Down Payment Dilemma Part II: To Gift or Not To Gift?
Previously, we wrote about the risks of gifting your children a down payment in today’s housing market. Stifling mortgage payments, rising interest costs and house price corrections all need to be considered, particularly in hot Canadian real estate markets like Toronto and Vancouver where even modest housing price corrections can wipe-out generous gifts. Still, providing financial assistance to loved ones remains at the top of many parental wish lists, with down-payment support ranking about as highly as the desire to help with education costs. Options like these are also often preferred to cash gifts if there’s any doubt about an offspring’s ability to responsibility manage large cash handouts.
Should you vs. can you
Leaving aside the potential issues with assisting your child with buying a house before they are financially ready, the basic question our clients frequently ask is whether they can afford to give their children (or grandchildren) a gift for a house down payment.
Consider the case of Anne, a 60 year-old recent retiree, who is considering gifting $200,000 to each of her two adult children in an effort to help them crack the Toronto housing market. Anne’s been clear that the money is only to be used toward a down payment. Through prudent saving, modest living, wise investing and her late husband’s life insurance policy, she has amassed an $800,000 portfolio.
Anne has no idea how long she will live, but her mother lived to 90, so from a financial perspective, we would advise her to plan on managing her finances as if she were going to reach at least that age.
Anne has worked through a budget and believes she needs approximately $60,000 per year before tax to comfortably maintain her lifestyle. After accounting for her Canada Pension Plan, Old Age Security and a modest pension income totalling $20,000 annually, she will need to rely on her portfolio to provide an additional $40,000 per year in supplemental cash flow.
With her $800,000 portfolio Anne has put herself in a position where she’s in a comfortable position to maintain her $60,000 per year lifestyle as she only needs $40,000 from her portfolio each year. If her portfolio earns 5% per year, she could cover this amount without drawing down any of her capital.
But the question is: can she afford to gift $200,000 to each of her two kids, leaving her with only $400,000 to live on for the next 30 years?
Under this scenario, if Anne wants to keep her original capital intact, her portfolio would have to generate a pre-tax rate of return of approximately 10% ($40,000 / $400,000 = 10%). Achieving this type of return could be difficult and it would obviously mean she would have to invest in a much riskier portfolio.
Can she do it?
The main issue with shifting Anne’s portfolio toward a more aggressive, equity-oriented asset mix is that her portfolio volatility will likely increase substantially. While she might be able to achieve a 10% average annual rate of return over the long term, the variability in her actual annual rates of return will likely be relatively high. It is highly probable that her portfolio will experience annual returns which are both extremely negative and positive. The issue around this volatility is how will she feel and react when her portfolio is declining during down periods.
If temporary negative returns are going to make her uncomfortable and lead to her reducing stock market exposure after equities decline, then investing more aggressively is clearly a bad idea. After all, buying high and selling low is not exactly a winning strategy for making money!
The other factor that Anne may want to consider is that she does not necessarily have to maintain the value of her portfolio over her lifetime, especially if one of her primary financial goals is to assist her kids in buying a home. If Anne wanted to consider this approach, she should work with a wealth management firm on a financial plan to determine what might be feasible. The key issue will be to work through various analyses to see how much she will reduce her original principal over time given the size of the gifts she wants to make and based on reasonable rates of return on investment from a conservatively managed portfolio. The outcome from these analyses will also give her a good sense of whether she will have enough money to make it till the end of her life.
Consider all alternatives
Anne may come to a variety of conclusions after having discussed different scenarios with her wealth advisor: smaller gifts, deferral of gifts, perhaps spacing out the gifts so the kids receive them only when they each reach a certain age. She may even choose to help out with future educational expenses, foregoing the housing market investment all-together. Each scenario will offer different risk and return profiles as time passes, but with the multitude of estate planning decisions to make as one ages, it’s always a good idea to start early.