MoneySense Magazine, October 2008
7-day makeover: Do try this at home
You can perform your own seven-day makeover. Here’s how.
This article was first published in the October 2008 issue of MoneySense.
The participants in our Seven-Day Makeover gained a new outlook on money. The good news? You, too, can make over your bottom line — and you don’t even have to leave your home to do it. We’ve distilled the essence of the Seven-Day Makeover into a plan you can follow on your own. It goes like this:
Before our participants showed up for the makeover, we asked them to send us copies of their tax returns, their credit card statements, their insurance policies, their bank account statements, their mortgage statements, and their pension information. You should collect all those same documents for your own makeover.
We recommend you buy an accordion folder with multiple pockets — one pocket for tax stuff, another pocket for credit card statements, and one pocket each for pension stuff, bank account statements and mortgage papers. You may need additional pockets for RRSP statements, brokerage accounts and so on.
We know what you’re thinking — collecting all this stuff is about as exciting as dusting your baseboards. We agree. But it’s crucial. We were struck in the makeover by how little most of our participants knew about their own finances. They often weren’t aware of the details of their pension plans, or their insurance, or how much they were spending in interest on their credit cards. Once they did find out, the answers to their questions were often obvious.
So think of this paper-gathering stage as a way to gain control over your life. Once you have all your papers in one place, your entire financial existence is at your fingertips. And, believe us, that is a major step toward gaining control over your destiny.
Now it’s time to take the first big step on your road to prosperity. This involves figuring out your net worth — the amount of money you would have left over if you sold everything you owned and paid off all your debts. Your net worth is probably the single most important indicator of your financial health.
Your net worth includes your home and any other property you own. Your net worth also spans your RRSPs and other investments, as well as any money you may have in the bank or any businesses you own. Included, too, are any pension benefits you’ve built up at work. (Your human resources department should be able to provide you with an estimate of the current value of your pension.) The total of all these goodies represents your assets.
From these assets, you will have to subtract your liabilities — the amount remaining on your mortgage, your credit card debt, other loans. What’s left over when you take away your liabilities from your assets is your net worth.
If you’re like most people, your net worth will rise gradually over your lifetime. Most of us have little or no net worth when we’re in our twenties. We start to build wealth in our 30s, but the process is agonizingly slow. The median Canadian family, including both husband and wife, has a net worth of only $160,000 by the time the major breadwinner hits 40. Net worth swells to $265,000 by the time the major income earner turns 50 and grows to $450,000 by the time he or she reaches 60. It then begins to decline in retirement.
You can gain a rough sense of how you’re doing by comparing your own net worth against the median numbers we’ve just quoted. Most people are delighted to discover they’re not as far behind as they thought. But what’s more important than absolute numbers is the direction that your finances are headed in. Taking on debt to finance your education, buy a house or start a business can be entirely sensible, but as a general rule, your net worth should be increasing, slowly but steadily, each year from the time you finish your schooling until you retire. If instead it’s steadily falling, you have reason to be concerned. You should calculate your net worth once a year—perhaps on your birthday or New Year’s Day — to see where your finances are headed.
Now you know where you stand. Your next challenge is determining where you want to go.
Our advice? Pick the single goal that is most important to you right now — it may be paying down your debt, saving toward a sabbatical, ensuring your family’s financial security, building up your savings, or something else entirely. Focus on this goal until you feel you’ve achieved it. You’re more likely to succeed if you concentrate on a single goal than if you split your attention among multiple objectives.
Whatever your goal may be, it is likely to involve living on less than you earn — saving money, in other words. Some of us are natural savers; most of us aren’t.
Why don’t we save? One big reason is that we don’t know where our money is going. Our participants learned this first hand when we asked them to chart their spending before they arrived at the makeover. Several were surprised to discover that they couldn’t pinpoint where thousands of dollars were vanishing every year.
If you find this hard to believe, we invite you to draw up a table of your own spending, just as we have done in each of the articles about our participants. Do you know where all your dollars are going? If not, we invite you to carry around a small notebook and track your spending for a month. (If it makes you feel better, let me confess that I’ve done this exercise and was embarrassed to discover that I was spending $150 a month on Diet Coke. That’s $1,800 a year wasted on my habit of gulping down chemically flavored water. Yes, I’m working on it.)
You may have your own vices. The key question, though, is whether you’re managing to save. The time-honored rule is that you should aim to save 10% of your income. Most of us fall far short — the savings rate among Canadians is now under 3%. If your spending is higher than you would like, it’s time to set up a savings program.
This is easy if your spending is more or less under control. All you have to do is to pay yourself first. You decide how much you want to save each month, then arrange to have this amount automatically deducted from your paycheque and whisked away to a savings account or other investment. You’re free to spend whatever is left over, no questions asked.
But what if your spending is out of control? What if you never pay off your credit card and are deep in debt? Debbie Gillis, a credit counselor from Kingston, Ont., showed our participants the tough-love strategy she uses with clients in serious trouble.
You start, as with any other type of budgeting, by planning your spending. But you then place each type of spending into one of three categories.
The first category is fixed expenses. These include housing costs, insurance premiums, car payments and debt repayments. These expenses recur each month at about the same time and don’t change unless you move, disconnect service or pay off your debt.
The second category is periodic expenses. These are foreseeable expenses that occur at certain times of the year: Christmas gifts, back-to-school clothing, family vacations, oil changes on the car.
The final category is day-to-day expenses. These include groceries, gas, haircuts, toiletries, going out for a drink, and so on.
With Gillis’s strategy, you handle each category of expense in a slightly different way.
In the case of fixed monthly expenses, you set up automatic withdrawals to pay the bills directly from your paycheque or bank account. This ensures that all your major expenses are covered before you get to touch a penny of your salary.
In the case of periodic expenses, you estimate how much you can spend on these expenses over the course of a year. You then set up an automatic withdrawal plan to deduct an equal amount from each paycheque to cover those expenses. (If your periodic expenses are, say, $4,800 a year, you would deduct $400 a month and put it in a savings account.) You no longer allow yourself to pay for Christmas gifts, back-to-school clothing or other periodic expenses by using a credit card — you go to the bank, remove the money you’ve accumulated, and pay for these expenses in cash. This means you never pay credit card charges. It also means your savings plans are never ambushed by recurring expenses.
Finally, there are day-to-day expenses. You also use cash for these. Once a year, you determine how much you can afford to spend each week on day-to-day stuff. You withdraw that amount each week on the same day. During the week, you pay for everything in cash. When the cash stops, so does your spending.
Gillis stresses that her program is not for everyone, but if you are deep in debt, it’s one proven way to get back on track. “It’s about learning new habits and learning to avoid using credit as a way to handle periodic expenses,” says Gillis. “What this program teaches people is that credit should be for emergencies, not for day-to-day stuff or foreseeable expenses.”
For more on smart ways to reduce your borrowing costs and get out of debt, see The golden age of debt.
So now you’re saving. That’s good. But how do you invest what you save?
Any stockbroker will be happy to fill your ear with descriptions of the stocks and bonds and mutual funds they can sell you. But a far smarter investment may be right under your nose. Paying down your debt is the single best investment you can make. Every dollar you put toward your credit card debt guarantees you a double-digit return. Even paying down your mortgage ensures you an after-tax return of 6% or so. That is more than bonds or GICs are paying and it also beats what you could expect to earn in a typical mutual fund. “Paying down your mortgage is a completely risk-free way to earn a good return on your money,” says Malcolm Hamilton, an actuary at Mercer benefit consultants and one of the presenters at the makeover. “To have a chance of earning higher returns, you would have to take on far more risk.”
Once you have your mortgage and other debts paid off, it’s time to invest. Here, again, the key is to turn off much of the financial industry. “You see these?” Norbert Schlenker of Libra Investments asked our makeover group, as he waved around a clutch of financial newspapers. “They’re financial pornography. They’re gossip. And you should do your absolute best to ignore them.”
Schlenker, a trained financial analyst, told our participants that trying to beat the market is a mug’s game for most people. Decades of stock market history show that the vast majority of actively managed mutual funds fail to keep up with the market, largely because of the hefty fees they charge. Over the past decade, for example, the average Canadian equity mutual fund produced a 7.9% return while the market gained 9%.
So how do you invest intelligently? Schlenker recommends you construct a simple portfolio using what are known as index funds. These funds track the market, but don’t attempt to beat it. The great virtue of index funds is their low, low fees — which means that more of your portfolio’s profit winds up in your pocket and not in the pocket of your financial adviser. You’ll pay close to $2,500 a year to invest $100,000 in a standard selection of actively managed funds; you can pay less than $500 to invest the same amount in index funds. Over the course of 10 years the difference in fees is enough to buy you a new car.
Regular readers of MoneySense will recognize this indexing approach. It’s what we call Couch Potato investing. We’ve included a brief description in Be a Couch Potato. Putting together your Couch Potato portfolio requires no more than 15 minutes a year, but it will perform better than 80% of professionally managed money. It’s smart investing made simple.
By this point, you’re well along on the path to prosperity. But there is one major issue you still have to confront — risk control. Illness or an accident can kick apart your carefully planned finances unless you’ve built in the necessary safeguards.
Life insurance is a key component of how you manage risk. But you should understand the limitations of this type of insurance. It’s intended primarily to replace lost income, so it makes no sense to have a life insurance policy on your children. You should understand, too, that no matter what the salesperson tells you, life insurance is not the best way to invest. “Whole life” policies that combine lifelong coverage with an investing component are expensive and usually unnecessary.
The best deal for just about everyone is a term policy that covers you for 10 years or more. Ideally, you should shop for such a policy through a broker who can present you with several quotes from different companies. Look for policies that guarantee you the right to renew — this protects you in the event that your health takes a turn for the worse.
Just as important as life insurance is disability insurance, which covers you in the event that you are no longer able to work because of illness or accident. Many of us are covered by disability policies at our workplace, but you should inquire into the details. If your employer pays even a dollar of your premiums, any disability payments you receive will be regarded as a taxable benefit. So it’s actually good news if you discover that you are paying the entire shot yourself through a payroll deduction. This means that any payments you receive will not be taxed.
While you’re investing your coverage, inquire whether your disability insurance is “own occupation” or “any occupation.” The former guarantees you payments so long as you can’t return to your previous line of work. The latter guarantees you payments only so long as you can’t return to any type of work, even if it has nothing to do with your chosen profession.
You may think the difference in wording doesn’t amount to much. In fact, it’s huge. Say you’re a skilled carpenter who can’t work at your profession because of double vision from a car accident. If you have own-occupation coverage, you will receive disability payments. But if you have any-occupation coverage and the insurer believes you can take a job serving hamburgers, your disability payments could be cut off. “Most employers only offer any-occupation coverage,” adviser JoAnne Anderson told the makeover. “If you want own-occupation coverage that fits around your coverage at work, you’ll have to buy it yourself.”
There is only one major financial challenge left — retirement. For many of us, this looms as the biggest worry of all, but Hamilton, the actuary, had words of comfort for our participants. “You are going to find that retirement is far less of a financial challenge than you expect,” he told them.
Most Canadians aren’t aware of the size of the government stipends coming to them in retirement. If you’ve worked in Canada all your life and retire at 65, you will collect at least $11,500 a year from the Old Age Security and Canada Pension Plan (or Quebec Pension Plan in the case of Quebecers). The figure can rise as high as $16,600 a year. And don’t forget that if you’re married those figures can almost double.
At the same time as government starts filling up your wallet, many of your expenses begin to vanish. In retirement, you no longer have mortgage payments, child-rearing expenses or RRSP contributions. Your tax bill dwindles because your income is lower. A middle-class couple with children who replaces even half of their working income in retirement should be able to maintain much the same standard of living as they enjoyed while working, Hamilton estimates. He points out that government benefits alone will go a long way toward reaching that goal.
What do you have to do to enjoy a rich, rewarding retirement? Nothing remarkable, says Hamilton. Before you retire, pay off your house and erase your debt. Keep your investing costs to a minimum using low-cost index funds and similar investments. Build up your savings as best you can, but don’t fret if you fall well short of a million dollars. “Frugality is a virtue — savings not so much,” Hamilton told the makeover. An RRSP stash of even $200,000 per person will provide you with a solid financial backstop and allow you to indulge in a bit of travel while you’re still young enough to enjoy it. Finally, develop some inexpensive hobbies. That’s it.
By this point, your makeover is essentially complete. But there is one thought we would like to leave you with. It comes from Amanda Mills, a financial therapist in Toronto, who talked to our makeover participants about their feelings in regard to money. At her session, a couple of our participants cried as they confessed their worry over finances. “Managing money is all about emotion,” Mills told them. “People think it’s all about figures, but it’s really about the hopes and fears you’ve built up around money.”
Those are wise words. Many of us sabotage our own financial lives — sometimes by taking on foolish risks in search of a big payback, sometimes by using spending as a substitute for love, sometimes by ignoring our finances because they’re too stressful.
To help you get a grip on your feelings, we would like to leave you with one modest suggestion. It’s to keep a financial diary. Use it to jot down your feelings about your money situation, explain your financial decisions to yourself and track how you’re doing.
At the very least, you’ll find it fascinating to read your diary in a few years and remember how you felt when you bought that stock or that house or that car. You will find, too, that forcing yourself to write down your reasons for a decision helps you to think through your choices more clearly. Over time, keeping a financial diary will give you insight into how you think about money — and that insight will enable you to learn both from setbacks (which are inevitable) as well as your growing success.
You can build a great portfolio in 15 minutes a year
Couch Potato investing is based on two fundamental ideas: diversification and low costs. You can read more about this approach at here, but the essentials are simple. Open a discount brokerage account. Select the lowest-cost index funds you can find (TD e-series funds are the current low-cost leader, but are only available online). Then put 40% of your money in a Canadian bond index fund, and 20% each in a Canadian stock index fund, a U.S. stock index fund and an international stock index fund. That’s it. You now have a diversified portfolio that spans the world at rock-bottom costs. Adjust your portfolio once a year so you get back to your original 40-20-20-20 split.
MoneySense Magazine, October 2008