Investors' remorse

Lamar and Farah should be dreaming of a debt-free retirement. Instead, the mid-50s couple is fretting over what to do with a six-figure investment loan backed by their home.

Five years ago, at the peak of the stock market, their financial adviser persuaded them to use a home equity line of credit (HELOC) to borrow $140,000 to invest in mostly equity mutual funds.

"I should have retired last June, but because of this problem with the HELOC, I've put in this year and I'll put in one more year," says Lamar, a teacher.

"I was a little nervous about doing it in the first place, and he told me 'There's no way you're going to lose your money.' "

Their adviser assured them they were investing in blue-chip stocks and the banks would have to fold for the strategy to backfire.

"In actual fact, they didn't fold in Canada, but they did in other places and we lost a pile of money," he says, referring to the credit-crunch crisis of 2008, which did lead to the collapse of banks in the United States and Europe, including Lehman Brothers.

Today, the couple's leveraged investment account is worth about $87,000.

"We feel a little duped by it all," he says. "In the long run, maybe the investments will all come back, but we don't have the long run."

The couple want to avoid selling at a loss, but they're also realistic. Their investments won't recover by the time they retire next year. As a backup, they've been saving as much as they can in case they sell the investments and pay off the line of credit. So far, they have $70,000 in savings.

"That's our last resort. I've thought of all kinds of things," says Farah, a federal civil servant, also a year from retirement.

"Most times, I close my eyes and make the interest payments."

Certified financial planner Doug Nelson says rarely is there ever a need for the average person to use a leveraged investment strategy to save for retirement, especially a couple who will receive a guaranteed monthly work pension payment once they retire.

"Was a leveraged investment loan ever needed in this situation?" says the financial adviser with Nelson Financial Consultants.

The answer was, is and always will be 'no,' says the author of Master Your Retirement. But many people are convinced by greed and fear to do it nonetheless. Either they fear they won't have enough money to retire, or they are convinced doubling down on the stock market will make retirement even better.

But these misconceptions can easily be doused by some clear-headed retirement-income planning, he says. Largely, this involves estimating after-tax income and expenses in retirement.

Based on Lamar and Farah's monthly expenses today, they would need about $3,000 a month after taxes from their pensions and savings when they retire. This figure includes items such as gifts, donations and vacations, but it doesn't factor in HELOC interest payments.

"If they were to retire today, they would have an approximate after-tax income of about $3,227," he says. "This would suggest that, based on their pensions alone, they are very close to having enough to retire today, without drawing on any more income from any other source."

As they age, their incomes will increase because they can collect CPP at age 60, and at 65 they will receive OAS.

Even if they didn't have enough money to retire, leveraged investing still makes no sense.

"In my view, this is akin to going to Las Vegas and rolling the dice, hoping for the perfect financial outcome," Nelson says. "If you are 'behind,' the best approach is to focus on high-probability outcomes, not gambling with what you have."

And if you are on track -- like Lamar and Farah -- leveraged investing is really only a good way to ruin retirement.

Fortunately, they can still retire as planned, only a little poorer.

Now, they need to decide what to do with the investments and outstanding loan.

If they sold the investments today and used the proceeds to pay some of the loan, they would still owe about $52,550.

They could then use the money they have set aside in savings -- $70,000 -- to pay off the remainder.

This would leave them with $17,450 in non-registered savings for emergencies, and they would still have more than $100,000 in RRSPs and TFSAs. Furthermore, that $52,550 loss can be used to offset taxes on any future capital gains on investments outside of their RRSPs or TFSAs. Or the loss also could be used to reduce taxes on other income from their estate upon death.

"Before they sell their funds, it is important to determine if there are any back-end-load withdrawal fees on these mutual funds," he says. "It appears the answer is 'no,' but it is best to check before proceeding on liquidating the assets."

Back-end-load fees are also called deferred sales charges -- or DSCs -- and are applicable upon early withdrawal from a fund.

"When investing on a DSC basis, no commission is charged up front by the adviser and his or her financial institution," Nelson says. Instead, the mutual fund company pays a commission of about five per cent of the invested value to the adviser and the advisory firm. This fee's cost is embedded in the annual management cost -- the MER -- a percentage of between one and four per cent of the invested capital.

On a fund with an MER of 2.5 per cent a year, for example, the adviser and advisory firm's compensatory share might be 0.5 per cent.

The DSC charge applies if the investor sells out of the fund and does not reinvest in a fund managed by the fund company. That's because the fund company must recoup its upfront compensation paid to the adviser, Nelson says.

Typically, the DSC is based on a sliding scale depending on how long the investor stays invested in funds with a mutual fund company. The cost can be as high as 5.5 per cent of the market value of the investment for years one and two, decreasing by 0.5 per cent until year seven.

At this stage, Farah and Lamar might even consider selling funds with DSCs because holding onto these investments in a rocky investment climate could be more costly than paying a penalty of about two to three per cent of invested assets.

"The problem with waiting is that if stocks continue to fall -- the TSX is down 14 per cent over the past 12 months -- then it will only cost more to wind up this strategy."

Furthermore, leaving the investments as is -- hoping they'll recover -- while paying interest on the loan, which is tax-deductible, is even more risky. It's more likely interest rates will increase than their investments will completely recover over the short to medium term. As a result, the HELOC's interest costs will become increasingly expensive at a time when they are shifting from work to retirement.

The painful truth is Farah and Lamar are better off realizing sooner than later the cost of their investment mistakes -- especially given that their retirement is already largely funded by their work pensions.

"Why continue with risks when you don't have to?"

giganticsmile@gmail.com

Farah and Lamar's finances

ñü INCOME

Farah: $74,647 ($3,900 net a month)

Lamar: $80,858 ($5,615 net a month)

ñü EXPENSES

Monthly: $2,966.94 (excludes $500 HELOC payment and $3,600 savings contributions)

ñü DEBTS

HELOC: $140,000 at four per cent interest

ñü ASSETS

Home: $400,000

Savings: $70,000

Non-registered savings: $2,993 in GIC

Lamar RRSP: $64,484

Farah RRSP: $55,231

Lamar TFSA: $5,855

Farah TFSA: $5,855

Non-registered investments (leveraged): $87,450

Lamar work pension: $2,600 a month in 2013

Farah work pension: $1,083 a month in 2013

Total assets: $621,868 (excludes pensions)

ñü NET WORTH: $551,868

Republished from the Winnipeg Free Press print edition May 5, 2012 A29