Financial planning is not difficult. This is especially true if you and your spouse are employees. The industry has a self-serving interest in creating a mystic around the topic. The more difficult financial planning is perceived to be, the more likely the services of an advisor or planner are demanded.
Why is financial planning easy for employees? There is only so much you can do. You get paid, the governments take their cut directly from your paycheque, other non-tax deductions are taken directly from your paycheque and you are left with your paycheque net of tax and net of non-tax deductions. Expenses, including expenses for fun such as vacations, are paid and the remainder is saved. If the remainder is negative, you have a problem. Savings are being depleted or debt is growing. This can’t go on forever. If the remainder is positive, financial planning is simply are you saving enough to finance spending plans, typically plans in retirement and, protecting your plan from catastrophic events.
Three Key Financial Planning Concepts
Net worth = what you own – what you owe.
Net worth is the value of everything you own less everything you owe at a specific point in time. This can be simplified to everything you own that is not depreciable. The car you paid $50,000 for 5 years ago is worth considerably less today. Eventually all depreciating assets are worthless. Your home and financial assets are standard assets that appreciate over the long-term.
Net worth should grow over time and this is typically the case. As you pay down your mortgage or other debt you reduce what you owe and grow net worth. If your house appreciates in value what you own increases. If you save, every contribution increases what you own. If you are buying depreciable assets on credit, you increase what you owe and eventually not what you own. If you buy an appreciating asset on credit you increase what you own and what you owe.
Net worth is an important number. The higher your net worth the higher the degree of financial safety you have. Should you run into financial trouble you could sell everything you own, pay off what you owe, and you are left with your net worth.
It is essential to grow net worth in working years and is quite fine to draw down net worth in retirement years. If there is no intention of passing on wealth, your plan could be to draw down net worth to zero by the time you pass away.
cash flow = income – expenses.
A cash flow statement illustrates the flow of money in (income) and out (expenses) over a period of time.
Income is well understood. Expense is everything you pay for. If cash flow it is positive you have savings. Savings add to net worth. If cash flow is negative you are either growing debt or spending savings. You likely have an estimate of cash flow in your head. Few live without any thought to their cash flow situation. Ultimately, if your income is less than expenses, you can not save.
Note that a forced savings plan or a savings plan with great incentives, like a company sponsored retirement plan, is not an expense. This income is being saved, not spent.
Write down all income and all expenses for a month or two. Much good comes from this. Many can’t figure out how they end the month with little money. Even those with big salaries. Understand where money is spent and you will understand where money is wasted. All have expense leaks that could be plugged with a little effort and research. Creating a budget is a useful exercise. Ultimately cash flow can be increased by reducing expenses, increasing income, or purchasing investments that provide an income flow such as a GIC or dividend yielding investment.
Net worth and cash flow are linked. Positive net cash flow leads to savings and adds to net worth.
Protecting Net Worth and Future Net Worth
The best of plans can go astray. Life is variable and replete with risk. Insurance was created to address risk. At its most basic, insurance protects your net worth from catastrophic events. Imagine you and your spouse work and have children and a mortgage. One of you dies. Not only is this devastating on its own but the paycheck also dies. Can the mortgage and all other bills still be paid? Can the lifestyle be maintained? Do savings need to be exhausted? Insurance protects the beneficiary from the ramifications of a dying paycheck. Sickness and disability also may result in a dying paycheck.
Contemplate what happens when a paycheck dies and you are on the correct thought process for evaluating insurance needs. There are many calculators that help determine protection needs.
Our Tax System - Play with the EY Tax Calculator for 20 minutes. Then look at the rate and bracket page for the province you live in for 10 more minutes and you will develop a useful understanding of our tax system.
The Three Accounts & Our Tax System - Understand the basics of the RRSP/RRIF/Company Pension and sister accounts, the TFSA, and the non-registered account.
Project the value of past and future savings to retirement date and project what sustainable annual income that generates in the retirement years. A 3% and below annual withdrawal rate is conservative. 5% and above is aggressive.
Understand the concept of asset allocation and build your low-cost, broad-market, passively-managed portfolio. The spreadsheet on the resources page can help.
Relax, rebalance, and revisit everything periodically; especially the assumptions.
All employees share two goals whether they know it or not. We all want an increase in income, typically in the form of a raise or promotion, and we all want to increase net worth.
We bust our backsides to get raises and promotions. The easiest method to increase savings from cash flow is to get a raise or promotion. Increased cash inflow should increase savings which increases net worth.
The other long-term method for growing net worth faster is to have our non-depreciable assets grow at a faster speed. Many in the GTA are now living enviable retirement lifestyles because the house they bought for $70,000 40 years ago is now worth over $1,000,000. This was an unexpected but fortunate boost to net worth. They are in a safer financial position as a result.
Consider savings plans. Many invest in low risk, low returns savings vehicles like GIC’s. Many invest in higher risk, higher return savings vehicles that provide exposure to equity markets. Everyone has a different risk tolerance but again I will focus on the long-term benefit of adding greater return to savings. $5,000 growing at 4% per year grows to $16,217 in 30 years and to $38,061 in 40 years. At 7% per year, $5,000 grows to $24,005 in 30 years and to $74,872 in 40 years. Imagine a series of $5,000 contributions over a lifetime growing at a faster rate of return. There are serious long-term consequences to those who eschew risk.
The Greatest Tax Shelter
I discussed this at length under the tax tab. The RRSP, and derivative accounts including company sponsored plans, is the best tax shelter available. As long as the savings are earmarked for retirement, and income in retirement is expected to be lower than in working years, the RRSP is should be fully utilized.
Saving For Retirement (And A Rainy Day)
How much do you need to save? It depends on you. but likely not as much as the financial service industry suggests. The financial service industry is not an unbiased participant. The more you save, the greater the revenue the industry generates. Here is a calculator from TD. The calculator assumes that the least amount of income you need in retirement is 60% of pre-retirement income. For many people 60% overestimates their need. Ultimately this depends on your plans in retirement. If you enter retirement with a home and a low or no mortgage, 60% is likely more than plenty. The calculator tells you what you need save to get to the retirement point. Here is Blackrock’s calculator.
Why do you need less in retirement? Expenses fall drastically in retirement; especially your income tax bill. A key factor is your housing situation. Will you or won’t you have a home? If you have a home will there be a big, small or no mortgage on the home the day you retire? A person with no mortgage needs less than a person paying rent or with a big mortgage. New retirees are surprised how little they need per year.
You can use the 4% general rule. If you redeem 4% of your financial assets per year and earn a 4% rate of return you can finance life without reducing your financial assets. In today’s environment (late 2017) you will be hard pressed to get a GIC with a 3% rate. That means you will have to include growth in your portfolio to generate a long-term average rate of return of 4%. Or, withdraw less than 4%, or draw down your savings. 4% of $500,000 is $20,000 per year + CPP + OAS gets annual income to between $32,000 and $40,000. If your average rate of return until death is 4%, $500,000 less any potential tax will be passed on to your spouse or the next generation.
Many of us, and especially retirees, are good at reducing our own personal inflation factor. We substitute high priced goods with low priced goods. If the price of beef goes through the roof we eat more chicken. If gas doubles we stay home 10% more. Your personal inflation rate is much more important than the general inflation rate calculated through the CPI. Homeowners are happy when housing prices rise. Headline inflation will rise but the homeowner is affected to the positive. You can see the weight of CPI components here. Note that OAS and CPP payments increase at the inflation rate. Retirees have at least partial protection from inflation.
Good debt / Bad debt
Debt reduces net cash flow. Buying a depreciating asset on credit is bad debt. Often this is unavoidable. Buying a car is typically done with debt. Just make sure you know this is bad debt. Buying a home is good debt. Eventually we pay off the debt and are left with an asset that has appreciated in value.
The higher the interest rate on debt the greater the effect on net cash flow. Pay down the debt with the highest interest rate first.
A home is not a good investment. I bought a house for $250,000 in 2002. Paid roughly $50,000 in property tax and another $50,000 in upgrades and maintenance. It is worth $800,000 in 2018. That is between a 4.5% to 5.5% annual rate of return. And, that is in a great housing boom. It isn't a great investment. However, it is a beautiful forced savings plan. Every mortgage payment reduces my debt and increases net worth as long as the value at least remains constant. Eventually, I will have no mortgage and an asset that continues appreciating in value.
Savings Plans Through Work
Work may offer a savings plan. The big three are a defined benefit pension plan, a defined contribution pension plan, and a group RRSP.
DB Pension Plans are not offered much anymore. Government employees and quasi-government employees, such as teachers, are close to the only ones left who get offered DC pension plans. The deal is both you and the employer contribute and the plan promises to pay a certain predetermined amount per month in retirement. The plan and the employer take the risk of subpar investment returns. They made the promise and must keep it regardless of how much money is in the plan.
DC Pension Plans and Group RRSPs are similar to each other and both differ from the DB Pension Plan in the same way. The monthly payment in retirement is not known in advance. The monthly payment in retirement depends on a number of variables. Two main variables are the amount of the company matching benefit and the average annual rate of return earned during working and retirement years. Both the employee and employer contribute to an account in the employee’s name. The employee is responsible for the investment performance. Investment performance will largely depend on the balance between growth and safety. Typically, the employee receives a booklet with investment options, a risk profile questionnaire, and some information. This steers the employee toward a reasonable balance between growth and safety. (Do you really need to pay a professional 2% per year to arrive at the same conclusion?) The key to both these plans is to contribute at least the amount of money that gets maximum matching contributions from the employer and to have a reasonable asset allocation.
A typical structure, as an example, is the company will match employee contributions up to 5% of the employee’s salary. If the employee earns $100,000 and contributes $5,000 per year the company will contribute $5,000 and total contribution will be $10,000. If the employee contributes $3,000, the company contributes $3,000. If the employee contributes $7,000, the company contributes only $5,000. The key to these plans is to contribute enough to get maximum company contribution; $5,000 in this example. In this example, the employee gets an instant 100% return on the employee contribution up to $5,000 per year. Instant 100% returns are not easy to come by.
Often publicly traded companies (companies whose shares trade on a stock exchange) have a plan that allows employees to buy company shares at a discount. Shareholding employees are motivated employees. The company will sell the employee shares at a discount up to a certain maximum. An example would be the company will match 40% of the cost of the share purchase up to 5% of salary. So, if you earn $50,000 and purchase $2,500 the company will contribute another $1,000. If you purchase $1,000, the company will contribute $400. As with before, contribute the amount necessary to receive maximum company contribution.
Note that these plans can become dangerous. Many Nortel employees had too much wealth invested in shares of Nortel and paid a heavy price. It is prudent to hold only a small portion of your wealth in the prospects of one company. Diversification is a key, risk-mitigating concept. As your holdings grow, you will need to periodically sell. Before selling, you need to know that the company contributed shares are vested to you. What is vesting? Think of vesting in this manner. In the above example, the employee receives an immediate 40% return. The company does not want the employee triggering the gain immediately after receiving the free company contributed shares. The company mandates that if you participate in the plan, you must hold the shares for at least a specified period. Vesting periods vary per plan.
Which Account Type is Best?
What Do You Want To Pass On To The Next Generation?
We do not have an estate tax in Canada. However, everything gets redeemed or triggered when the surviving spouse passes away. This can lead to a large final income tax bill. Again, to illustrate the concept, if the doctor magically knew that the surviving spouse will pass away in 5 years, it is tax efficient to trigger 1/5 of capital gains and redeem 1/5 of an RRSP or derivative account per year for the next five years instead of all in year 5.
You need a will. Here is what happens to your estate when you die with or without a will in Ontario. The completion of the estate process takes much longer without a will. Google "dying without a will in xxx" (xxx = your province) to get a sense of what happens in your province.
Converting Your RRSP to a RRIF
You decide to retire. What now? Your RRSP, your TFSA, maybe some non-registered savings, a company pension or group RRSP were all funded for retirement. Once you make the decision to retire, you probably want to convert your RRSP to a RRIF. The purpose of an RRSP account is to accumulate retirement savings. The purpose of an RRIF account is to extract the savings. You can set up an automatic monthly withdraw from your RRIF to your bank account. This can't be done with an RRSP. If you don't need the money you may postpone the conversion. You can postpone until you or your spouse turn 71. You can't postpone forever and you likely don't want to. It is tax inefficient to pass away with a large RRSP / RRIF balance unless you are sure the surviving spouse lives a long time.
Many start to hate the RRSP / RRIF concept at this point because the redemption adds to taxable income and to the tax bill. Remember, RRSP / RRIF money is money you have paid no tax on yet and depending on total income you may not be paying much tax in retirement.
Note that there is no tax difference between redeeming from an RRIF or an RRSP. How much can you expect from your RRIF per year? This calculator assumes the required minimum is withdrawn. RIFF rules state that the annual minimum must at least be withdrawn. Any withdrawal above the minimum withdrawal amount is subject to withholding tax. What is withholding tax? The minimum is a small percentage of the account per year.
Employees earn T4 income. By law employers are required to deduct income tax, employment insurance and Canada pension plan payments. All other deductions are benefit deductions and are typically voluntary such as insurance and pension payments. The income tax deducted off a paycheck will be reasonably close to what you should be paying. It may be slightly over or under. You settle the difference when you file your income tax. Understand your pay stub. You may be saving directly off your paycheck and you may have other benefits. Here is a sample pay stub. Here is an explanation of the sample pay stub.
That is Pretty Much It
A Little Bit Of Education