Thursday, June 25, 2015

“I Don’t Want to Go into Debt for This”

Decades ago, it was common for people used to say “I can’t afford it” when discussions came to big things like houses or cars and even for small things like going out to dinner. However, as Mark at My Own Advisor observed, we don’t often say we can’t afford things any more. I think the culprit is easy access to debt.

When people used to say they couldn’t afford things, what they meant was that they didn’t have enough cash in their wallets or bank accounts right now. However, today’s salespeople are well-trained on how to get past this objection by steering you towards debt.

Try telling a car salesperson you can’t afford a certain car. He’ll scramble to work out lease details to get the payments down to an amount you can afford. You’ll end up with a debt and a stream of payments you don’t want. Even a dinner out may go on your credit card and become debt if you can’t pay it off at the end of the month.

The next time someone is trying get you to spend money you don’t want to spend, instead of saying “I can’t afford it,” try something like “I don’t want to go into debt for this” or “I don’t want to go any further into debt.”

Monday, June 22, 2015

Guilt-Free Spending Through Planning

Most people’s personal finances don’t measure up to the typical advice from experts. This is particularly true for young people who haven’t had a chance to build up retirement savings or an emergency fund. Knowing that your finances need improvement can make you feel guilty and worried every time you spend some money. The remedy for this is some planning and setting yourself on the right path.

I think of my savings as three categories: long-term savings, medium-term savings, and an emergency fund. Each serves a different purpose in keeping your finances on track.

Long-Term Savings

Most experts call this “retirement savings,” but I prefer “long-term savings” for a couple of reasons. For one, it can be difficult to motivate people to save for their much older selves. Another reason is that you may end up using the money for some other purpose. You shouldn’t use it for consumer purchases like cars, but you may use some of it to fund a career change or a move to another country. Building a pot of money gives you choices during your working years and funds your lifestyle after you retire.

Each person should decide how much to save for the long term. My default recommendation for young people is 20% of take-home pay. But individual circumstances can make higher or lower percentages make sense. It’s reasonable to count company-sponsored pension plans toward this percentage.

Medium-Term Savings

Medium-term savings are for covering any large purchase you can anticipate that is outside your usual monthly spending. Suppose you want $15,000 to buy a car in 5 years and you get paid every 2 weeks. You have 130 pays to save up and should add $115 per pay to your medium-term savings. If you want to take a $4000 vacation in two years, that’s another $77 per pay to save. If you’re planning to get married in 3 years and have to pay $10,000 of it yourself, you need to save another $128 per pay.

It can be scary to add up all the things you hope to spend money on: what if it’s all too much? Go ahead and add it all up anyway. Maybe you’ll get lucky and the total savings per pay will be manageable. If not, you’ll have to scale some plans back. Whatever happens, it’s better to figure it all out now as best you can instead of never being sure whether you can have the things you want in the future.

Emergency Savings

No financial plan can anticipate everything. That’s where an emergency fund covers you. Maybe you’ll lose your job and it will take a while to find a new one. Maybe the cat will need an operation. Going further into debt each time life knocks you down is a formula for financial disaster.

Experts usually recommend that your emergency fund be enough to cover essential expenses for 3 to 6 months. Figure out how much you could cut back if you were out of work and add up the essential expenses such as rent, food, and clothing. This will give you a target amount to save.

The next thing to decide is how much you’ll save from each pay toward your emergency fund. Even as little as $50 every two weeks will give you $10,000 in less than 8 years. Once the emergency fund is full, you can add that $50 to your day-to-day spending. But, if you’re ever forced to dip into your emergency fund, the $50 per pay savings has to start up again.

High-Interest Debt

When you don’t have enough long-term and medium-term savings or your emergency fund isn’t full, you need to cut back a little from day-to-day spending to carve out some of your pay for saving. However, having high-interest debt such as a credit card balance is a more serious situation. You may have to put off other saving to focus on killing off the expensive debt as quickly as possible.

Some lifestyle changes to reduce spending should be automatic if you owe on credit cards. Eliminate non-essentials like eating out and other indulgences. This can be difficult, but the pain should only be for a short time. Once the credit cards are paid off, the large payments you made can be split between various categories of saving and increased day-to-day spending.

Automate the Savings

A key to making a plan like this work is to automate the saving. When your pay lands in your bank account, the amounts you’ve decided should go into savings should be set up to go automatically. It’s far too easy to skip the saving one pay or stop altogether.

Benefits of this Plan

Once you’ve made a plan and you know that while your finances aren’t perfect right now, they are on the right track. The direct benefit of having a plan and following through is that you’ll have solid personal finances. But there is an indirect benefit. After your automated saving amount and your fixed expenses come off your pay, whatever is left over you can spend in any way you see fit, guilt-free.

Friday, June 19, 2015

Short Takes: Mutual Fund Investor Confusion, Long-Term Care Insurance, and more

Here are my posts for the past two weeks:

“Household Savings Rate” is Highly Misleading

Test Your Debt Savvy

Tax-Free Contributions to a Group RRSP are not a Special Tax Break

Crappy Retirement

Here are some short takes and some weekend reading:

Kerry Taylor explains mutual fund fees for investors who think they don’t pay any fees. The challenges she describes in helping people understand the fees they pay is something I’ve encountered myself.

Can I Retire Yet? has some clear thinking on long-term care insurance. He analyzes the important parts of policies and shows how he made his decision of whether to buy or not.

Preet Banerjee explains why you should calculate your net worth annually in his latest Drawing Conclusions video.

Canadian Couch Potato explains the recent changes to Vanguard’s All-World ex Canada (VXC) ETF to include mid and small cap stocks.

The Blunt Bean Counter takes on the questions of whether rich people will leave Canada or cut back on how hard they work if income tax rates go over the psychological 50% barrier. His 25 years of working with high net worth people gives him useful insights on these questions.

Gail Vaz-Oxlade explains the top 5 reasons why people fail at budgeting.

Boomer and Echo say that having multiple income streams is better than having an emergency fund. This is true, but until you have those multiple income streams in place, you should have an emergency fund.

Big Cajun Man has a very different take on how to indulge yourself by splurging.

My Own Advisor offers advice to millennials on saving and investing.

Thursday, June 18, 2015

Crappy Retirement

I finally read one article too many about how people’s expenses decline as they age. This is used to justify saving less for retirement and spending more money early in retirement. Here I analyze this line of thinking with the technical concept of retirement crappiness.

It’s fair to say that some people have enough money to have good retirements, but others are more strapped for cash and have crappy retirements. The typical retirement is only somewhat crappy.

Let’s consider what will happen to the typical retiree destined for a somewhat crappy retirement. Some of these people will see the moderate crappiness coming and will control their spending to a not-too-painful level. However, most typical retirees won’t see the crappiness coming or won’t admit it to themselves and will initially spend enough for a good retirement. At some point they’ll be forced to cut spending and start experiencing some crappiness. A common experience as funds dwindle is continued spending cuts and an increasingly crappy retirement experience.

This explains the results of studies that find people spend less as they age. As savings decline, spending declines and crappy retirement experiences increase. Some would have you believe that people voluntarily seek crappiness as they age, but the dominant reason for decreased spending over time is having no choice.

So, when someone tries to tell you that you don’t need to save so much for retirement and can live it up in your early 60s because of some study or other, what they’re really saying is that lots of people have crappy retirements and you should plan to have a crappy retirement too.

Tuesday, June 16, 2015

Tax-Free Contributions to a Group RRSP are not a Special Tax Break

It’s common in high tech for employers to pay annual bonuses to most employees. Those who run a company’s group RRSP like to make an enticing offer: “transfer your bonus into your group RRSP TAX-FREE!” They make it sound like this is a special privilege where you’re getting some huge tax advantage, but this isn’t true.

To start with, any amount you transfer into your group RRSP counts against your RRSP limit, so be careful not to contribute too much.

The next thing to understand is that the only tax advantage of transferring a bonus to a group RRSP is the timing of your tax refund. Let’s look at an example. Suppose Alice and Ben are both in a 40% tax bracket and both get a $10,000 bonus. Alice puts hers in a personal RRSP account, and Ben contributes to his group RRSP.

Alice’s employer will deduct $4000 in taxes from her bonus and give her $6000. If Alice has another $4000 kicking around, she can make a $10,000 RRSP contribution and get her $4000 back as an income tax refund when she files her taxes next year.

In Ben’s case, the full $10,000 bonus goes into his group RRSP, but he will not get a tax refund for this when he files his taxes. Essentially, he got his refund right away because there were no payroll taxes taken off. His only advantage over Alice is that Alice had to wait to file her taxes to get her refund.

In the event that Alice didn’t have $4000 lying around, she could contribute only $6000, get a $2400 tax refund at the end of the year, contribute that to her RRSP to get a $960 refund the following year, and so on. This way she will eventually get $10,000 into her RRSP. In this case, Ben’s advantage is that he got the full $10,000 growing in his RRSP sooner than Alice did.

So, Ben got some advantage, but it has nothing to do with how much he ends up paying in taxes. Ben either gets his refund sooner than Alice, or he gets his money growing sooner than Alice. Some people get confused by all this and think that Ben is somehow saving $4000 more on his taxes than Alice is. This is not true.

Something else to consider is the investment choices available in the group RRSP. If Ben likes his investment choices and has the RRSP room available, then he might as well put his bonus in the group RRSP.

In my case, my group RRSP investment choices all have high fees. So, I do a direct transfer of my group RRSP assets to my personal RRSP every year. In my case, it makes no sense to put my bonus in the group RRSP.

Others in my situation who prefer a personal RRSP may think they’re missing out on a big tax break if they don’t put their bonuses into their group RRSP. Rest assured that you’ll eventually get the same tax break with a personal RRSP.

Thursday, June 11, 2015

Test Your Debt Savvy

As the saying goes, there are more opinions about debt than there are people. Here’s short quiz to test how much you know about debt.


1. A few years ago, newlyweds Emma and Liam decided to buy a house. Their combined income was $100,000 and the bank said they qualified for a $450,000 mortgage. They borrowed $50,000 from their parents as a down payment and were the proud owners of a $500,000 house. The mortgage payments were a stretch, and all the house costs they didn’t know about in advance added to the financial pressure. Even before Liam lost his job, they were starting to run up their credit cards. By the time Liam found new work at lower pay, their high-interest debt was spiraling out of control. They held on for a while, but eventually declared bankruptcy and lost the house. Where did Emma and Liam go wrong?

a) Emma married a loser.
b) Their cheap parents should have given them a larger down payment.
c) They did nothing wrong. Mortgages are good debt and they were just unlucky.
d) Maybe going into debt for a house isn’t always a good idea. People need to have margins of safety in their finances.


2. Sarah just completed her university degree. Unfortunately, she has a $45,000 student debt. It would have been worse without some help from her parents. She could have lived more frugally at school and during the summers, but she just assumed the great job she’d get after graduation would take care of everything. If she had been more careful with her parents’ money and her summer job income, she could have kept her debt down to only $15,000. Once she starts working, Sarah will pay 6% interest per year. If she pays the debt off at $400 per month, how much longer will it take to pay off $45,000 than it would have taken to pay off only $15,000?

a) 6 years and 3 months.
b) Almost no extra time at all if she can get her parents to pay off her student debt.
c) It doesn’t matter. Student debt is good debt. The more the better.
d) About 10 years and 4 months.  Investing in an education is a good idea, but students should still try to keep their student debt to a minimum. The education is good, but the associated debt is still bad.


3. Life is going well for Matt. He has a steady job that covers his rent, food, and other expenses. He’s got some credit card debt, and a car loan. Matt heard that he should have an emergency fund in case he loses his job or can’t work for a while to make sure he can keep covering his loan payments and other expenses. What should Matt do?

a) He should get a line of credit that he can dip into in an emergency.
b) He should just count on his parents to bail him out if necessary.
c) Being in debt is normal. Nervous Nellies should get a life.
d) Owing money on a credit card is a hair-on-fire emergency. He should cut back on spending to pay off the credit card as quickly as possible. Then he should start building an emergency fund and start saving separately for his next car to avoid needing a new car loan.

It shouldn’t be too hard to see which answer I think is right in each case.


Tuesday, June 9, 2015

“Household Savings Rate” is Highly Misleading

When I first heard that the “household savings rate” is 5%, I thought this meant the average family saved 5% of their income toward retirement. Maybe you thought the same thing. Boy was I wrong.

Malcolm Hamilton’s recent criticism of the Ontario government’s assertion that Canadians save too little (full paper here) got quite a bit of attention. I’m still unsure of whether Canadians have a retirement savings problem, but I’m confident that the household savings rate measure is very misleading.

Hamilton describes a number of problems with this measure, but to see that it is misleading you only have to understand one of the problems. After people retire and begin to draw retirement income from their RRSPs, this counts as a negative household saving rate. So, even if I saved 25% of my income throughout my working life, I count as a spendthrift after I retire.

This makes it clear that “household savings rate” doesn’t mean anything close to the average percentage of income that Canadians save toward retirement. If we’re going to have a sensible discussion of programs for mandatory and voluntary retirement savings, we have to at least start with meaningful information about how much people are actually saving.

In fact, we need to get beyond average figures and look at the distribution of retirement savings amounts for each income range to identify groups who may be in trouble. Such an approach could lead to sensible new retirement policies. Misleading measures and speaking only in averages won’t get us anywhere.

Friday, June 5, 2015

Short Takes: Economic Impact of Driverless Cars, Choosing Risk Levels, and more

Here are my posts for the past two weeks:

“I Don’t Pay Any Fees”

Climate Change Mutual Finds

The Wrong Investing Goals

The Two-Income Trap 

Here are some short takes and some weekend reading:

Zack Kanter has some fascinating predictions about how driverless cars will change our economy and completely reshape the way we live.

Dan Ariely has a very interesting take on how to choose the level of risk in your investment portfolio. He’s no fan of risk questionnaires.

Malcolm Hamilton says the Ontario government is wrong about Canadians’ savings rate and that the new ORPP is not a good idea. There is also a full report.

Life Insurance Canada has some excellent suggestions for improving the life insurance industry. This plain-spoken piece will open your eyes to some of the risks associated with life insurance.

Gail Vaz-Oxlade explains just how expensive overdraft protection can be. She has a very direct style, and her recommendations include “If you think that sounds like too much work, you’re a dope.” My solution is to choose a minimum to keep in my account, like $2000, and I think of it as overdraft if I go below this amount. This way, I never need real overdraft protection.

Andrew Hallam explains a study into how money affects our morality and the implications for financial advisors.

Canadian Couch Potato calls out Google Finance for a number of types of misleading financial data.

Tom Bradley at Steadyhand has some sound thinking on investing and debt for the young.

Big Cajun Man celebrates the end of 3-year cell phone contracts.

Boomer and Echo call for city councils to ban door-to-door sales.

My Own Advisor says planning to live off dividends is a viable retirement strategy. This depends on the investments and the nature of the dividends or distributions. Some income funds have distributions that don’t increase with inflation and aren’t sustainable even in constant dollars. On the other side, many portfolios produce dividends as low as 2% per year, which is overly conservative.

The Blunt Bean Counter has some financial and tax planning advice for the terminally ill. This continues with part 2.

Wednesday, June 3, 2015

The Two-Income Trap

Common belief is that those who declare bankruptcy lack the self-discipline and morals to live within their means and pay their debts. After extensive studies of people who declared bankruptcy in the U.S., Elizabeth Warren and Amelia Warren Tyagi paint a very different picture of the reasons why people go bankrupt in their 2003 book The Two-Income Trap: Why Middle-Class Mothers and Fathers are Going Broke.

If we go back to the 1970s, the typical family with children had a father who earned an income and a mother who stayed home. Thirty years later, the typical family with children had both parents working. It’s natural to assume that this means the modern family is better off financially, but the authors show that this isn’t true.

According to the authors, U.S. families entered into a bidding war for housing in good neighbourhoods near good schools to give their children a safe place to grow up. Between the explosion in housing prices and other higher inflation-adjusted costs, “after an average two-income family makes its house payments, car payments, insurance payments, and child car payments, they have less money left over, even though they have a second, full-time earner in the workplace.”

The effective marketing of debt by financial institutions has certainly played a role in egging families on to larger purchases. “Just a generation ago, the average family simply couldn’t get into the kind of financial hole that has become so familiar today” because “the average family couldn’t borrow very much money.” Easy access to high-interest debt has changed all that.

So, adding a second income does not give more disposable income than people in the 1970s had. But living on two incomes adds significant risk. Now there are two people who might lose their jobs, and the family can’t maintain the life they want for their kids on just one income. While in the 1970s a mother could step into the workplace if her husband fell too ill to work, two-income families have no such safety net now.

The authors certainly aren’t calling for a return to the single-income family. They want some measures that will help the typical two-income family. They would like to see public schools give parents more choice of where to send their kids. This would make it possible to send kids to a good school but live in a less expensive neighbourhood.

Another measure they’d like to see is a cap on interest rates tied to the prime rate (e.g., prime + 10%). “If a family does not have the income to qualify for a loan at a reasonable rate, then they should not get that loan.” I certainly like the idea of financial institutions being forced to be more selective when lending.

The book also contains some very detailed advice on how to proceed if you are already in financial trouble and must go bankrupt. Apparently, collection companies use some unpleasant tactics to try to collect on loans, even after the loans have been discharged by the courts.

Although this book is getting a little dated and is U.S.-centric, it still provides an interesting counter to the usual story that those who go bankrupt are self-centered and lack morals.

Monday, June 1, 2015

The Wrong Investing Goals

Big Cajun Man published an amusing list of “frustratingly correct” answers to financial questions. Some of these questions and answers illustrate nicely that most people have the wrong ideas about financial goals.

The big man’s first question and answer:

Question: When is the best time to sell my stock?
Answer: When it reaches the highest price.

One criticism of this answer is that it offers no prescription for how to determine when a stock is at its highest price. But, apart from this, the answer is correct for active investors who try to beat the market. This is the way most people think about investing.

However, the majority of active investors must underperform the market. We see this play out year after year. The vast majority of investors would benefit if they stopped trying to beat the market either by themselves or by finding an advisor or fund managers to try to beat the market for them.

For investors who embrace passive investing, the first answer to the question of when to sell a stock is that they don’t own individual stocks in the first place. They tend to own low-cost broadly-diversified ETFs and mutual funds.

If we ask passive investors when they should sell their funds, the answer is when they need money or need to rebalance their portfolios. The answer “When it reaches the highest price” is incorrect to a passive investor.

The next question and answer:

Question: Any tips on how to win the lottery?
Answer: Yes, buy the winning ticket.

Once again, this answer offers no prescription for how to pick a winning ticket, but to lottery players, this seems like the correct answer. However, for those who have figured out that lotteries are a terrible deal, this answer is wrong. The real answer is that you win the lottery when you don’t buy any tickets.

I quite liked the final question and answer:

Question: Is there such a thing as good debt?
Answer: No. If you owe money, you owe money, which is bad.

As I’ve said before, there can be good reasons for going into debt, but the debt itself is still bad. This mindset can help people keep their debts to a minimum even when they go into debt for good reasons.

Overall, I find that even among investors who claim to have embraced indexing, the majority still think about jumping in and out of the market in misguided attempts to avoid market declines. They still think the correct answer to when to sell is when prices are at a maximum. True index investors are still rare.