership, amount, interest rate, and if insured for death)
• Investment statements (for both registered and nonregistered plans, for all institutions, including listing of holdings and amounts, adjusted cost base where applicable, education savings plans if any)
• An estimate of annual expenses
• HRDC statements (for latest estimate of CPP benefits)
• Summary of life insurance coverage (death benefit amount, beneficiary, when coverage expires)
• Summary of disability insurance coverage (benefit amount, coverage options selected, who pays premiums, when coverage expires, any retirement protector)
• Any additional relevant documents

Courtesy Elizabeth Summers, financial planner at TD Waterhouse

Elizabeth Summers, CFP, FMA, FCSI, a financial planner at TD Waterhouse in Victoria, B.C., prefers to account for real-estate assets on net-worth statements, because that’s where average Canadians are most heavily invested. “After all, a client with $5,000 in the bank and an $800,000 home—fully paid off—has much more net worth than a client with just $5,000 in the bank,” she says. “If needed, he or she could sell the home to meet retirement needs, or take out a home-equity line of credit.”

A net-worth statement that includes all liquid and illiquid assets serves another important purpose for Summers’ older clients. “It’s a very accessible source of information for their executors. If you don’t have details of your home in there, executors won’t know whether they have a mortgage that needs to be discharged.”

David Chucko, partner at PwC in B.C., breaks real estate into two categories when determining net worth. “Consumption real estate is one where you write a cheque to own it; investment real estate is one where someone else writes you a cheque to own it.”

While investment properties generate cash flow, personal-use properties often end up as a legacy for the next generation. For that reason, Chucko advises clients to buy only what they can comfortably afford, and not lock too much money into illiquid investments.

Money mirage

In addition to real estate, RRSPs constitute a large chunk of average clients’ technical net worth. But Dessa Kaspardlov, CEO of KL&A, Financial Planning Consultants in Windsor, Ont., cautions against weighting them too heavily on networth statements. “RRSPs aren’t a savings or chequing account you can draw upon at will,” she says.

Many clients also have a lot of net worth concentrated in their employer’s stock options or purchase plans, pension plans, or group RRSPs. “From an investment perspective, that’s a very high concentration of risk,” Miazek says. “A natural disaster, regulatory or legal change, or other unknown variable could quickly impact this portion of the pie.”

He encourages clients to diversify away from their employers—to other companies in that sector, or other sectors and economies around the world.

And then there are clients with small incomes and meagre savings who overlook pension benefits when discussing net worth. Summers tells these clients they have a leg up on most of their neighbours. “To have a $1,000-a-month income, you’d need a hefty GIC.”

At a 2.5% interest rate and 25% marginal tax rate, that GIC would have to be $600,000 (not accounting for inflation).

Similarly, art or antique aficionados tend to treat their treasures as investments. But most advisors remain wary.

Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management, ignores personal-use assets like vehicles, jewelry, furniture or artwork—unless there’s a substantial art collection (see “Beautify your client’s portfolio,” ).

Net worth line items

Liquid assets

• Cash
• Bank accounts
• Certificates of deposit
• Mutual funds, stocks and bonds
• RRSP
• Pension plan

Illiquid assets

• Real estate
• Cars (at their current Blue-Book value)
• Life insurance policies (cash value on termination)

Liabilities

• Mortgage
• Home equity loan
• Car loan
• Student loans
• Credit card debt
• Insurance premiums

Most advisors leave depreciating assets, such as cars, completely off the tally. “[That’s] unless you’re looking at something like an RV worth $100,000 that the client intends to sell,” says Summers. “Even though it will fetch less, the amount will add to cash flow.”

For small-business owners, Golombek doesn’t treat inventory, equipment or machinery as line items. “That stuff depreciates quickly,” he says. He only includes real estate owned by the business, such as a store or an industrial plant.

He does, however, assign a value to professional-service businesses such as dental practices, accounting firms, or law practices. That value is generally derived using a multiple that’s applicable to that particular industry.

Generational Divide

While it’s relatively easy to talk about net worth with boomer clients, it’s more difficult to evoke the same interest or urgency in Gen X or Gen Y clients. Most of them still have negative net worth (when you factor in their mortgages or education loans) and less experience building wealth or cash flow.

In his conversations with early starters, Golombek weighs their human capital the same as financial capital. “I stress the importance of spending on post-secondary education. They may initially be mired in student loans, but it isn’t bad debt in the long run.”

Summers puts things in perspective by sketching three figures on top of networth statements: a person, a house and a dollar sign. The person denotes human capital or earning power; the house signifies the amount they spend on rent or mortgage; and the dollar sign represents the assets they’re starting out with.

“Net worth is a mix of all three,” she tells them. “Initially, you’ll have a negative dollar sign; the shelter will be a flat line. But there’s huge earning potential in the person. These signs will keep changing with time.”

Clients should, for instance, see higher shelter values after buying their first houses. As well, earnings typically rise as people age, but peak before retirement.

To stoke her younger clients’ financial enthusiasm, Summers includes even depreciating assets such as cars in their net worth statements, because often that’s all they have. Clients must estimate what they’d get for these assets, and if they’re actually going to sell them, she asks them to conduct a market survey to find out a reasonable price. “We recalibrate net worth at every annual review. It’s also good for them to witness early what is and isn’t an investment.” Younger clients tend to be complacent about wealth planning. They have a notion of infinite time before retirement.

Miazek tries to instill in his younger clients that there’s a finite period in which they can accumulate net worth. He points out that if retirement is 30 years from now, saving $10,000 a year only amounts to $300,000 (assuming inflation eats interest). For older clients, his conversations centre on how long retirement could potentially stretch. He works to give them a sense of winding down; and becoming comfortable with consuming rather than consolidating.

As clients age, it’s critical to involve their children in conversations about net worth. If a 55-year-old client decides to invest in an apartment building in Vancouver, Chucko lays it out clearly: “You’ll face a cap rate of real return of about 4%—and a 25-year term to double your money. When it’s time to reap the returns, you’ll be turning 80. You’d better start thinking of bequeathing it to the next generation.”

But, regardless of his younger clients’ legacy prospects, Golombek takes a conservative view of inheritance, and keeps it off their net-worth assessments.

“You have no idea what it’s going to be. Mom and Dad could change their minds,” he points out.

Some decide to leave money to charity instead; other times, parents could lose the money.

It’s personal

When it comes to calculating clients’ financial progress based on net worth, there are no standard formulas.

“It all depends on your spending habits, and how much you need to live on,” Golombek says. For his own net-worth calculations, he projects the amount of cash he’ll need in 20 years.

Then, he calculates a rate of return based on historical asset allocation and runs simulations to determine whether or not he’ll outlive his money.

Assuming he outlives his spouse and dies in his 90s, his goal is to not outlive his cash in 70%-to-90% of scenarios.

A net-worth statement is but a starting point; a snapshot of what clients have to begin with. How it’s treated when making cash-flow projections depends entirely on individual situations and aspirations.

In debt to their detriment

With Canadians in $1.5 tillion of collective household debt, it’s just as important to talk about liabilities as assets when discussing net worth.

Dessa Kaspardlov, CEO of KL&A in Windsor, Ont., says many clients tend to compartmentalize money.

“One of my clients had three months’ living expenses stacked away in a rainy-day account, and a line-of-credit loan of roughly the same amount.

The client was making interest and principal payments of $600 per month on the line of credit, while $22,500 languished in low interest accounts.”

It’s your job to help such clients understand the carrying cost of debt.

“I tell them there can be no saving as long as there’s debt,” Kaspardlov says. “They need to first fix that line item in their networth statement.”

Bad versus good debt

David Chucko, a partner at PwC in B.C., defines debt for personal consumption as bad debt because it detracts from net worth. But leverage for investments, he says, is good debt because it’s an effective way of increasing rate of return.

For example, if you had $1,000 that made you $100 a year, your rate of return would be 10%. Now if you were able to borrow $500 at 5%, your return would be $75 on a $500 investment. The total rate of return would go up to 15%. “But the riskier the debt, the less of it you should have in your portfolio,” Chucko warns.

Timing matters

The order, timing and frequency of how clients invest are important. “For example, investing money at the beginning of the year helps accrue more interest,” says Kaspardlov.

“Change the frequency of mortgage payments from monthly to bimonthly to weekly, and you start benefiting from dollar-cost averaging,” Kaspardlov adds. “Work the same kind of frequency on the debt side of the balance sheet, and the results are dramatic.”