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Boomers must bail out before they can sail out

Bad investment advice leaves property-rich couple thousands of dollars underwater

Special to The Globe and Mail

At 49, Betty and Bob have done well for themselves, amassing a real estate portfolio worth roughly $1-million with no debt. They have a rental condo in Florida, a modest house on one of B.C.'s Gulf Islands and a condo in Vancouver, where they live. They also have substantial retirement savings. They attribute their success to luck, hard work and living within their means.

Bob makes about $65,000 a year working as an educational consultant, and Betty earns about $30,000 doing administrative work. They live on less than $30,000 a year after tax. When they retire, they will have some pension income - Bob used to work as a teacher and Betty works in the public service - but they don't know how much. They had hoped to retire at 55 to do the things they like best. For her, that's boating; for him, drawing and reading. They plan to move to a new, larger condo in their North Vancouver neighbourhood when it is finished in two-and-a-half years. By that time, they will have saved up the $90,000 down payment. They figure that $90,000, together with the sale proceeds from their existing condo, will enable them to move up without taking on any debt.

Knowledgeable though they may be about real estate, Bob and Betty are less so when it comes to investing. At the advice of a commissioned salesperson and former colleague, they borrowed $150,000 about four years ago to invest in mutual funds - the high-cost, deferred-sales charge type - and they are now thousands of dollars under water.

"We're upset about that," says Bob. "The sales person knew we were into real estate, so he compared what he was suggesting to getting a mortgage on a rental property" - with the idea that the interest would be deductible and the income would pay off the loan. The adviser also recommended Betty make changes to her locked-in retirement account from a previous employer. Because she is risk-averse, he suggested shifting the money into a complicated insurance product that holds segregated mutual funds. The plan guarantees a payout of 5 per cent of the value each year for a minimum of 20 years, no matter what the stock or bond markets do. But with stock markets faltering and their balance shrinking, Bob and Betty are facing a tough decision.

We spoke with Warren MacKenzie, president and chief executive officer of Weigh House Investor Services, and Marc Henein, adviser and financial planner with ScotiaMcLeod in Toronto.

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*****

THE BASICS

$13,200

cash in bank

$66,000

in condo down payment

$72,000

in Betty's RRSP segregated funds

$50,000

in Betty's RRSP

$70,000

in Bob's RRSP

$100,000

in mutual fund portfolio

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WARREN MACKENZIE'S TIPS

Betty and Bob have acted on questionable advice from their financial adviser, Mr. MacKenzie says. The insurance company product can be appealing in theory, because if financial markets rise, the 5 per cent annual payout would be based on ever higher amounts. "The problem is that capital growth will be severely restricted by the 2.86 per cent average management expense ratio on their investments," he says. A significant portion of the 5 per cent return "is simply a return of their own capital." Such a product offers nothing in the way of long-term inflation protection.

"Their second decision is even worse," Mr. MacKenzie says. Bob and Betty were on track to reach their financial goals without resorting to high-risk investment strategies. Given their goal of retiring in six years or so, and turbulent stock markets, "it made no sense to borrow $150,000 to invest in equities." Their mutual funds have an average management expense ratio of 3.2 per cent. Morningstar data show the funds have consistently underperformed both the benchmark index and their peer groups, Mr. MacKenzie says.

If they sell now, Betty and Bob will be left owing about $50,000, or about $40,000 after benefiting from the tax-deductible loss. (They will have a $50,000 capital loss, half of which will be deductible against other income. This $25,000 deductible loss will reduce income tax by about $10,000.) "It would be a bitter pill, but given ... the possibility of further market declines, I would take the loss and consider it a lesson learned," he says. "In the future, if they want the risk and excitement of using leverage to increase returns, I would do it by using a 'couch potato' portfolio of exchange-traded funds."

*****

MARC HENEIN'S TIPS

Betty's insurance company product is complex and expensive, Mr. Henein says. But since she has it, he suggests she shift her holdings to a more conservative 60 per cent fixed income and 40 per cent equity, with the stock portion overweight in Canadian holdings. She should be able to switch funds at no cost.

As for the underwater loan, borrowing to invest only works when markets are rising or at least holding steady, he notes. Given the European and U.S. debt problems, financial markets are likely to stay turbulent for some time. "It seems apparent that this loan will take many years, if ever, to recoup the losses sustained." He recommends the couple consider selling the mutual funds and paying off the loan.

"This seems painful and expensive in the short term, but it is smarter to cut your losses now and redeploy your hard-earned savings" rather than watching the investments continue their downtrend. If there is a silver lining, it may be that they can use their capital loss to offset capital gains on their Florida rental property if they decide to sell it. Mr. Henein suggests Betty and Bob consult their accountant before paying off the loan.

© 2007 The Globe and Mail. All rights reserved.

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