Case Study - How long term projections can help clients prioritise their goals
When your clients have competing goals and not much cash to spare, the idea that “We cannot do everything at once, but we can do something at once” comes to mind. So, then the question is, how do we choose what to do at once, and what can wait until later? In this case study, we will show how comprehensive, long-term modelling can help clients prioritize their goals.
This case study has Andrew and Melissa, who are in their thirties, and their daughter, Charlotte, who is turning two. They have two high priority goals:
- Save for Charlotte’s high school fees before she starts high school
- Pay off their mortgage as soon as possible
Their current situation is:
- Andrew has a salary of $110,000/year and Melissa has a salary of $40,000/year (before tax, not including super guarantee).
- Their annual living expenses are $70,000/year (not including mortgage repayments)
- Their assets are:
- A family home with a $600,000 mortgage with a minimum annual repayment of $40,000/year
- $10,000 in cash
- Superannuation funds with $50,000 each
The modelling and results
Using Optimo Pathfinder’s holistic modelling, we did 20-year projections to work out an initial strategy for meeting their two high priority goals. The results did not have any cash flow shortfalls, which indicates that Andrew and Melissa can afford to follow this strategy.
The assumptions used in the following strategy were:
- Their salaries increase by an AWOTE of 3%pa
- All expenses are indexed by CPI 2.5%pa
- Their home mortgage has an interest rate of 5%pa
- They keep their $10,000 cash aside for emergencies
- Andrew and Melissa do not want to consider other investments or making voluntary super contributions
- The analysis starts from the start of the 2017/18 financial year
- Earnings within the Insurance bonds are taxed at 30% and will not be added to their personal tax. Since Andrew’s marginal tax rate is 37% (plus Medicare levy) and Melissa’s is 32%, they will pay less tax with the insurance bond than in a cash account.
- Andrew and Melissa will hold the bond for more than 10 years, and therefore can withdraw their investment tax-free.
- It is consistent with their risk profile.
- It will provide some discipline to their savings, since they want to have the amount fully saved before their daughter starts high school.
Goal One: Saving for their daughter’s high school fees
Since Charlotte, will be starting high school in twelve years’ time, we will assumed that an insurance bond would be a suitable product because:
We also assumed that:
- The insurance bond has an after-tax return of 4%pa.
- The high school fees are $15,000/year in today’s dollars and indexed by CPI (2.5%) from the first year of analysis. The schedule of school fees is in Table 1.
Table 1: Charlotte's school fees
Pathfinder was given the following modelling instructions:
- Withdrawals from the insurance bond must be the same as the school fees, above.
- Deposits are allowed from the first year of analysis until the year before Charlotte starts school.
- Within the above restrictions, Pathfinder can calculate the schedule of deposits. By default, it will keep within the rule that a deposit cannot be more than 125% of the previous year’s deposit.
Based on these inputs, Pathfinder projected the following results:
- • Initial deposit of $2,491 made in 2017/18
- • In the 11th year of the analysis (2027/28), before Charlotte starts high school:
- A final deposit of $17,075 is made
- The highest projected balance of $111,462 is reached
- • In the 17th year of the analysis (2033/34), in Charlotte’s last year of school
- The largest withdrawal of $22,268 is made
- The account is closed
The complete schedule of deposits is as follows:
Table 2: Schedule of deposits to the insurance bond
The above schedule gives Andrew and Melissa an idea of what is feasible within the assumptions.If they are not sure about the deposits – for example, they may think that the deposits are too skewed towards the later years – then they can consider changing their initial deposit or allowing deposits within a different year range. However, having an initial schedule will give them an anchor for exploring feasible options.
Goal two: Pay off home mortgage
Andrew and Melissa also said that they wanted to pay off their home mortgage as soon as possible.
In the modelling, we let Pathfinder work out the schedule of mortgage repayments.This means Pathfinder paid the required minimum repayment and then each year, decided whether or not they could afford to make extra repayments and if so, whether it would increase their overall wealth. (Note that to simplify the case study, we did not include an offset account, but it is possible to model this in Pathfinder).
Pathfinder projected the following results:
- Loan repayments above the minimum required amount are made
- Loan projected to be fully repaid in 2035/36. Projected final loan repayment is $63,745.
In these results, extra repayments to the mortgage are only made after meeting all other expenses, including deposits to the insurance bond. It is only after they have saved the school fees that they can start making significantly larger mortgage repayments. These results give Andrew and Melissa an idea of when they could feasibly pay off their loan, and will show that if they wanted to pay it off sooner than projected, and they didn’t make other adjustments to their income or expenses, then it would impact on their goal to save for Charlotte’s school fees.
Andrew and Melissa wanted to pay off their home mortgage as soon as possible and save for Charlotte’s school fees before she started high school, but the projections have shown that they cannot afford to do both at once and it is best to focus on saving for Charlotte first. By showing them this, Andrew and Melissa can consider whether they are happy with this approach or whether they would like to adjust their goals, income or expenses.
It should also be noted that since these are very long-term projections, Andrew and Melissa would need to review their situation every year, and adjust their strategy, if necessary. However, by seeing the outcome of some comprehensive, long-term cash flows projections, Andrew and Melissa can more confidently prioritise their competing goals into short-term and medium-term actions they are happy to follow.