SECURE YOUR FUTURE:
Financial Tips for Realtors on a Variable Income
by Michael LaHurd
This blog is intended for Realtors who own their own business and have a variable revenue source – they work on commission and don’t make the same amount every month or even every year. Nothing in this blog should be used in place of actual legal advice. Please contact an attorney or financial planner if you have any questions.
Today’s guest speaker is Michael LaHurd, founder of Vindex Financial Partners. I love that “vindex” is Latin for “advocate” because he truly is an advocate for you guys. Feel free to call him if you’d like to go more in depth on what we’re talking about today.
Our approach to financial planning is a little different than some; rather than start with a goal-planning exercise, which is a subjective measure of your success, we like to start with a benchmark-based planning approach, which means we start with objective measures of success, comparing the client to those measures, and creating an action plan to close the gap and get them on the right path.
When I do these presentations for clients and take the time to add in the client’s actual financial info, the whole meeting takes about an hour. For the purpose of today’s class, I’ve put together a sample case based on a Realtor and their spouse. This is based on an average of the younger Realtors I’ve worked with throughout my career and their general spouse’s income. We use the Living Balance Sheet to determine what areas need attention and where we can make the biggest impact for clients.
So what you see here on the Living Balance Sheet is a 32-year-old Realtor and their spouse along with the following sample financial situation:
- Realtor income: $80,000 average – variable
- Spouse income: $60,000 – variable or fixed
- Personal assets/personal property: $60,000 – roughly the equivalent of 2 cars
- Savings: $10,000
- Investments: $10,000
- Retirement plan: $65,000 – this is usually through the spouse, who likely has a retirement plan through their job
- Real estate: $375,000 – this is the primary home
- Short-term debt: $45,000 – car loans, etc. with payments of about $8,500/year
- Mortgage: $300,000 with payments of about $22,000/year
- Disability: $3,000/month for the spouse, $0 for the Realtor
- Life insurance: $500,000 for Realtor, $250,000 for spouse
- Savings: $1,000/month or $12,000/year
The remaining balance can be spent on lifestyle. You don’t have to worry about the taxes section much at this stage as it is just an estimate of 35% taxes due if you liquidate some of the assets – this can be changed later on.
All of these benchmarks are combined into the Financial Balance Scorecard. This is a measuring stick with red, yellow, and green indications of how close to the ideal scenario the client is.
The first thing we look at is protection. The reason we start here is that if something happens and we haven’t properly protected, it’s too late – we can’t go back and correct it. If we get off to a slow start in building assets or we aren’t paying liabilities down as quickly as we’d like, we can always make adjustments to those areas, but we can’t in the protection arena. The first area is what happens if you get sued; this is not professional liability, it’s personal liability. For example, if you get in a car accident or someone slips and falls at a house and they sue you because they’re injured or they can’t work. In this case we have a $100,000 liability limit, so if someone is unable to work for two years and they make $200,000/year, the judgment filed against you would be for $400,000. In this scenario, $100,000 would be paid by the insurance company and $300,000 would be left for you to pay. Because we don’t have $300,000 on our balance sheet, about 23% of your income can be deducted until that settlement gets paid.
Given what you do for a living, most of you are probably familiar with umbrella liability policies. This is where we like to talk about our philosophy for insurance in general, which is simply that if you can afford to write the check for whatever risk you’re assessing, then you should probably self-insure that risk; if you can’t or if it would be too painful to write that check, then you should transfer that risk to an insurance company. In the sample scenario we’re using today, a $300,000 check is too big to write, so we would recommend umbrella liability coverage to sit on top of the homeowner’s and auto insurance policy to make sure that anything you’d come in contact with as far as personal liability would be protected. This insures your balance sheet.
The next thing we look at is what happens if you get sick or injured. I know when I was 32 years old, I never considered that I wouldn’t be able to work due to injury or illness, but as I’ve grown older I see now that there were some things along the way that this would have helped with. Disability is about 3x more common than a premature death. This has become an area we really focus on heavily because, for the majority of my clients, when they can’t work it’s a severe change of lifestyle and we want to protect that.
The disability arena is very contract-oriented and you have to be very careful when purchasing coverage of assessing the risk that you’re trying to protect. Oftentimes we find that the spouse may have some coverage through work and the Realtor will not. Because you are on a variable income, in order to determine how much coverage you can have, the insurance company will look at historical earnings – depending on how long you’ve been doing this job, you may be extremely variable or you may have become a little more consistent. Typically they’ll offer up to 60% of provable income.
Next up is the section for your will. Everybody should have a will, but the reality is that it’s a very important item but not an urgent item. For most of our clients, they either don’t have a will or had one written years before that doesn’t really apply anymore. We always recommend making sure you have a will in place, so if you currently don’t you should make an appointment for a consultation.
Next up is what happens if you die. What we often see is that clients do have life insurance in place when they come to us, but it’s usually well below the amount they should have. In this case, the insurance company qualifies the Realtor for $2.4M, which is 30x a 32-year-old Realtor’s earnings. What they’re doing is trying to replace the income stream you’d have over your working years. In an ideal scenario, the life insurance would be put in some sort of earnings portfolio – a combination of stocks, bonds, and cash – so the surviving spouse would get around a 4-5% return. This means each $1M of coverage would generate $40,000-$50,000 of income, so in our sample scenario we’d need about $2M of life insurance protection for the Realtor. The spouse would get an amount equal to 30x their earnings, or at minimum they can get half of what the higher earning spouse would get. For example, a homemaker or a spouse who makes significantly less would still qualify for half the amount of life insurance the higher earning spouse purchases.
As far as assets, we’re looking at building assets and how and where this happens. The first thing we want to look at is how someone is progressing toward an ultimate retirement goal. In this sample, the client is in his 30s and so we want to generate assets about 1x his earnings. So if the household earnings are $80,000 and $60,000 to a total of $140,000, we want to have about $140,000 in assets ideally. In the sample we show that they have $85,000 in assets, so they’re well on their way – they have 8 more years to accrue the difference between the two amounts.
For our younger clients, we tend to focus more on what is being saved on an annual basis because if you’re saving enough annually then the assets-to-income ratio will take care of itself. In this scenario they’re saving about $12,000/year, which is about 9% of our total annual income; our recommendation is a minimum of 15%. That may seem like a lot, but I can tell you that accumulating assets over a long period of time is much more about the amount you save rather than the returns you get on what you have already saved. Just between taxes and the way the markets work, you can grow those assets over time, but you’re fighting inflation. Tracking the amount that’s being saved is the most critical piece of the puzzle. That said, normally when we’re working with clients we’d talk about the budget process, and though we’re big proponents of budgeting during life change or career launch, we don’t feel like it’s the best way to manage your cash flow. It helps your cash flow and setting your priorities, but there are better tools to actually manage your cash flow, which we will discuss shortly.
Here we differ from a lot of other advisors in that your typical advisor will tell you that you’re golden if you have 3 months worth of expenses set aside. During Covid, though, we saw that this isn’t always enough as a lot of people were in a pretty tough spot and the government had to come to our aid. There was a lot of damage done here. We recommend you have 1x your total annual earnings in short-term capital. This can be in investment accounts as long as they aren’t tied up in a retirement plan, but ideally you want to have at least half of that in bank savings or government bonds you can access without penalties. When you’re on a variable income, it’s very difficult to accomplish this because you’ll take a step forward but then have a slow month or a slow quarter and you have to dip back into your savings. There are a variety of ways to deal with this through regimented savings programs or through a cash flow protocol called FLO that we’ll discuss as we’re wrapping up. Ideally, though, you want to be in a situation where if you had to go 3-6 months without earning income for whatever reason (disability or loss of work, etc.), you want to know that you’ll survive it. The flip side of this is that we also consider that to be opportunity capital. In your line of work, you could come across a foreclosure opportunity and you’re in the right place at the right time to take advantage of that, and you have the capital on your balance sheet where another person may not. So we consider it emergency capital but also opportunity capital in trying to build something for the future.
Over the last 10 years, short-term debt has been very different than short-term debt historically in that rates have been so low that if a person wanted to buy a car and had the amount on their balance sheet, they’d probably still finance the car. In our sample scenario we see $45,000 in auto loans, which are probably at 1-2%. While we ideally don’t want to accrue any unsecured short-term debt, we frequently recommend that our clients use the lower-term loans. This is changing as we speak, though, because interest rates are going up and we’re getting to the point where you’d want to avoid getting into this kind of debt as it provides a drag on your ability to save and grow assets.
Retirement Plan Tax Liability is a measure of how much of what someone has accumulated is in a tax-deferred account, so a 401K or a traditional IRA. Taxable assets are rental homes, a portfolio of securities you own in your name instead of in a retirement plan, which are taxed a little bit differently. When something is in a retirement plan, you defer the taxes when you put the money in and will ultimately pay them in retirement. All we’re measuring here is what percentage of what this client owns is going to have to pay tax in retirement. It’s not bad to defer taxes, we just don’t know what tax rates are going to be at the time you need to pay them. For that reason, we recommend your savings be diversified in stocks, bonds, and cash. Within stocks you’d want large cap, small cap, foreign and domestic. Our recommendation is to have some assets that are tax-deferred and some that are tax-free – that can be Roth, life insurance, annuities, HSAs, etc. – and some that are taxable (savings in your name that aren’t in a retirement account where you pay taxes as you go and won’t have to pay a big tax bill upon retirement).
Lastly is mortgage selection – a great debate. Bank policy in the past has gotten us into some very significant economic times. On the downside, as Realtors, I’m sure you’d like your clients to buy the biggest house they can so commissions are bigger. We recommend that our clients keep their mortgage payment to about 15% of gross income. Banks will lend at least 20% now, or usually in the 25% range. There have been times where they’ve gone to 30%, and when they did that we went into a major recession. Being house poor is a real thing that we try to avoid. That said, if we have a client making $140,000 and they’re spending 15-20% of their gross income on their mortgage but their income is expected to grow, we know that percentage will be reduced as time goes on. If you keep your housing expense to 15% though, it makes those savings measures that much easier to attain.
In preparing this presentation, we talked a lot about how, as Realtors, your income may be consistent but it’s not fixed. One thing we look at with a client on a variable income is how they invest money. There was a book written years back called Are You a Stock or a Bond? – the book basically says that if I’m a government employee and I get the same payment every two weeks, then my career acts like a bond so my investments should be a little more stock-like. This discussion helps us understand the best way to invest money for our clients. As a Realtor, your income looks more like a stock – it’s variable, you can have a really big year followed by a slower one, etc. This means your investments should be more fixed, or bond-like. Most Realtors I’ve worked with make a significant amount of their investment in real estate – they know it, they understand it, they’re comfortable with it. The only thing we would caution you about in this respect is maintaining enough liquidity on your balance sheet so you don’t get caught short in a down year. We always want to make sure our Realtor clients are operating with plenty of margin so they can survive rough patches.
Part of ensuring Realtors’ finances stay stable is making sure you’re managing your cash flow in an efficient manner. To do this, we use a tool called FLO, which is just a way to reach financial freedom faster.
In the above image, the light blue line is your income line and the dark blue line is your expenses. If you’re like most Americans, there’s a very tight relationship between those two lines – “make more, spend more” is how most American families operate. What we’re trying to do with our clients is simply disconnect those two lines.
This doesn’t mean that if your income increases significantly you can’t increase your expenses at all, but what it does mean is that anything that increases your expenses is well thought out and planned, and it doesn’t just increase because your income went up. With this method we’re able to reach our ultimate family and retirement goals easier.
The reason this usually doesn’t happen for most families is that if they earn $1, they deposit it into their checking account and then spend it out of that account; every dollar in that account is always looking for a place to go. Most people, when considering whether or not to make a big purchase, will look at their checking account to determine whether or not they can afford it. Psychologically, every dollar in that account is meant to be spent, and then whatever is left over at the end of the month, if anything, may get deposited into a savings account.
We’ve known for many years that if we can plug the savings function in above the checking account that it would improve our clients’ ability to save. You don’t need us to do this – we’ve been telling clients to do this for years without our help. The problem has always been that it’s a manual process, and when it’s manual there is room for inconsistency. What we decided to do was automate that process, and that’s what FLO does.
FLO is simply a reservoir account, which is just an FDIC-insured money market account like you’d get at the bank. We take the client’s earned income and deposit it into the reservoir instead of into their checking account. We then create a fixed “drip” into their expense account or checking account. This means that regardless of the amount you make in a month, you would always receive, for example, $4,000 in your checking account every month for your expenses. Because the drip is fixed, there is going to be accumulation in the reservoir account; you have a big month and the reservoir grows, then you have an average month and drip most of it into the expense account, then you have another big month and the reservoir grows. As the reservoir grows above your target number of savings, we call the client and say, “There’s more money than we want to maintain in the reservoir account, so now is the time to address any spending priorities.” These can be things like getting a new roof, or even deploying those funds to some kind of passive income opportunity such as purchasing an investment portfolio, investing in a business, or purchasing a rental property. Doing so would create additional cash flows to feed the reservoir so that it becomes less dependent on your variable income. At the point this happens, you’ve achieved retirement or financial independence.
There is a FLO app that you can access on your phone and that we can access on our end as well. The app tracks all of your inflows (income) and outflows (expenses), plus any capital allocations. Most of our clients have no idea how much they’re saving when they first come to see us; this app will track your free cash flow so that we have the information we need in order to give the client really good advice on how to manage their money.
This cash flow protocol is simply a way to manage your money that is far superior to the budgeting process. You can always budget within your expense account to further manage spending, but FLO allows you to save in a much more efficient way.
Do you recommend a $1M or $2M umbrella policy?
Mike: We recommend a minimum of $1M or an amount equal to your net worth. So if you have a net worth of over $1M, we’d recommend bumping it to a $2M policy or even higher. When we meet with clients on an ongoing basis, we’re always reviewing these benchmarks as we go to see if it needs to be bumped up. Usually we’d say to take as much as the insurance company will give you because they would typically base it on your net worth.
Is it worth it for younger people to get involved in financial planning early on, or should they spend some time earning and building their assets first?
Mike: It’s absolutely worth it, especially for those on a variable income. Having a partner that can guide you through some of the pitfalls that might occur is beneficial. The sooner you get on a more regimented program of managing your capital, the better off you’ll be and the less risk your career will experience.
It’s predicted that 2023 is going to be a slower year for Realtors. Can you touch on that a bit and do you have any advice on how to handle a year where they’re already projected to make less income?
Mike: We follow numerous economists, one of which I follow very closely who works for a bank called First Trust and we do a lot of business with their investment trust. The consensus is that there will probably be a significant slowdown next year mainly because interest rates are going to be higher, we’ve got inflation raging and likely not slowing for a period of time, and these will both put a damper on the economy as a whole. That said, the market does not always translate directly to the economy. I believe the economy will slow, but that doesn’t necessarily mean the financial markets are going to suffer over the next 6-12 months. They’ve already slowed a bit but I think they’ll bounce back at the end of this year. I don’t think we’ll see a recession, but it’s certainly possible. There are certain parts of our country that are still opening and parts of the supply chain that are still trying to work out the kinks from pandemic delays, so while that’s happening I think corporate profits will continue to grow and people will see more money in their 401Ks and investment accounts. Geoffrey would probably have a better idea of how real property is going to be affected, but I expect it has already started to turn down some and will likely level off to a historical norm.
Geoffrey: The real estate market is really interesting to look at because you have the national averages where you see that plateau effect where we can’t just keep going up and up forever, and then you have micro-economies, like Huntsville, with huge growth – Space Command is coming here soon, Toyota and Facebook have recently moved here, and we always have the government fallback with the Arsenal. These things are bringing a huge influx of people and that will likely have an effect on the market here during a time where other cities and states are slowing down.
Mike: Huntsville is definitely a hot market in real estate right now!
If you’d like more information on financial planning or the FLO Cash Flow Protocol, please reach out to Mike. As always, we’re here for questions as well.
By: Michael LaHurd
Founder, Vindex Financial Partners
Written in July 2022