As we outlined in the introduction, this book is specifically designed to help you understand how you can go about creating a platform from which you can build wealth over the long term. This wealth will allow those who follow our advice to attain financial security, particularly in retirement when our traditional income stream, i.e. our salary, ceases.
Before we delve into the 'how' of building your wealth, it is important to explain the 'why'. We believe the why is compelling and is the primary reason that we decided to write this book (we have assigned a suitably serious title for this next section to explain ...).
As some readers might already know, there is a global demographic transformation underway that will have serious consequences to the economies of rich nations in the coming decades. Although we don't plan to go into too much demographic analysis, you need to know that the changes are very real and their economic impact will be felt well within our lifetime. You can read more about the demographic changes in our previous book, entitled Wake Up!. These are the key points you need to know:
The global population is steadily increasing and is expected to hit the nine billion mark by 2050 (a 50 per cent increase in just 50 years). The irony is that 85 per cent of this growth is from, and will continue to come from, the poor and developing countries. The developed countries are faced with a negligible or, in some cases, negative population growth.
Improved farming techniques and engineered crops will enable us to feed the growing population, up to a point.
A large demographic 'bulge', known as baby boomers (those born after World War II and before 1964), have started to retire and will continue to do so over the next two decades. As they leave the workforce, they will leave a void that will result in a shortage of skilled labour in the Anglo-Saxon economies.
The retiring baby boomers will put a huge burden on the economy as they will be spending money, i.e. drawing pensions from governments and corporations, as well as spending their own savings.
Because of their large numbers as a percentage of the population, baby boomers will put huge strains on the current medical care system as they age.
These changes will be irreversible, at least for the 21st century. Change is always painful, particularly for those who are unprepared. By taking the initiative to read this book, you will be in a much better position to plan for the future.
'But where is the savings crisis in all this?' you may ask. The crisis stems from the simple fact that the 'system', i.e. governments, corporations, healthcare providers, pension schemes, etc., will not be able to handle such a demographic change in such a short (relatively speaking) period of time, and as a result it will fail at its weakest point, which we believe is likely to be in the area of pensions – our lifeline in retirement. Unless we as individuals take steps to avert this future disaster, we risk living a miserably impoverished retirement, so we need to think wisely and make sure that we put enough away for retirement to ensure that this doesn't happen to us.
Source: US National Center for Health Statistics. Other developed countries have very similar figures.
The vast majority of the populations in the Anglo-Saxon economies have not saved enough for their retirement. Most are still saving based on an era when life expectancy was less than 70, and without considering the unprecedented stress that the retiring baby boomers will be loading on the economy.
If you plan to retire on your state and/or corporate pension, you had better take a closer look at how much this will actually provide for you in retirement, as the vast majority of you will be shocked by how little you will have to live off once you have retired. To avoid disappointment and financial hardship in later life, make the time to really understand your financial position and follow our common sense advice.
Governments have been too slow to react and haven't taken the bold and painful steps necessary to address the shortfall in state pension funds. Do you know what a full state pension is in the UK? It's £90.70 per week for a single person and £145.05 per week for a married couple. Annually, that's £4716.40 and £7542.60 respectively. Could you maintain your current lifestyle on this income, even if you had paid off your mortgage? Do not rely on the government to look after you in your retirement because it will be too busy raising taxes to make up the shortfall in tax revenue as a result of baby boomers dropping out of the workforce.
Governments will also be scrambling for additional income to fund the spiralling healthcare costs as a result of looking after the aging population. In short, governments will have their hands full trying to make ends meet – don't expect any meaningful handouts from them by the time you retire.
Rather than spending sleepless nights trying to solve the governments' dilemma, it's more productive and valuable to think about your own predicament so that you won't have to hope that they will have figured everything out by the time you're a pensioner. It is our belief that they will not have. So be selfish and think about yourself and your loved ones because that's the only way to ensure your financial security. Ask yourself this alarming question:
|How am I going to fund my life for 25 years without a salary?|
Most of us can't survive more than six months without an income, let alone 300 months. If you think about how long 25 years actually is, you will appreciate how much money you will need to be financially secure for this length of time. Don't forget that you will end up spending more than you think in retirement, especially if you wish to maintain your lifestyle and enjoy privileges such as overseas travel. There will also be the high cost of medical care – especially private healthcare. Remember that as we get older, we don't have the luxury of time so we can't just put our names on a government hospital waiting list and hope we get a call in nine months, because it might be too late by then.
Getting older also means we're probably going to be popping a few life-extending pills (to combat diseases affecting our heart, cholesterol and blood pressure, to name just a few of the more common ones), as well as making the odd trip to the doctor and/or hospital.
To put some sort of perspective on this, most of us have a working life of around 40 years. In that time, we need to have saved enough for the next 25 years, so the stakes are very high. If we retire at 60, we have a good chance of making it to 90 and beyond. That's a long time to be living without a salary, wouldn't you agree? Will you have put away enough by the time you reach 60 or retirement age? Not knowing is the biggest danger because the last thing you want to discover is that you haven't saved enough for retirement after you have already retired. At that point it will be too late to do anything about it.
If that's not enough to concern you, we also believe that higher risk investments such as equities will experience increased uncertainty as a result of the retiring baby boomers. Why? Boomers' pensions will switch to lower-risk assets as they start to retire because they will need to draw on them regularly. As a result of the aging population, it is estimated that 20 per cent of the populations of the US and UK will be over 65 in the next 20 years. Think of all those investments currently in stocks today that will be switched to cash, bonds and other lower-risk assets. There will still be opportunities in equities as there have always been, but it will mean that picking the right stocks will be more crucial than ever.
Although this all sounds rather daunting, it need not be. Today, we have the luxury of two extremely precious resources that we can use to build wealth. The first is time, a truly invaluable commodity when seeking to build wealth. As obvious as it sounds, the second is a regular source of income, which for most of us comes in the form of a salary. Once we reach retirement, we lose both of these and it will by then be too late to do anything about changing our financial position (unless we win the lottery or inherit vast sums of money from a rich uncle we never knew we had – both extremely unlikely events, so don't gamble with your financial future).
Japan is a good leading indicator of what awaits many developed nations. Already, over 26 per cent of Japan's population is over 60 and its population as a whole is expected to shrink from its present 127 million to 100 million by 2050.
This spells disaster for the dependency ratio – a measure of the number of retirees/over-60s to the number of workers in a country. Countries with higher dependency ratios as a result of low birth rates and tighter immigration policies will no doubt undergo weaker economic growth and poorer investment returns.
The UN believes that, by 2020, the combined dependency ratio (over-60s to workers) of the US, Europe and Japan (these countries make up 70 per cent of the global economy) will shift from 30:70 to 50:50. Let's explain what this ratio shift is saying: today, there are 30 retirees/over-60s to every 70 workers; by 2020 they will be evenly matched, one-to-one.
Here is an example to illustrate the significance of this point: suppose that a retiree draws a pension of $100 per month. This $100 is collected in the form of national insurance/social security from the current workforce. For a dependency ratio of 30:70 (or 0.429), each worker would have to 'chip in' $42.90 in social security. Using the same example with a dependency ratio of 50:50 (or 1) means each worker's contribution would have to go up to $100 to ensure that a retiree can receive his pension. Granted, not everyone over 60 will be retired but the statistics are compelling nonetheless.
It is unlikely that workers' contributions will rise by the same amount to keep up with the rising dependency ratio without riots in the streets. So we believe that the most likely 'fix' will be a curbing of benefits to retirees, and a further raising of the retirement age, perhaps to around 72 years. Those dependent on the government for their pensions will be forced to work for a lot longer and get a lot less. That's just not an attractive future to look forward to.
We hope that by now we have been able to convince you of the magnitude of the situation and that as a result you are sufficiently motivated to act now by taking the right steps to secure your financial future before it's too late. We have written this book to share with you our BigIdeas for the coming decade which will ensure that you have invested wisely for your retirement.
In fact, these demographic changes lead us nicely into our first BigIdea. Although we haven't yet advised you on how to go about building wealth, this BigIdea is so closely linked with the aging population that we thought we would discuss it now while all the demographic facts are still fresh in your head. You will, of course, still need to read the 'how' later on in this chapter to fully appreciate how the big investment ideas fit into the overall picture of wealth creation.
BigIdea # 1
As you will have read earlier, or you may have known beforehand, we in the rich world are living longer. The global population is increasing (to 9 billion by 2050 from the current 6.7 billion), the percentage of people over 65 is also increasing (to 1 billion by 2030 from the current 500 million – doubling) and the baby boomers have started to get older and retire (right now, in the US alone, an average of 330 people are turning 60 every hour).
As an aside, there is a very interesting website that contains a world clock with a difference. This website tracks a multitude of statistics, including world population, births, population growth and deaths, to name just a few. It's worth spending a few minutes watching the rate that some of these numbers increase. The website is:
Now, back to how we can turn an irreversible demographic trend into an investment opportunity. One of the ways this can be done is to invest in something that almost all old people use at some point in their life – no, not a golf course, something far less glamorous: nursing homes, sometimes referred to as assisted living. Some of the affluent retirees are opting for a more up-market environment by choosing to live in retirement communities instead. These allow retirees to still receive all the medical attention they need but without the dreary feeling of living in a hospital.
There is no doubt that we're going to need many more places where retirees can live, feel part of a community and have access to elderly care as and when needed. These retiring baby boomers are not going to hold back either – they will spend as much of their savings as it takes to ensure a comfortable retirement with 24/7 access to first class medical care.
So how do you go from identifying the concept of an investment opportunity to actually making an investment in this BigIdea? We're not suggesting that you go out there and start up your own nursing home, although if you have a business plan, the drive and the funding to do so, it could prove to be a very lucrative venture for you. Good luck. But for the rest of us who intend on keeping our day jobs, we suggest investing in a basket of companies that are well-established in this field and offer considerable growth opportunities.
There are quite a few companies out there that focus on building and/or managing homes for retirees. A few examples of such companies are Assisted Living Concepts (listed in the US), Brookdale (listed in the US) and Emeritus (listed in the US and Germany). If you have the time, the ability and the inclination, we would encourage you to do your own research in this field and invest in the companies you believe have the best growth potential.
We do, however, appreciate that you may not have the time, inclination or even the ability to analyze companies' financial data and make investment decisions based on your own analysis. But don't despair; it doesn't have to be that complicated if you don't want it to be. There is still an excellent investment opportunity for you in the form of a packaged, easy-to-buy financial product that invests in a basket of nursing homes/healthcare related companies. These packaged products are called REITs (Real Estate Investment Trusts) and there are quite a few REITs that specialize in this area. We discuss REITs in more detail in Chapter Three. There are around a dozen or so major REITs specializing in properties catering to retirees. Here are just a few to consider:
Get online, spend some time reading up about these REITs and pick the one you feel most comfortable with. Don't rush. This REIT will be part of your investment portfolio and integral to your wealth creation. If you really can't decide between two REITs, it is okay to choose both of them but we suggest you don't choose more than two. Incidentally, if you come across another healthcare REIT during your research, by all means include it in your short-list – the ones we name are just a few examples of the types of companies to invest in for this BigIdea.
BigIdea # 2
So compelling is the investment opportunity from the aging population that our second BigIdea also takes advantage of this trend. After all, the retiring baby boomer phenomenon is a sure thing and there aren't many of those around. The elderly will continue to make up an increasing percentage of the population and rich nations are faced with a record number of retirees on their hands.
So our second BigIdea relates to investing in companies that have the most to gain financially from serving or selling products and services to retirees and the older generation. Put yourself in a retiree's shoes – what would your needs be at that stage in your life, assuming that you've already found your nursing home or retirement community to live in? You'd be making sure that you had a good health insurance plan, that you took your medications regularly, and also your nutraceuticals, which are natural extracts that are believed to promote wellbeing and prevent certain diseases. An example of a common nutraceutical is glucosamine, which is taken in tablet form and used to maintain healthy joints and for the treatment of osteoarthritis.
As unfortunate as it seems, we're also likely to be spending some time at doctors' clinics and possibly in hospitals, so we'll be using the latest screening techniques to diagnose our ailments as well as the next generation medical equipment – Magnetic Resonance Imaging (MRI) machines, ultrasounds and equipment that doesn't even exist today. Doctors may also be able to screen our DNA and determine what is wrong with us or what we are genetically predisposed to.
New breakthroughs and reduced costs will make cutting-edge technology affordable to everyone. The types of companies that will likely be providing these products and services of the future are health insurance companies, pharmaceutical companies, companies specializing in research of one of more diseases – particularly the ones that tend to affect the older population, such as Alzheimer's – companies involved in genetic screening and sequencing, biotechnology companies, medical suppliers, and medical equipment companies. All of these can be categorized under healthcare.
We're not expecting you to analyze every company that falls under these categories, but we are trying to stimulate your thought processes because you may be developing your own BigIdea along these lines that we haven't mentioned so far.
For those of you looking for an easy-to-invest formula in healthcare – and we're not saying that it's a bad thing – we recommend that you consider investing in a managed fund that specializes in healthcare. There are quite a few of these available today, each with its own angle. There are also Exchange Traded Funds (ETFs) to consider. These are passive funds that invest in a basket of listed companies. We explain more about ETFs in Chapter Four. Some ETFs give a strong weighting to a handful of companies, whilst others cover around 30 companies. The latter would be less volatile as their performance won't hinge so much on the performance of a small basket of companies. Some ETFs have a very specific theme; others track one or more industries, regions, currencies, etc.
Let's discuss a particular ETF to give you a clearer understanding of what they are. We'll use a quite specialized healthcare ETF managed by iShares (part of Barclays PLC). The ETF is called Dow Jones U.S. Medical Devices Index Fund (ticker symbol: IHI) and invests in non-disposable medical equipment companies including manufacturers of medical devices, such as MRI scanners, prosthetics, pacemakers, X-ray machines and other non-disposable medical devices. At the time of researching this ETF, it was made up of a basket of 43 companies. To find out the names of these companies, you can go to the iShares website and look up this particular fund (
The important thing to remember here is the theme – medical devices. An aging population will increase the need for medical equipment, thus creating additional motivation for new and effective ways of diagnosing disease and prolonging life.
There are a number of other iShares healthcare ETFs you can look at in more detail, from healthcare providers to pharmaceuticals. If you can't decide on a specific healthcare theme, you can opt for the broader ETF entitled Dow Jones U.S. Healthcare Sector Index Fund (ticker symbol: IYH), but we like the more focused themes such as the medical devices, diagnostics or cancer research.
So what is the best way to go about planning the path to prosperity? After all, who wouldn't want to have a retirement that is free from financial concerns? Certainly, investing in some of our BigIdeas or some of your own BigIdeas will help in getting superior returns on your investment; however, fundamentally more important than that is building a stable financial footing from which you can invest and grow your wealth. We will refer to this as your investment platform.
In this section we discuss what we believe to be the building blocks of prosperity. Without these blocks in place, creating and building wealth becomes a serious uphill battle. We believe the building blocks to prosperity, in this order, are:
Eliminate Your Debts – the ones that charge the highest interest rates first
Live Within Your Means
Adopt the Discipline of Saving
Own the Home You Live In
Think Long-Term – the invisible block
As we've stated many times before, especially in our previous book, Wake Up!, being in debt is the worst thing for creating wealth. The most dangerous of all debt is credit card debt. What is the point of trying to save money if you have an outstanding debt that is costing 20−30 per cent per annum to service? It's simply not possible to get a risk-free return on investment that is greater than the interest rate charged by credit card companies, so don't even try saving any money before you've paid off your debts.
Spend however long it takes as, without a doubt, this is the most important building block in wealth creation. Don't even try to move on to the next building block until you've eliminated your debts. This is the foundation block and if it's not in place, the stability of the other blocks is at risk. If your debt is scattered and out of control, consolidate it. Just remember these two guiding principles when it comes to debt consolidation:
So take a moment to add up all your debt, then extract equity from your home mortgage (if you have one) and use it to pay off all your non-mortgage debt. You will feel a whole lot better for having done so, plus you will immediately save yourself money as the cost of servicing the debt will fall from an annual percentage rate (APR) of up to 30 per cent to around one fifth of this amount, which on a debt of $10,000 equates to a saving of $2400 in only one year. Think of this as a form of saving, as not paying this money to credit card companies as interest means it ends up in your pocket instead of theirs.
If you don't have a mortgage that you can tap into to release equity, consolidate your debt by taking advantage of a new credit card promotion that is offering debt consolidation and low to no interest for periods of three, six, or even nine months.
For readers living in the UK, it is worth visiting a comprehensive comparison site such as Moneyfacts (
www.moneyfacts.co.uk) or Moneyextra (
www.moneyextra.com) – you will be able to review the best credit card offers and the interest-free periods before deciding on the deal that is most suited to you.
Once you've consolidated your debt and you're living under the 'interest-free period' of the new card, you need to devote the bulk of your monthly wages towards paying off as much of your debt as possible. No expenses, other than essential commuting costs, groceries, rent and utility bills. Please don't dismiss this suggestion – it is simply a case of short-term pain for long-term gain.
Every month you remain in debt is another month in the opposite direction of saving and reaching your financial goals. The pain associated with adopting an aggressive debt repayment plan will also make you realize that credit cards are not a source of 'free money' and that this is literally pay-back for the months or years you have spent living beyond your means. Do it and kick the debt habit. Debt elimination is the start of wealth creation.
Building Block 2: Live Within Your Means
Putting it another way, living within your means is not spending more than you earn. For example, if your net income every month is $3000 after taxes, your total outgoings every month should not exceed this amount. As obvious as this sounds, the average household in most Anglo-Saxon countries is breaking this very basic rule every month, getting deeper and deeper into debt (see Building Block 1) and therefore preventing them from ever leaving Building Block 1.
Living within your means does not mean that you have to spend exactly what you earn either – you need to strike a balance so that you can meet your most essential financial obligations every month, such as food, rent/mortgage, medicines and transportation, and still have enough to invest. The amount that you need to put aside is very important and is determined by a number of factors that we shall cover towards the end of the book in Chapter Nine, on how to use our DiagnosticGrid.
After paying the bills, the mortgage and buying the groceries, many of us head out to the shops to spend the rest. This, unfortunately, leaves us cash-poor not long after payday and we end up having to hang on for the next pay-cheque to survive. Some impatient spenders may go one step further and resort to the dreaded credit card to buy things with money that they haven't even yet earned. It all starts off innocently and well-intentioned with a couple of impulsive purchases, but it doesn't take long before these purchases become compulsive. Buying on credit is, for many people, the start of a long, slippery slope into indebtedness that gets tougher and tougher to get out of.
This is clearly an unhealthy and unsustainable pattern. But old habits die hard and in order to realistically and successfully go about creating wealth we need to completely change our mindset about spending, investing and how we perceive debt. Getting stuck at Building Block 1 for a while is a result of not living within our means. If you qualified for Building Block 2 without having to stop at Building Block 1, congratulations, as Building Block 1 is the biggest of all hurdles. If you did spend some time on Building Block 1, then you will have more than learned your lesson on the consequences of careless spending and living beyond your means and you will certainly never want to revisit Building Block 1 again.
Having eliminated your debts (excluding the mortgage of your home), the next step is to rein in spending. In order to do this, you need to know what financial state you are currently in – if you think of your household as a small company, you need to look at its income statement; in other words, what are the household revenues or income, and what are its expenses? If revenues exceed expenses, then the household is making a 'profit', and this money can be 'reinvested' in the household's future, i.e. financial security through the creation of wealth.
If you would like some guidance on how to budget your household and how to classify each item of incoming or outgoing cash, we have prepared a simple budgeting template in Appendix A (p. 217), which can be used to get you going. Appendix A also contains a template to help you determine the current state of your finances – your household balance sheet. You can download a more comprehensive electronic version we have created called DiagnosticGrid by visiting
www.bigideasbook.com and clicking on the Downloads tab.
Be honest in the budgeting process and don't forget to collect a receipt for the tiniest of purchases, as only then will you be able to discover where the 'leaks' in your wallet lie. At the end of the month you then need to take the pile of receipts and divide them into the following categories (as per the budgeting template in Appendix A):
Home (such as mortgage, rent, home repairs, bills, appliances and groceries)
Utilities (such as gas, telecom charges, electricity and water)
Transportation (such as car, taxi, train and bus)
Other (such as tuition fees, dental costs and medical bills)
Discretionary spending (yes, we need to include those shoes and handbags/purses because we know this is a soft spot for many ladies)
Once you've added up the spending in each of these categories, you will be able to clearly see (a) what you have left from your salary every month and (b) which categories are costing you the most.
Even if you don't manage to get a receipt for something, just put the amount and a brief description on a piece of paper and include it with the other receipts – otherwise you could be fooling yourself into thinking that the purchases that took place without a receipt won't impact the budget.
To really track your household finances, use your bank statements, your chequebook stubs and your credit card statements to complete the template, as this should provide you with all the information you need. If you are having trouble with this approach, try another: for an entire month, keep a receipt for every transaction you make. At the end of that month, you will be able to tangibly see what your money was spent on. Even the most disciplined are often surprised at how much money is 'wasted' on unnecessary expenses – dining out frequently and the liberal use of taxis (for the city dwellers) are two of the most common, but also it's those spontaneous retail therapy moments that give us the initial post-purchase euphoria before the item ends up being discarded and shelved for the remainder of its existence. Think before you buy. Ask yourself the following questions: How necessary is this item? How much utility will I get out of it? Is the price reasonable? Am I borrowing money (i.e. running a balance on my credit card) in order to afford it?
As a general guideline, we recommend that your household spending does not exceed 50 per cent of your net income – so that includes all items that fall under Home and Utilities in our budgeting template. If it does, it is more than likely you are living beyond your means and you need to make some adjustments before you are ready to embrace Building Block 3. Analyze your spending to identify where cost cuts can be made. It may simply be that you are living in a place that is too expensive for your current income level. If that's the case, don't be ashamed to move to a less expensive place. Remember that this would actually help you become financially better off so it would be a step towards creating wealth. See how your household spending is made up – are you spending more than 35 per cent of your net income on rent or mortgage payments? If so, you're probably living beyond your means as you won't have enough money left to allocate spending to the other categories and still be left with something to invest.
Although you are free to spend your money on anything you wish, we are fairly certain that you are reading this book because you are interested in learning how to save effectively and to build sustainable long-term wealth. Chances are that if you are currently living beyond your means, you either already know it or have a gut feeling telling you so (or a credit card balance that is keeping you awake at night).
Bear in mind that budgeting is not a science and every household is different, but at least this exercise will allow you to take a good hard stare in the mirror and understand how you are looking financially, as good or as bad as it may be. It will also allow you to see if your spending pattern is completely out of line with your income. This will force you to review each expense and determine whether you can reduce it or do without it altogether. For example, do you subscribe to any magazines that you don't read? Do you subscribe to a club that you rarely visit? Consider cancelling such subscriptions.
Once you've reviewed your spending and made the necessary adjustments (or even budget cuts), you should be left with some spare cash at the end of the month. If not, we're afraid that you are still living beyond your means and you will have to go back and make additional spending cuts. Only when you are able to come out with a surplus of around 10 per cent of your net income every month will you be ready for Building Block 3. The actual recommended percentage will be determined by our DiagnosticGrid in Chapter Nine, but 10 per cent is our broad guideline. Before moving on to Building Block 3, we need to ask you again, have you paid off all your debts (with the exception of the mortgage of your primary residence)? If not, you need to use your surplus money every month to pay off your debts, starting with the lenders that charge the highest interest rates. If you have any savings, the best use for them is to pay off your debts (excluding the mortgage of your primary residence).
Once you have done this, you are finally ready to start investing ...
Building Block 3: Adopt the Discipline of Saving
Having cleared those burdensome debts and established a positive monthly cash flow, we can discuss how to go about building that nest egg. At the risk of sounding obvious, we believe the most effective way to build your wealth for later life is to invest a little amount on a monthly basis. Why monthly? Simply because most of us are paid monthly and it is the opportune time to invest some of our money before we are tempted to spend it foolishly on things that have no future value. If you are paid bi-weekly, investing monthly, i.e. every other pay day, would also work.
You need to change your mindset from spending what you earn – it's all about adopting a new and more productive habit of putting some money away every month from your salary or other income source. In time, this should become a habitual ritual, a life practice, drilled into your behaviour patterns until the day you are ready to retire.
You can view Building Block 3 as the transitional building block as it takes you out of the habit of living for today and towards one that prepares you for living for tomorrow. This doesn't mean that you'll have to stop living for today, of course, but it does mean that you'll need to give more thought to how you spend your hard-earned cash.
Remember that each month when we are paid is a unique opportunity for us to invest in our future prosperity and we should make the most of this opportunity. As tempting is it may be, don't yield to careless spending as you'll end up back at Building Blocks 1 and 2 for the rest of your life and with nothing when you retire. Stay in control of your finances, because if you're not in control of them, by default they are in control of you, and that is not a good position from which to become wealthy.
The unique DiagnosticGrid that we referred to earlier will help you to determine how much money you need to invest every month based on your current personal and financial circumstances. It will also help you with recommendations on how your investments should be allocated, i.e. what percentage should go into stocks, what percentage into currencies, gold, bonds, commodities, property, etc. So the output will be a tailored monthly investment plan to help you invest a little every month. This leads us nicely into our third big investment idea.
BigIdea # 3
To create a solid investment strategy that will withstand the test of time and provide you with some flexibility, we recommend that you structure your investments around your home, which should serve as your core asset. You can then allocate your investments around this based on the amount of funds you have available to invest. Once a structure that is suited to your financial profile has been created (and we help you with this in Chapter Nine, entitled DiagnosticGrid), you can then allocate the appropriate percentages every month based on the amount you have available to invest. The following diagram illustrates how an investment platform could look, where the home is the core asset.
Now you may be thinking that there is no way you can grow wealthy from putting away a few hundred dollars a month, so we will try to convince you with a couple of examples designed to show just how much of an impact compounded returns over time can have.
A 35-year-old person who manages to invest $500 (or pounds if you prefer) per month, with an average annual return of 5 per cent after tax on his investment, will be sitting on $77,641 in just ten years.
If you think that's impressive, let's introduce a third resource into the equation (the first two being money and time): wisdom – the great multiplier. If you took money, time and wisdom together and applied them to the same example above, the results would obviously be better. By investing wisely, you would be able to achieve a superior rate of return, say on average 10 per cent per annum after tax. After the same ten years, the same monthly investment plan would be worth $102,422, which is a 32 per cent better return on investment.
Now let's take this same example one step further to demonstrate what an incredible multiplier time and discipline can be.
If you followed the same investment plan of $500 per month from the age of 35 and were able to achieve an annual net return of 10 per cent for 20 years, at age 55 your nest egg would be worth a very respectable $379,684. This further illustrates that investing monthly is more effective and less burdensome than making lump sum investments. The other important point to emphasize is the way you invest your money really makes a difference over the years – as you can see, after 20 years of investing $500 every month, one can build a sizeable investment portfolio.
Building Block 4: Invest Wisely
Having created the right environment for your finances to flourish through the establishment of your investment platform, you are now ready for the important part – the investing. The reason why this is so important in wealth creation is because investing wisely can mean the difference between an average annual return of 3 per cent versus 20 per cent. Compounded over 20 years, this makes a huge difference. For example, if we put $100 in an investment for 20 years earning 3 per cent per annum, at the end of that period it would be worth $180.61 – a growth factor of 1.8; but if that same $100 brought in an average annual return of 20 per cent, it would be worth $3833.76 over the same 20-year period – a growth factor of 38. So you can begin to see why investing wisely is such a valuable building block in allowing your money to work for you. Albert Einstein described compound returns as the 'eighth wonder of the world' and with the example above you can see why.
Much of our book is dedicated to investing in products and areas that we believe will provide you with superior returns on investment, but, again, these investments must be made from a stable platform over the long-term and diversified in a way to spread the risk and maximize the return. There are a number of asset classes available, each with their own pros and cons, and we discuss them separately in the subsequent chapters. But for the time being, let's move on to Building Block 5.
Although we dedicate the entire next chapter to the subject of real estate, it is worth discussing briefly the value of owning your own home in the context of our building blocks to prosperity. Property has arguably been the hottest investment topic in the western world over the past decade. Everywhere you look, there's a frenzy of salivating investors and developers. And if that wasn't enough, there has been a barrage of property-related TV programmes, covering subjects such as fixing up homes, finding homes, selling homes, buying second homes, finding investment properties, etc. – you name it, chances are there's already a TV programme about it. This media exposure has certainly done its part in further feeding the property frenzy.
There is no denying that the past decade or so has seen some incredible increases in property prices. However, for the past few years we have been of the opinion that we were on borrowed time. In Britain, house prices rose by 205 per cent from 1997 to 2007, according to Nationwide Building Society. That's an annual average increase of 20.5 per cent. Sure enough, such levels of house price inflation proved to be unsustainable and prices in 2008 fell by 16% per cent from the previous year, with a general expectation that prices had a lot further to fall.
Over the same ten-year period, house prices in the United States increased by 175 per cent according to the Case-Shiller Home Price Index published by Standard and Poor's. That's an annual average increase of 17.5 per cent. They too of course have seen similar falls in 2008.
Wages have certainly not kept up with these increases. So how were people able to buy property at such stratospheric prices? Simple – by being offered incredible financing terms. The extra debt taken on didn't seem to bother home buyers because for some reason they had all got it into their heads that property prices would always go up, thus allowing them to make significant capital gains. This theory, of course, has proved to be nonsense.
Who could have imagined that it was possible to 'buy' a house without actually putting any money down and only paying off the interest of the loan every month? Does that really count as owning the house or is it simply holding the title to it on behalf of the bank/lender – the true owner of the house? It's really just a more elaborate and riskier way to rent.
With big falls in 2008, we don't expect prices to stabilize until two things happen: (1) banks start lending again; and (2) consumer confidence returns – without consumers believing that property prices have bottomed out, why would they even consider buying? By our reckoning, we don't believe these two things will happen until some time in 2010. Of course the global financial crisis could worsen further in 2009, which could push out the recovery to the tail end of 2010 or even 2011.
Now let's go back to the subject of owning the home you live in – when we say 'own', we mean a home you actually have some equity in. By that we recommend a minimum of 25 per cent and a partial repayment of the outstanding loan (principal) every month. If your stake in your home is less than 25 per cent, we suggest that you work towards increasing your home equity as a priority until you reach this target. If you own little to no equity in your home and 25 per cent seems like an unattainable target, we suggest you sell your home and rent a smaller place for a while until you have saved up enough for a 25 per cent down payment. The last thing you want to have happen to you is to get caught with only a 0–10 per cent equity stake in your home when property prices are nosediving. It would only take a 20 per cent drop in house prices, which has already happened in some regions, to send you into negative equity and then you're back to Building Block 1 and all the hard work of getting to Building Block 5 would be undone.
If you still think that there is some upside in the housing market and that you should hang on to your home and your nominal equity in it, then you're gambling with the future of your wealth. This book is about building wealth through long-term wise investments – leave the gambling to Las Vegas and Macau. If you've been caught out in the property crash and are now sitting on negative equity, try your best to renegotiate your mortgage with the bank. Try and get a deferral on your interest or principal repayments for a while. Banks are being more flexible during the credit crunch because the last thing they want is to repossess thousands of homes and to auction them off as a distressed asset. They stand to lose more than you and banks don't want to end up with a pile of repossessed homes on their books. They have enough problems as it is.
As a long-term goal, there is nothing like the feeling of owning your own home. The benefits are undeniable – the physical and mental security of having a roof over your head no matter what happens; the financial security of knowing that you could cash out if you wanted to or had to sell it, relocate, downsize, travel, etc. Let's not forget the significant increase in disposable income you would have – no longer would 25 per cent to 35 per cent of your salary disappear every month towards paying your mortgage or rent. This additional money could improve your lifestyle and allow you to strengthen Building Blocks 3 and 4.
Do not lose sight of the goal of owning your own home as the core building block in your investment portfolio. But don't rush to buy if the market is looking too expensive (like it is just about everywhere in 2008 and 2009) – property prices are cyclical. Be patient. Use the time to plan and save. Rent a humble place in the meantime to allow you to save more. We discuss real estate in more detail in the next chapter.
Before moving on to the chapters that focus more on the types of investments you can make to build your investment portfolio, it is worth spending a few moments on a subject that is very important in countries with a relatively high tax base – pensions. The reason why it is important to factor pensions into your investment strategy is because of the tax breaks that are offered to investors by governments. For example, if you wanted to buy $1000 worth of a healthcare company, ideally you would try to do so from your gross income, i.e. before it has been taxed, otherwise you may need to earn, say, $1600 to net the $1000 after taxes. By investing within your pension scheme, your money would remain untaxed (although there are caps on how much you can invest) until you retire.
Seeing as you are investing largely for your retirement, you would not need to access this money until then in any case. Again, there are exceptions to when you can access your pension fund; the rules change frequently and are different for every country so you need to understand how it applies to where you live and work.
In order to ensure that you don't start drifting off, we'll only give you a brief outline of pensions, and we'll limit our scope to the UK, the US and Australia. Wherever you live, you need to speak with a pension specialist or financial advisor as he or she will be able to advise you of the most efficient way to invest in your BigIdeas to minimize your tax exposure. Pension laws and regulations are complex and in a constant state of flux, so it definitely pays to keep aware of these changes: not taking advantage of tax breaks in your country's pension schemes can drastically reduce the net amount of funds you use to make your investments. Also, investment gains made outside a pension scheme are often subject to other forms of tax, such as capital gains tax and dividends tax.
We hope we haven't started to lose you already ... have another shot of espresso and make sure that you at least understand the basics before you arrange to meet with a financial advisor.
In all fairness, we agree that it isn't the most riveting topic in the world because it forces us to think about retirement, which is associated with aging and edging closer to our inevitable departure from this world. But dying is unavoidable and an inevitable conclusion to living so we shouldn't delude ourselves into thinking that it somehow doesn't apply to us or that we won't get old – we will actually get older and live longer than ever before so we need to plan better for our retirement than previous generations. Not planning and preparing for our later life in advance will likely result in financial hardship and subsequent misery.
The best way to visualize how we should all be planning for our retirements is to think of ourselves as captains of big cruise ships at sea: it takes a lot of time to analyze our destinations, study the charts, chart the course and make subtle course adjustments along the way. We can't make drastic manoeuvres with a 100,000 tonne vessel, hence we need to know where we're going well in advance so we can pick the appropriate speeds and headings. We will certainly need to make course corrections along the way, but the further we drift from our heading the more drastic the course corrections will have to be. Similarly, the longer we leave the future of our finances unplanned, the more drastic the measures we will need to take to get us back on the right course. A well-planned trip with smooth sailing is our objective.
Let us discuss state pensions first – and what a state they are in.
Given how we have already discussed the frightening rate at which the developed nations are aging, it will come as no surprise to many of you that almost all major developed nations are carrying massive pension liabilities – somewhere in the range of 100–250 per cent of Gross Domestic Product (GDP). Since governments of Western nations have already spent the pension contributions made by the generation of workers who are only now starting to retire, the burden falls on the current workforce to fund the pensions of these retirees – the baby boomers who have now started to retire and will continue to do so over the next 25 years. But the workforce over this same period will not be sufficient to provide pensions for these retirees.
In the UK, a fully paid-up worker, i.e. 44 years for men, 39 years for women, is eligible to receive a full state pension of £90.70 a week from the British government. That works out to be £4716.40 a year. So unless you're planning to retire in the remote fringes of the developing world or live like a hermit, grow your own vegetables and raise your own livestock, it isn't going to be enough money for you. This is the situation today. No doubt it will deteriorate further over the next 30 years. The state pension is so derisory that you are better off assuming that you will be receiving nothing from the state when you retire. It's best to view a state pension as a pleasant surprise should it still be around in some shape or form when you reach retirement age, but don't count on it in your retirement plans or you will surely be disappointed.
In the US, there is Social Security but it is in tatters. It is estimated that Social Security is under-funded by some $7 trillion and there does not appear to be a solution to address these unfunded liabilities. So, again, it is safe to assume that there will be no social security of any substance waiting for you when you retire. To make matters worse, the baby boomers are going to push the percentage of the population over 65 from 12 per cent to 20 per cent over the next 20 years. This will put further strain on social security.
Many countries have a structured pension system that allows employees to put a percentage of their income away into a pension fund every month during their working life. The tax breaks tend to be attractive enough to make investing in this way worthwhile. The problem is that not many people know how their money is working for them while they dutifully say goodbye to a chunk of their pay cheque every month, because many pension schemes are not very transparent. In addition to that, investors seldom take an active role in managing their pension funds.
UK residents are rather fortunate when it comes to non-state pensions – it has very generous tax breaks and legislation that favours the employee, yet many of us are not taking full advantage of them. As we have already explained, we completely advise against anyone relying on a state pension for retirement as it will not be enough to live off and in all likelihood will not even be around by the time most of the post-baby boomer generation (often referred to as generation X) retires.
A defined contribution scheme is essentially a segregated account set up specifically for your pension, which you and the employer invest into. The employer is not responsible for the pension's performance and whatever it is worth by the time you retire is yours to keep (provided you have worked with the employer long enough to have the right to the employer contributions).
A defined benefit scheme is when an employer guarantees an employee a percentage of his or her salary upon retirement for the rest of his or her life. Typically, employees with 40 years of service would receive two-thirds of their salary at the time of retirement for the rest of their lives. Whilst this is an excellent arrangement for long-serving employees, it is an incredible headache for companies offering this annuity pension to its employees. They need to determine the demographic profile of their work force and employ expensive actuaries to advise them on how much cash they need to free up from their balance sheets to make these pension payments.
Pension liabilities can run into the billions of pounds for large corporations. A few of the companies with the largest pension liabilities on the London Stock Exchange are BT (£39 billion), Royal Dutch Shell (£31 billion) and Royal Bank of Scotland (£27 billion).
It is no wonder that companies are doing everything they can to switch over to the defined contribution scheme. If you are fortunate enough to be enrolled in a defined benefit pension scheme, do everything you can to hang onto it. It's a benefit that truly outweighs any other and is being phased out so don't let it go without a fight. It is also worth putting in the years of service required to ensure a guaranteed salary during your retirement. However, there is no sure thing in this world and you are exposed to the risk, however remote, of your employer going bankrupt at any time between now and the day you depart from the land of the living. That could be 25 years from now or 55 years from now – either way, it's a long time and anything can happen, even to today's FTSE powerhouses. Many of today's big corporations were not in the same position 30 years ago.
The government has taken some steps to address this risk to employees and retirees: in 2005, it established the Pension Protection Fund (PPF) to ensure that retirees continue to receive their pension in the event the employer goes bust. The catch is that there's a cap on the amount the PPF commits to covering if your employer goes bust before you retire. At the age of 65, this cap was £30,856.35 for the 2008–2009 tax year, so if your pension is likely to be more than this amount, then you are still exposed to the possibility of your employer going bust at some point between now and when you retire.
Although there isn't much you can do to ensure the future survival of your employer (unless of course you are the Managing Director/CEO of your company, in which case you're at the helm), we recommend that you keep an eye on any changes that are being considered to the company pension scheme. If you are ever offered a lump sum cash payment instead of a guaranteed salary during retirement (annuity), consider it carefully. A lump sum payment means you are no longer exposed to your company's success in the future and the money would be transferred to your name to invest and to live off directly. We are the type of people who prefer to have our money under our control, so we would opt for taking the lump sum pension payment if it were ever offered to us – provided it was a fair amount, of course.
If you are enrolled in a defined contribution pension scheme with your employer, it can be either contributory or non-contributory in nature. The contributory scheme means that you are required to invest a portion of your gross salary (usually 5 per cent) towards your pension, whereas the non-contributory scheme means that the employer is making all the pension contribution each month.
Quite often in the contributory scheme, the employer will match or sometimes even double the employee's contribution. So, for example, if you put away £200 per month towards your pension (which is not taxable), your employer would also contribute £200 or even £400 per month in addition to your contribution, which means that you have immediately doubled or even trebled your pension investment amount before your money has started to work for you. And did we mention that it's tax-free?
The downside of a defined contribution scheme (both types) is that in many cases employees don't have many investment choices or much flexibility in the products available to them.
If you work for a smaller company and your employer does not have a pension scheme set up, we recommend that you consider setting up a personal pension to take advantage of the tax relief. A Self-Invested Personal Pension (SIPP) allows investors to have reasonable control of how their money is invested and also offers a broader range of products, including:
Insurance company funds
Commercial property and land
Unit trusts and investment trusts
This would allow our UK readers to invest in our (or your) BigIdeas in a tax-efficient manner.
We should also mention another vehicle available to UK residents that is exempt from taxation – Individual Savings Accounts, or ISAs, as they are more commonly known. There are no restrictions on having an ISA and a private pension at the same time. The main difference between an ISA and a pension is that you make your payments into an ISA from your NET income, i.e. income that you've already been taxed on. But once the money is in the ISA, it is exempt from income tax and capital gains tax.
ISAs are very flexible and can be used to invest in most asset classes in any geography. Upon retirement, the ISA can be converted into an annuity (an ongoing income, often monthly). ISAs come in two flavours: a maxi-ISA and a mini-ISA.
The investment limits of ISAs are set by the government and are subject to change, but at the time of writing, you could invest up to £7200 a year in a maxi-ISA (using one ISA investment manager), or you could invest into a number of mini-ISAs, each under a different asset class and different investment manager. So you could set up a number of mini-ISAs; for example, one in cash and another in stocks and shares. There is also a limit under each mini-ISA which is determined by the asset class of the mini-ISA. It is also worth mentioning that you cannot have both types of ISA at the same time, so it's best to discuss ISAs with a financial advisor to determine whether they are a good fit with your BigIdea investment plans.
In the US, there is the 401(k), an employer-sponsored retirement savings plan. In many cases, the employer also contributes to the employee's plan, sometimes 50 per cent of the employer's contribution, sometimes matching it. The reason why they are attractive to employees is because 401(k) plan contributions are made from the gross salary, i.e. pre-tax. As long as the funds remain within the 401(k), they are exempt from tax. To some extent 401(k) plans offer the flexibility of being self-directed and portable.
If you don't have an employer-sponsored plan such as a 401(k), you can consider setting up what's referred to as a Roth IRA (Individual Retirement Account). This is widely considered to be the most advantageous retirement scheme available after an employer-sponsored retirement plan such as a 401(k). One drawback to it, though, if you want to be an aggressive saver, is that it has a contribution limit of only $4000 per year (this amount may have changed by the time you read this book).
We're almost there, just one other thing to add ... in 2006, the government introduced a new investment scheme called a Roth 401(k), which combines the features of the traditional 401(k) with those of the Roth IRA.
It is offered by employers just like a 401(k) plan, but the Roth IRA contributions are made with after-tax dollars. However, once the money is in the Roth IRA, it can grow tax-free. Additionally, any withdrawals made during retirement will not be subject to income tax (as long as you're at least 59½ years old and you've had the account for at least five years). The contribution limit for the Roth IRA is around $15,000 but you'll need to check that as these limits tend to be adjusted every now and then.
Basically, the difference between a 401(k) plan and a Roth IRA plan is down to when the tax is paid: with a 401(k) the money is not taxed on the way in, but is on the way out; with a Roth IRA, after-tax money goes in, which is then typically tax-free coming out.
In Australia, the mandatory retirement investment vehicle is known as a superannuation, often just referred to as a 'super'. All employers are required to enrol their employees into a super and must contribute a minimum of 9 per cent (there is a cap on the amount) of the employee's base salary into a super fund of the employee's choice. Employees have the option of topping up their super by making contributions from their gross salary.
Since its introduction in 1992, the superannuation pension scheme has been working well in establishing a financial safety net for retirees. By the end of 2007, total superannuation assets were around $1 trillion (Australian dollars) and are forecast to reach $2 trillion by 2014. For many people, their superannuation ends up being their most significant asset by the time they retire.
The super can also include components of life insurance cover and disability insurance. Given the high tax base in Australia, we recommend that you contribute as much of your income as is permissible into your super fund to minimize your tax exposure.