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Case study
Net worth strategy in action

Last week, I introduced the concept of the 'net worth approach' to designing investment strategies. This week, I'll show you how this approach can be put into action and why it makes good sense.

Hypothetical client: George

Age: 57
Occupation: Mortgage broker
Income: $40,000 + bonus based on sales
RRSPs: $130,000
Pension Plan: Defined contribution
Pension Value: Currently worth $110,000
Objective: Moderate and fairly consistent growth
Investor Type: Average

Analysis

With eight years to retirement, George's retirement accounts should reach a total that reasonably could start generating $20,000 per year. This will supplement his estimated $15,000 in government pensions - also to start at retirement - giving him a comfortable income based on his needs.

As a mortgage broker, both the amount and stability of George's income is based on mortgage sales. Mortgages sell in larger amounts when interest rates are low - which also results in larger bonuses on top of George's base salary.

George's pension plan, a defined contribution plan, is nothing more than a personal investment account - no unlike his RRSP. Defined contribution means that the ultimate pension benefit is uncertain, just like our personal retirement savings.

Both his pension plan and personal savings are invested in a variety of balanced funds so his effective asset mix is about 60 percent stocks and 40 percent in fixed income (i.e. bonds and cash). This is generally consistent with George's self-described "average" risk tolerance and modest investment goals.

Recommendation

I won't get into mentioning specific funds or other investment products since the focus is on strategy design. Frankly, this is where most investors' time should be spent.

Given George's stated retirement goals, a minimum rate of return of 5 percent is required - with a return of 7 percent ideal. Hence, the asset mix policy we've assessed for George will allow both the stock and fixed income components to fluctuate within a 40 to 60 percent range. I'd tend to prefer his current mix be a more neutral 50/50 split.

A more specific makeup of those segments will see a typical equity mix with a core of value-oriented stock pickers. The fixed income side is where a greater level of customization will be needed.

Since George's income rises with falling rates, his earnings are interest rate sensitive. The vast majority of his bond exposure (via balanced funds) is to government and investment grade corporate bonds, which carry the same type of interest rate sensitivity. Hence, it's unlikely a wise move to have such a large portion of George's net worth (i.e. his income and investments) so heavily tilted toward this type of interest sensitivity.

Hence, we won't mess around with the 50/50 strategy, but we'll certainly make sure to shift a significant portion of his fixed income assets toward vehicles that benefit from rising rates. The core will be in government of Canada Real Return Bonds, which thrive in inflationary environments - exactly the type of scenario that will hurt his income, his bond portfolio, and to a lesser degree his stock holdings. RRBs, still yielding a real return of nearly 3 percent, remain attractive.

This RRB core will be supplemented by a relatively smaller weighting in high yield bonds. For now, government bonds will be avoided for two reasons: a) because of the interest-sensitive nature of his income, and b) because of the high valuations (i.e. low yields) on government bonds today. So, a split of 2/3 RRBs and 1/3 high yield seems a reasonable mix.

What this also implies is that George should dump his balanced funds, in favour of separating his equity and fixed income segments. This will allow the type of customization we've noted above.

Conclusion

When the industry talks of customized investment solutions, the 'net worth approach' to designing investment strategy should be the reference. George's situation is a bit simplistic, but still very specific. It is this level of customization that will not only smooth out fluctuations in your portfolio - but in your total net worth.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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