On the Path to Early Retirement

With a combined annual income of $81,000 and no kids, Amy and Brent Kerr can afford to buy BMWs, talk nonstop on cell phones, dine in fancy restaurants and pay full price at the movies.

Instead they drive old cars, time long-distance calls to get cheaper rates and carry brown-bag lunches to work. They economize on entertainment, not by attending bargain matinees--even that’s too extravagant--but by renting videos to take home.

Thanks to their frugal lifestyle and consistent investing, the young couple have accumulated about $97,000 in retirement savings plans and more than $115,000 in other mutual funds and individual stocks. Their equity in two properties totals about $145,000, and they have cash savings of $6,000 in a money market fund.

Amy, an administrator for UC San Diego, and Brent, who oversees construction and maintenance of bus shelters for RAL Transit Field Services, are both 28--surprisingly young for having amassed a net worth exceeding $360,000.

Seeking reassurance that they are heading in the right direction, the Kerrs asked for a Money Make-Over. Amy and Brent wondered if they own too many mutual funds, if they should sell their rental property and if they can retire at age 55.

Michael K. Donohue, a certified financial planner in San Diego whom The Times asked to review the Kerrs’ finances, praised the couple’s willingness to forgo luxuries to prepare for early retirement.

“Many people in their 20s lack the discipline to establish a savings plan,” he said.

A comfortable retirement and children are both feasible options for the Kerrs, Donohue said, although their portfolio needs some fine-tuning. There are tax issues for them to consider as well. First, though, the Kerrs should focus on protecting what they already have--by getting more insurance and creating an estate plan.

The couple do not have wills. Brent has no life insurance, and Amy doesn’t have enough. More important, they both lack disability policies, other than the meager state and federal programs.

“What happens if one spouse dies or becomes disabled?” Donohue asked.

In the Kerrs’ case, the surviving spouse might have to sell their three-bedroom, three-bath home in San Diego’s Scripps Ranch, and likewise for their former home, a two-bedroom condominium in Irvine that they operate as a rental unit.

Insurance a Modest Expense

Assuming each Kerr would want to continue his or her current lifestyle if tragedy were to strike, Donohue advised Brent to get $400,000 in term life insurance and Amy to increase her coverage to $350,000. Noting that injury and illness are statistically more likely than premature death, Donohue suggested that each spouse buy a disability policy, which typically provides between 50% and 80% of pretax income.

The Kerrs should also buy $1 million worth of “umbrella” liability insurance. Such policies cover a variety of potential damages and go well beyond the liability limits of basic homeowners and automobile coverage. People with substantial assets are more likely to be pursued in court, and “California is a lawsuit-happy state,” Donohue said.

All the extra insurance recommended by Donohue would probably cost less than $1,500 a year--a modest expense given the Kerrs’ income and high savings rate. If the couple’s net worth grows substantially when they are older, they might decide they don’t need all the coverage.

Donohue also said the Kerrs should draft simple wills and perhaps a living trust to make sure their hard-earned savings are used the way they want in the event of death or disability.

The couple’s more immediate question about having too many mutual funds--15 outside and 13 inside retirement plans--is well-founded, Donohue said.

Kurt Brouwer, a Tiburon, Calif., investment advisor and author who also evaluated the Kerrs’ holdings for The Times, agrees.

For most people, holding more than a dozen funds presents record-keeping problems. “You have to consider the realities of tracking so many funds, not just for performance but for tax purposes,” Brouwer said.

A general rule of thumb is no more than 10 funds per $100,000, he said, with six being more manageable and even fewer preferable.

Brouwer noted duplication in the Kerrs’ portfolio: three bond funds, three international funds, two health-care funds and two “concentrated” funds that hold a small number of stocks. In addition, one fund--Vanguard STAR--invests in other mutual funds.

However, a large number of funds may be manageable for Brent Kerr, who considers studying mutual funds a hobby. “Some people enjoy analyzing funds,” Brouwer said. “The important thing is having investments that make sense.

“Now is the time to do a little reflective thinking and pruning,” he continued. “I would question whether they need bond funds at all because they are so young.”

Municipal Bonds Soften Tax Bite

Both Donohue and Brouwer suggested that the Kerrs opt for tax-exempt municipal bond funds if they feel compelled to own bond funds at all.

One reason the Kerrs might want to own municipal bond funds is that their income borders key tax brackets. In 1997, 1998 and most likely again this year, a small difference in their taxable income might make a big difference in their final tax bill.

Donohue studied the Kerrs’ past tax returns and discovered that in recent years the Kerrs have reported more than $7,000 in capital gains and more than $4,000 in taxable dividend income.

Dividends and short-term capital gains are taxed like ordinary income, but “long-term” capital gains--those held more than one year--are subject to special lower tax rates.

The long-term capital gains tax rate is 20% if your taxable income is at the 28% marginal tax bracket or higher. It drops to 10% if your taxable income falls into the range of the 15% bracket.

This is especially important to the Kerrs, whose taxable income is near the $42,350 cutoff for the 15% tax rate. (Taxable income is what’s left after most deductions, but before most credits and not including capital gains. The 15% bracket cutoff will be higher for 1999).

With $7,000 in long-term capital gains, being on one side or the other of that line would be worth $700 to the Kerrs.

Shaking Up the Mutual Fund Mix

Given the possible financial impact, the Kerrs might want to discuss their situation for 1998 and 1999 with a tax professional, to discuss ways to reduce their taxable income and make sure they are not at risk for the alternative minimum tax.

For example, the negative cash flow and depreciation from the condo also might help keep them in a lower tax bracket for one more year. Although it’s not advisable to let tax considerations make you “penny-wise but pound foolish,” this could be an argument to sell the condo in 2000 instead of 1999.

In the longer term, Donohue said the Kerrs should switch more money to tax-efficient mutual funds.

One option would be funds that hold the stocks in a market index, such the Standard & Poor’s 500. An index fund buys and holds the stocks in the underlying index. Most indexes do not change often, so an index fund doesn’t generate many trades or capital gains taxes.

“There are also actively managed funds that consider the tax consequences of their funds,” Donohue said.

The mutual fund families owned by the Kerrs are well-known, high-quality operations: Acorn, Fidelity, Invesco, Janus, Vanguard. However, not all funds within those families are winners, Donohue and Brouwer warned. Brent needs to evaluate the funds as he narrows them down.

Researching funds and picking the ones with long histories of above-average returns shouldn’t be a problem for Brent, who is an avid do-it-yourself investor who uses Internet services to monitor his holdings and keep up with the latest financial news.

For example, Brent is proud he bought Fidelity Latin America at about $8 a share when the Mexican peso was dramatically devalued in March 1995. Then he cashed out at nearly $19 a share in July 1997. (The fund has since dropped back and is near $10.) He is also happy with the significant gains he’s accrued since buying several Janus funds and Fidelity Japan Small Companies.

But Brent acknowledges that his hunches aren’t always so lucrative.

For example, several years ago he and a buddy bought what they perceived to be an undervalued stock, Caldor Corp., for $9 a share. The retailer later sought protection from creditors under Chapter 11 bankruptcy laws. Now Caldor is worth less than $1 a share. “That came back to bite me,” Brent said. “I’ll stick with mutual funds.”

Amy does not share Brent’s passion for investing. If it weren’t for Brent, she said, she would hire a professional to manage her finances. “I’m not interested in tracking mutual funds every day.”

Sell That Condo--Soon

Donohue found that Amy and Brent share a high tolerance for risk by evaluating their separate written responses to his questionnaires. “They are both classic growth investors. That means 90% of their investments should be in equities and 10% in tax-free municipal bonds.”

Also, because the Kerrs can stomach the stock market’s ups and downs for the long haul, they should probably sell their rental property and invest that money in stocks. They bought the two-bedroom condominium in Irvine for $142,500 in 1993. When the couple decided to move to San Diego in 1997, the condo’s value had sunk to $130,000. Rather than absorb that loss, they rented it out and became absentee landlords.

Donohue figured the condo’s long-term annual rate of return is likely to be about 7%. “They could do better by investing in the stock market, bonds or somewhere else.”

Bobbi Cox, a real estate broker in Laguna Beach, said the Kerrs now have a good chance of making a profit on their condo.

Demand for housing soared last year after a deep slump. “Properties were selling before they were listed,” she said. In the last six months, she reports, home buyers have paid from $146,500 to $169,000 for condos identical to the Kerrs’ unit located in the Woodbridge development near UC Irvine.

Today’s intense demand for housing won’t last indefinitely, Cox warned. “The real estate market is always cyclical. The Kerrs have another year before it gets quiet again,” she predicted, noting that home sales tend to flatten around the time of presidential elections.

When the Kerrs do sell, all the proceeds may not end up in mutual funds. Indeed, Amy and Brent might finally spend some money on themselves. For starters, they are thinking about replacing Amy’s 1986 Volkswagen Jetta and Brent’s 1989 Honda Accord.

Amy won’t get her dream car, though: a brand-new Mercedes convertible. Instead she’ll buy another Jetta, slightly used. “As soon as you drive a new vehicle off the lot, you lose several thousand dollars of value,” she said. “It depreciates instantly.”

While Amy has happily adopted Brent’s thriftiness, she sometimes tires of the constant drive to save money. “The whole house is hand-me-downs except for the bedroom set,” Amy grumbled. “When we bought a couch in January, we couldn’t just go out one weekend and hit every store and buy what we wanted. It took us six weeks.”

But by waiting for a sale, the Kerrs snared a 10% price reduction for a new couch, scheduled for delivery in March. “I’m learning a little more patience,” Amy said with a sigh.

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Suzy Hagstrom is a freelance writer based in San Diego. To be considered for a published Money Make-Over, send your name, age, phone number, income, assets and financial goals to Money Make-Over, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. You can also e-mail money@latimes.com or save a step and print or download the questionnaire at https://www.latimes.com/HOME/BUSINESS/FINPLAN/make-over.htm.

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The Situation

* Investors: Amy and Brent Kerr, both 28, have a large nest egg and frugal habits.

* Gross annual income: About $81,000

* Investments: 28 mutual funds and an Irvine condominium

* Problems: Too many funds, insufficient insurance, lack of estate planning

* Ideas to ponder: Consolidate funds, maneuver into the 15% federal tax bracket, replace 10- and 13-year-old cars.

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This Week’s Make-Over

* Investors: Amy Kerr, college administrator, 28

* Brent Kerr, transportation manager, 28

* Combined gross income: About $81,000

* Financial goals: Fine-tune portfolio, retire at age 55.

Current Portfolio

* Real estate: San Diego home with about $100,000 equity and Irvine condominium with about $45,000.

* Cash: About $6,000 in Vanguard Prime Money Market fund.

* Mutual Funds

Major holdings, approximate value: Acorn Fund ($15,000); Acorn International ($15,000); Invesco Industrial Income fund ($10,000); Janus Fund ($17,000); Janus Twenty fund ($14,000); Vanguard Intermediate Term Corporate Bond fund ($7,000).

Smaller fund holdings, each with $5,000 or less: Acorn Twenty; Fidelity Japan Small Companies; Fidelity Latin America; Invesco Select Income; Invesco Health Sciences; Twentieth Century Ultra; Vanguard Aggressive Growth; Vanguard STAR; Vanguard Health Care.

Individual stocks: About $5,300 in Boeing Co. Smaller holdings in Cabletron Systems Inc.; Caldor Corp.; CustomTracks Corp.; Dense-Pac Microsystems Inc., ImmunoGen Inc.; Telefonos de Chile.

* Retirement accounts:

Amy: A Roth individual retirement account, valued at about $2,700, invested in the Vanguard Health Care fund. A 403(b) retirement savings plan at work has about $29,000 invested in three Fidelity funds and $17,000 in the University of California’s equity funds.

Brent: A Roth IRA, valued at about $1,700, is invested in Vanguard REIT index fund. About $46,600 in the retirement plans of three former employers, invested in a variety of mutual funds.

Recommendations

* Reduce the number of mutual funds. Eliminate bond funds or convert to a tax-exempt bond fund. Consider index funds and other tax-efficient funds.

* Sell the Irvine condominium by next year.

* Buy life insurance for Brent, increase life insurance coverage for Amy, get disability insurance and an umbrella liability policy for both.

* Start estate planning by drafting wills.

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Meet The Planners

Michael K. Donohue is the 1999 president of the San Diego Society of the Institute of Certified Financial Planners. Donohue’s fee-only practice is Donohue Financial/LPL in San Diego and is affiliated with Linsco Private Ledger, a broker-dealer.

Kurt Brouwer is the author of “Mutual Fund Mastery” (Times Books, 1997). He is president and co-founder of Brouwer & Janachowski, a Tiburon, Calif., investment advisory firm.