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EVEN THE RICH ARE GEARING DOWN

By: Thane Stenner
October 2008

A lot of Canadians have grown rich this decade from sky-high commodity prices for oil, gold, potash, nickel, and coal, as well as increases in real estate values. This means the country has thousands more multi-millionaires.

That´s good for them. Now for a reality check, don’t blow it.

‘BURN RATES’

A slower economy, higher inflation, and lower returns in the market today mean that even if someone has $10 million or $50 million, they still have to adjust their spending or ‘burn rates’ to protect and preserve their lifestyles for the longer term.

A study from JP Morgan, ‘Wealth Preservation: The rate at which you spend matters – Even more than your asset allocation,’ shows that an individual living solely off a fixed pool of assets, spending five per cent of their net wealth annually, has a one-in-three chance of suffering at least a 20 per cent reduction in real wealth over the course of two decades. This is more relevant to a 45-year-old than to a 70-year-old.

Gearing DownThose aren’t great odds. So how do you better your odds after inflation is factored in?

Tricia Stewart, author of the report and managing director with JP Morgan Private Bank in New York, would recommend that individuals “maintain their pre-tax spending at about an annual three per cent to four per cent level. You can’t be spending five per cent or seven per cent of a fixed pool of assets every year and still expect to meet your long-term lifestyle goals.”

Here’s a story about recent client who had just sold his three-generation, family business to a publicly traded company for $25 million. Of this, $15 million is in tax-deferred shares of the public company, leaving him with $10 million in pre-tax cash.

The conversation that followed was a little tricky. Here’s why. He was accustomed to drawing $1.5 million pre-tax per year in income out of the business and had a pretty decent lifestyle or ‘burn rate.’ The common shares he received as part of the transaction came with some ‘lock-up’ restrictions, and did not generate any dividend income.

SOUND LIKE A LOT

Ten million dollars might sound like a lot, but it shrinks to $7 million after-tax. It’s true, he can, and will, invest his $7 million wisely in top-notch dividend and capital gains oriented investments. Then, he can draw a tax-preferred cash flow, probably in the ballpark of $1 million a year, from his investments, to equal the $1.5 million in salary he was getting. However, this is withdrawing his ‘freed up’ cash at a 14 per cent clip, which is definitely not sustainable in the mid- to long-term. I had to caution him at this point of the conversation that based upon his “freed up” liquid capital, he was in danger of potentially too high a lifestyle spending rate.

This scenario also makes his retirement and lifestyle very dependent on the public company’s tax-deferred shares he will now be getting as part of the sale. I had to inform him that he’s got a concentrated stock position risk, and he’s quite dependent now on the future success of a company he no longer controls or runs.

Fortunately, we know a thing or two about “stock monetization” strategies. In essence, this is where a loan is advanced by various institutions against the stock position he now owns.

LIQUID CASH

This will allow him to diversify his holdings further and have more liquid cash to draw from. In this case, we were able to shop the market and he was able to do a seven-year tax deferred monetization, and pull out approximately another $12 million tax deferred, adding to his $7 million in cash to total just under $20 million liquid. Now drawing out $1 million from close to $20 million means a cash flow “burn,” or withdrawal rate, of just above four per cent which is almost sustainable longer term. We still suggested a slightly lower withdrawal rate for the next three to five years, and then he could go a bit higher over time with his lifestyle cash-flows.

I can’t get into all the details here on this strategy, but the end result is a much stronger position for the client to draw retirement income from, and a significant reduction erosion of the capital.

The lesson from all this is quite simple. If the rich are having to slow down their spending currently, it probably makes sense for everyone else to follow their lead.

Thane Stenner is managing director, private client, and founder of Stenner Investment Partners of GMP Private Client L.P., and author of ´True Wealth: an expert guide for high-networth individuals (and their advisors).´ (www.stennerinvestmentpartners.com)

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