Windfall

Manna in the form of big money falls from heaven or somewhere thereabouts; it is in the nature
of such benedictions that the brain often short-circuits. How do you control this and do the right thing?

Two million dollars unexpectedly lands in your lap, maybe because you picked that lucky lottery ticket, or because you stumbled upon a treasure chest on a deserted Caribbean island, or because you sold your house in Vancouver for 20 times its original purchase price. How do you manage that money?

 

John Drein and his wife, Drew (fictitious names), a couple in their early 50s, sold their Vancouver home for the seismic sum of $1.5 million. They bought an expensive sports car and put money in very risky investments that promised very high returns. In less than a year, they found themselves with less than half of the original amount. Mark Therriault, a financial adviser with Nicola Wealth Management in Vancouver, says that this happened despite the fact that “we had built a financial plan for them that would give them an early retirement and a steady income stream.”

 

This is not an exceptional story. Most of the financial advisers CPA Magazine spoke with for this story had a number of anecdotes about people who “lost it” under a sudden shower of money. A Quebec couple burned through the $1 million they won in a lottery thanks to the purchase of a luxury home, a Harley-Davidson, South Seas vacations and countless gifts to their children and family. Years later, health problems and mismanagement landed them on social welfare. “Happiness was much more present before we got the million,” the woman told Le Journal de Québec.

 

According to research by the National Endowment for Financial Education, 70% of people who suddenly hit the jackpot — any jackpot — end up broke within seven years.

 

PSYCHOLOGY FIRST

That’s why the key advice on how to manage a windfall is not financial, but psychological. First: don’t talk or brag about it; keep it to yourself. Nobody needs to know that you’ve just sold your house for an insane amount or that you have inherited money from an uncle you had never heard from. “Don’t tell your family and friends until you have things in place,” says Angela Mercier, a financial adviser in Dartmouth, NS.

 

The experience of most jackpot winners is that many long-forgotten siblings and friends suddenly emerge from the wood-work, says Mercier. For many years, the marketing pitch of Loto-Québec was: “It won't change the world, but. ...” Picking up on that line, infamous Quebec lottery winner Jean-Guy Lavigueur, whose ticket won him a family tour in hell in the 1980s, commented: “It doesn’t change the world, but everybody around me sure changed.” Today, only two of the family’s children are still alive, and the whole fortune has disintegrated, the surviving daughter earning her living as a hairdresser as of 2010.

 

Which leads to the second bit of advice: learn to say no, says Mercier. “Many people, especially young people, are very generous to family and friends. Some are unable to say no.” And to help you utter that word, do the following, says Lee Helkie, partner at Helkie Financial & Insurance Services Inc., in Toronto: “Don’t make any life-changing decisions for at least six months” (tip No. 3). And Mercier advises in that time “put it in a high-interest savings account [No. 4].” That way, the irrationality has time to evaporate and you have the best of excuses: “I can’t give you anything; the money is locked up.”

 

Meanwhile, follow tip No. 5: seek advice. “Very few people, maybe only 5% or 10% of investors, have the knowledge to manage that sudden money influx by themselves,” says Robert Lachance, vice-president of sales, investment and retirement, at Groupe Cloutier Investments in Montreal. And he’s talking only about investment knowledge. There’s also legal, fiscal and accounting knowledge. So shop around and find a lawyer, an accountant and a financial adviser, says Helkie. And remember, in dealing with the fireworks that a jackpot lights up, 99.99% of people will benefit from advice. Especially given that “it’s important to have someone in your corner you trust who will tell you the things you don’t want to hear,” she points out.

 

Why a lawyer? Because most people’s lives take unexpected turns, something Mercier, who is also a divorce mediator, is well aware of. “A woman won $5 million in a lottery and, because she went to the wrong adviser, she split the amount with her spouse. But they were common-law spouses, not married. A year later, they broke up and she ended up with only half of the $5 million.”

 

FOLLOW THE MONEY

Mostly, it’s about good financial advice and acumen. Helkie sets out the overarching priority: “We live in the keep-up-with- the-Kardashians world where shoes can cost $5,000. There are a lot of ways you can spend money fast. But there’s nothing better than having financial security, knowing that, even on rainy days, you will be OK. Two million can solve a lot of problems. Just be smart about it. You want to build an investment portfolio that can hold up in good times and in bad times.”

 

(We set the jackpot at $2 million for a strategic reason. One million dollars is fine, but in today’s economy, it doesn’t take you very far. Five million dollars definitely pulls you out of misery. But $2 million is ambiguous: it promises financial independence — but you still have to work at it.)

 

After all, a jackpot is about money, not just psychology. But first things first: money is about life and life plans, which can be quite different, depending on whether you’re 30, 45 or 60. But almost everyone asks the same question: can I quit my job?

 

Most 30-year-olds today are far from settled, says Mercier. They are not married, don’t own a house, don’t have children and are starting out on their career path. So, in the face of all those options, quitting a job and just living off the proceeds of $2 million is highly unlikely.

 

But having just pocketed $2 million, you want to celebrate. So go ahead, take that trip around the world or buy your dream $200,000 Mercedes-AMG GT C Roadster. Just remember, “the key is to understand the opportunity cost of any expense,” says Therriault. “Most people don’t understand the opportunity cost of a $200,000 sports car against that same amount compounding over 20 or 30 years or the university tuition for your child that you’re sacrificing in the long run.”

 

A central issue here is earnings. For Lachance, a safe rate of withdrawal to plan on for the long haul (up to age 90, which today 50% of Canadians aged 20 are expected to reach) is 3% for a balanced portfolio with 50% equity and 50% bonds, taking into account today’s low government bond yields.

 

At that low rate, you can preserve your capital over a period of 30 years, but consider that with a yearly inflation rate of 2%, you will be left with only 50% of your purchasing power 30 years down the road. So, a pre-tax revenue on $2 million will be $60,000 — not much to live on. That’s what being a millionaire looks like today.

 

You could build a higher-earning portfolio that contains the usual equity and bond assets, but also a substantial share of alternative assets that have a low correlation to stock markets, such as direct real estate projects, or infrastructure projects, even hedge funds. Much depends on the financial adviser you consult with. Therriault’s firm has its own private limited partnerships and pools that give its clients access to such asset classes.

 

Such three-part portfolios can have much higher rates of capital appreciation and higher revenue capacities, but it is risky today to plan on rates of earnings higher than 7% or 8%. This is crucial: portfolios that deliver yearly gains of 10% and 12% are a thing of the past. Some funds still hit that mark, but they are exceptions. “The best way to kill your financial security goals is to set your sights on unreachable earnings levels,” warns Lachance. “Today’s financial markets are mature, populations are aging, economies grow slower, which dampens corporate profits, and consumption can’t be indefinitely created by debt. Returns simply can’t be what they used to be.”

 

And, at 30, you will probably want to buy a house, or maybe quit your job and start a new career, or launch your own business. Ideally, you should invest the whole $2 million and only take out 50% of the potential revenue that it can generate to pay as you go through your projects. Or, you might shave off $1 mil- lion of the $2-million windfall and let the capital build on the remaining $1 million.

 

Let’s just remember that the key, through all projects, is to preserve and heighten financial security. So risk considerations in a portfolio must be well calibrated. Contrary to common wisdom, “30-year-olds will generally have less capital to take risk with and 60-year-olds will have more,” says Therriault. “Risk is not so much about age, but about each person’s situation.”

 

MID-LIFE MUSINGS

At age 45, life situations change. You have a mortgage, your children may be moving toward university, the debt load can be quite heavy and you might want to change your career horizon. Should you retire? Not quite yet. Most of the advisers recommend planning for an early retirement at about age 55.

 

“At 45, Canadians are trying to plan for retirement, but in reality, they’re just planning to get out of debt,” says Mercier. Priorities should be to totally pay off the higher interest-bearing debt load, like the 20% interest charge of credit cards. But if your mortgage interest rate is only 3.8%, let it run and build a portfolio that can deliver 5% returns.

 

Many Canadians have large unused RRSP and TFSA capacity. Since they are protected from the tax man, they can load those vehicles up to the hilt, and do so with interest-earning assets, which are 100% tax deductible. Leave capital- and dividend-earning assets that suffer more unforgiving 50% tax charges in unregistered accounts. “You might want to donate some part of the capital, which could help your tax situation,” says Mercier.

 

But if you hit that $2-million jackpot at 60 — retire. Just avoid any foolishness. Don’t shower your children with endless gifts. If you must eat into your capital, do so modestly. For people this age who have children, “it’s a good idea to think of giving away while they’re alive,” says Larry Bathurst, partner of Planex Financial Solutions, in Saint-Jérôme, Que.

 

At 60, estate planning also comes into focus. You will want to make sure your inheritors get the most of your money, not the government. Those who are not too preoccupied with leaving a large inheritance should consider insurance products that, once paid to heirs, would at least allow them to take off the tax bite on their inheritance. For example, a 20-year term life insurance plan with a face amount of $1 million that would be split evenly between four heirs could go a long way to alleviate inheritance tax woes. Monthly premiums for a 60-year-old non-smoking male wouldn’t be too expensive, about $1,000.

 

Two other insurance vehicles can be considered: participation plans for people over 45 and annuities for those 65 and older. Participating insurance, in which capital builds up after a number of years, can be part of an investment plan, but it should be only a part, warns Bathurst, who considers long-term gains of such plans rather iffy. “I’ve seen people buy insurance plans for the future and I don’t know a single one who got to where he thought he would land: company plans change, insurance tax rules change, whatever. If my son won $2 million, I certainly wouldn’t tell him to buy a participating insurance plan.” His advice is to treat insurance only as insurance, not as an investment.

 

Annuities can be very attractive, even though many recoil at the thought of giving an insurance company a whole chunk of their capital, because it takes away from their inheritors. “Yet a lot of people have company pension plans with $30,000 or $40,000 yearly payouts,” says Bathurst, “and they will never see the capital behind those payments.” How is that so different from an annuity?

 

Of course, an annuity should represent only a part of a retirement plan. And ideally, most of our advisers agree, it should cover basic recurrent expenses such as rent payments, food and transportation. Today, with annuity plans that pay out about $7,000 a year for each slice of $100,000, a capital of $1 million will deliver about $70,000 a year, which can go a long way to cover basic expenses. “All the remaining capital that you hold,” says Bathurst, “well, that’s for all the crème Chantilly you might want in your life.”