A major part of a financial picture is insurance, whether it be on yourself, your car, your business or anything else. Almost anything is insurable and the scope of things we can insure has grown rapidly over the past 25 years. It is even possible, as a farmer or vintner, to buy insurance against poor weather conditions! For the sake of the blog, however, I'll try to limit the insurance discussion to things that Canadians might (or should) think about as they grow old.
I think the best way to view insurance of any kind is as a hedge, or a form of protection. Yes, it is possible that insurance could be looked on as an investment as well, depending on your definition. If you think of it though, insurance is a way of keeping the odds in your favour, at a price.
For this article, I will keep the discussion to life insurance only, of which there are two main types:
1) Term insurance. This is normally the least expensive type of insurance, meant to pay you if you die during a specific term. A good example of this would be someone who buys a policy that would expire when they retire. If they were 40 and planned to retire when they were 60, then they would buy 20-year term insurance. That way, if they died unexpectedly during their 'earning' years (while their family depends on having an income), their loved ones would have something to help them get by until retirement. Because the odds of us dieing (touch wood) are much lower before we retire, this type of insurance is normally very cheap. With any term insurance policy, it expires at the end of the term with no value. It is possible to renew a policy, however, for another term. You might do this to avoid having to go through another medical examination (normally a requirement to get life insurance in the first place).
2) Whole Life or permanent insurance. As the name suggests, this policy is good for your whole life, meaning that your beneficiaries get paid when you die, regardless of the timing of your death. In my opinion, this type of insurance is good for protecting an asset that might otherwise be difficult to keep if you die. For some families, their cottage is a very important part of their lives and may have been in the family for multiple generations. The problem then becomes the tax that is going to be owed when the parents die and the kids inherit the place. By estimating the amount of tax we might have to pay on the cottage when it gets passed to the next generation (there is no tax to leave something to your spouse), we could buy a Whole Life insurance policy for that amount. Then the beneficiaries would have the money set aside to pay the tax on the cottage and keep the legacy alive. The best way to think of permanent insurance is that it is there to take care of a permanent problem, normally tax-related, that isn't likely to go away. There are types of permanent insurance that have an investment component as well (Universal Life) but I think that gets a bit complicated for today.
When should I buy insurance?
All situations are different of course but there are a few instances where I think insurance is a must. Remember, insurance is a hedge. It is meant to be there in case we die so that our loved ones can continue to lead as normal a life as possible. That's why in my opinion, the first time we should really think about insurance is when we have kids. Should anything happen to us, we would like our kids to have exactly the upbringing we had imagined for them. Insurance makes this possible.
I mentioned the cottage example. The same would apply for a second house, farm house or anything that you would like kept in the family but don't have the cash available to pay the capital gains tax.
There is the business example as well. If you owned a business with a partner and your partner died, would you have the money available to buy out their portion or would you want to risk being in business with someone new that you might not know? Or even worse, your partner's heirs have no interest in maintaining the business, you don't find a buyer and have to wind up the whole thing. You and your business partner can buy insurance on each other's lives to protect against this scenario.
Insurance as an investment
Insurance comes at a cost. Many people choose to avoid buying insurance for this reason - they would rather invest their savings themselves in order to leave something for their heirs. I don't have a problem with this logic, unless you die unexpectedly. Then you will need that money right away, leaving it no time to grow through investment. That's why I think it makes sense to look at insurance as an investment.
Let's say you want a Whole Life policy that has a death benefit of $1 million and you are 50 years old. The insurance company has looked at the results of your medical and deemed that to insure you for this policy, it will cost you $25,000/year over the next ten years, or $200,000 today to pay it in full (these are total ballpark numbers, by the way), if you prefer to get it over with. The insurance company is betting that you will live until the average life expectancy; let's say 85 years old. If you do, this policy would be in force for 35 years. That means if you invested the $200,000 yourself over 35 years, the rate of return to get it to $1 million would be about 4.7%; not a bad risk-free rate of return, but we could probably do better.
However, if something happened unexpectedly and you got hit by a bus one year after the policy went in force, you just invested $200,000 to get $1,000,000 in a year. That's a 400% return on your investment. THAT is the benefit of insurance. If you had chosen to invest the money yourself and got even 8%, you would have all of $216,000 when your heirs needed it.
A counter-argument might be that as we get older, our tax liability on something like a cottage would increase. So if anything happened to us earlier, we would pay less tax. That's a fair point. But keep in mind that an insurance policy is risk-free, as long as you make your payments (called premiums), regardless of what happens in the stock market, bond market, etc.
In conclusion, when thinking about insurance, think about the need and try to match the policy. If you need insurance only for while you're working, then buy it for only that long. Yes, the policy will expire worthless but guess what? That means you're still alive. Maybe it's a small price to pay to have the piece of mind that your heirs will be taken care of.
If the math works for you, then why take the chance?
Cheers.
Tuesday, March 23, 2010
Thursday, March 11, 2010
Week 10 - Mortgage Payments or RRSP Contributions?
Many of us don't earn enough money in a single year to both maximize our RRSP contributions and maximize the amount that we can pay down our mortgage without penalty. So, each year we are faced with the choice of which vehicle to tackle.
In my mind, there are two ways of looking at this question.
1) Rates. If we think about each vehicle as an investment, by paying down our mortgage, we are saving the interest that we would have had to pay on that amount of money. So if your mortgage rate is 4%, then you are effectively getting a 4% return on your investment, since if you didn't pay it down, that's how much you'd have to pay each year. The question therefore becomes whether or not you can get a better rate of return by contributing to your RRSP. I might go a step further and suggest that the expected return from your RRSP better be pretty close to 'risk-free', since your mortgage rate isn't likely to go down from today's levels. What I mean by risk-free is that you can choose to buy stocks with your contribution but if your stocks go down, then you were better off paying down your mortgage. If you bought a bond that pays 5.5%, then you are better off doing that, since your mortgage rate is 1.5% less than that. So by this criteria alone, as long as we can get a higher low-risk rate of return in our RRSP, we are better off doing that.
2) Tax Deduction. Because mortgage payments are made with after-tax dollars, we know we are going to be immediately ahead by making an RRSP contribution, since we get the tax refund. By this logic alone, we might want to consider an RRSP contribution instead of a mortgage lump-sum payment. I will offer this argument, however. Remember that RRSP contribution room doesn't go away; we can always use it later in life. If we are only earning $50,000 per year now, we aren't even really getting that high a percentage of our tax back, compared to earning $100,000 down the road. So, it might make more sense to pay down the mortgage today while you are in a lower tax bracket and save your RRSP contributions for later in life when you are making the big bucks. If you don't see your salary increasing much from today's levels, you should probably contribute now, while you can.
Unless...
3) Sleep-at-night factor. Sometimes in life, we do things that may not make the most financial sense but they allow us to sleep better at night. For many people, this means paying down debt as quickly as possible. I could show you all the arguments in the world where RRSP contributions would make more sense than lump-sum mortgage payments but if you are someone who hates having debt, it's going to go in one ear and out the other. And you know what? There is absolutely nothing wrong with that. Regardless of our financial situation, the most important thing is being able to sleep comfortably with as little stress on our mind as possible. And with money being the number one reason people get divorced, we can see why the sleep-at-night factor might be the most important factor of all. Not to mention, mortgage rates rise. We never know how what rate we'll be able to get when we go to refinance down the road. Being able to refinance at a higher rate is less of a big deal, if we aren't needing as much money.
It was a relatively short post this week but this is one of the more common questions I get from people in this situation. I think I outlined the three most important variables, in my opinion.
What would I do? Well, it just so happens that I am completely debt-free and my RRSP is totally maxed out, so luckily, I don't have to make that decision ever again.
PFFFFFFFFFFFFFFFFFFFFFFFFFF!!!!!!
Seriously now? I try and do a bit of both. I like the idea of getting some tax back each spring and also reducing the amount of money we owe on our mortgage. Sometimes, the best strategy is to pay down your mortgage with your tax refund, killing two birds with one stone.
My last piece of advice on this is to speak to an accountant. They have no bias either way and will be able to offer their educated opinion for you as it applies to your own situation. Then you will have a better understanding when it comes time to make the decision.
Thanks for reading my blog.
In my mind, there are two ways of looking at this question.
1) Rates. If we think about each vehicle as an investment, by paying down our mortgage, we are saving the interest that we would have had to pay on that amount of money. So if your mortgage rate is 4%, then you are effectively getting a 4% return on your investment, since if you didn't pay it down, that's how much you'd have to pay each year. The question therefore becomes whether or not you can get a better rate of return by contributing to your RRSP. I might go a step further and suggest that the expected return from your RRSP better be pretty close to 'risk-free', since your mortgage rate isn't likely to go down from today's levels. What I mean by risk-free is that you can choose to buy stocks with your contribution but if your stocks go down, then you were better off paying down your mortgage. If you bought a bond that pays 5.5%, then you are better off doing that, since your mortgage rate is 1.5% less than that. So by this criteria alone, as long as we can get a higher low-risk rate of return in our RRSP, we are better off doing that.
2) Tax Deduction. Because mortgage payments are made with after-tax dollars, we know we are going to be immediately ahead by making an RRSP contribution, since we get the tax refund. By this logic alone, we might want to consider an RRSP contribution instead of a mortgage lump-sum payment. I will offer this argument, however. Remember that RRSP contribution room doesn't go away; we can always use it later in life. If we are only earning $50,000 per year now, we aren't even really getting that high a percentage of our tax back, compared to earning $100,000 down the road. So, it might make more sense to pay down the mortgage today while you are in a lower tax bracket and save your RRSP contributions for later in life when you are making the big bucks. If you don't see your salary increasing much from today's levels, you should probably contribute now, while you can.
Unless...
3) Sleep-at-night factor. Sometimes in life, we do things that may not make the most financial sense but they allow us to sleep better at night. For many people, this means paying down debt as quickly as possible. I could show you all the arguments in the world where RRSP contributions would make more sense than lump-sum mortgage payments but if you are someone who hates having debt, it's going to go in one ear and out the other. And you know what? There is absolutely nothing wrong with that. Regardless of our financial situation, the most important thing is being able to sleep comfortably with as little stress on our mind as possible. And with money being the number one reason people get divorced, we can see why the sleep-at-night factor might be the most important factor of all. Not to mention, mortgage rates rise. We never know how what rate we'll be able to get when we go to refinance down the road. Being able to refinance at a higher rate is less of a big deal, if we aren't needing as much money.
It was a relatively short post this week but this is one of the more common questions I get from people in this situation. I think I outlined the three most important variables, in my opinion.
What would I do? Well, it just so happens that I am completely debt-free and my RRSP is totally maxed out, so luckily, I don't have to make that decision ever again.
PFFFFFFFFFFFFFFFFFFFFFFFFFF!!!!!!
Seriously now? I try and do a bit of both. I like the idea of getting some tax back each spring and also reducing the amount of money we owe on our mortgage. Sometimes, the best strategy is to pay down your mortgage with your tax refund, killing two birds with one stone.
My last piece of advice on this is to speak to an accountant. They have no bias either way and will be able to offer their educated opinion for you as it applies to your own situation. Then you will have a better understanding when it comes time to make the decision.
Thanks for reading my blog.
Wednesday, March 3, 2010
Week 9 - Basic Financial Planning
I'm going to spend a few posts outlining my opinions about financial planning and what we should all be doing on a day-to-day basis. There are many different reasons to do a financial plan but the goal of all of it is to get an idea of what is happenning with our money, both now and years from now.
On a whole, I'm not entirely a fan of spending a lot of time with financial projections. I agree, they can paint a useful picture but I'm not sure they should be relied upon. What I would say, however, is that any time you want to use financial projections, make them as conservative as possible. The last thing you want to do is find out that you don't have enough money because your investments didn't grow at the expected 8% per year. I'm not saying 8% as a long-term return objective isn't reasonable but would you bet your life savings on it? I'm not sure I would.
I'm going to try my first attachment in this post as well, so you can get an idea of what my financial plan would look like. Yes, it's simple. It should be. I am going assume that my investments grow by 5% per year because that's the level of income I can get right now, without assuming too much risk. No, government bonds don't pay it but good corporate bonds and preferred shares do. I'm turning 32 this year so I'll actually have all my money in stocks anyway, but I'm still gonna stick with my 5% long-term return forecast. Most of my clients have been able to maintain this average over the past ten years (even despite what happened in the past few years) so I'm comfortable with that going forward.
In my opinion, you need two things for your plan;
1) A good income statement. This should tell you exactly what all of your sources of income are in a year (after tax), and what all of your expenses are as well (this should also be an after-deduction number, for those of us lucky enough to write off certain things against our income). If you're not exactly sure what your tax rate is, here is a quick and easy calculator to give you a ballpark amount. http://lsminsurance.ca/calculators/canada/income-tax (no idea how I got the thing to properly link this time).
I can't get a file to link, so here's an example of an income statement:
This paints a picture. For this example, the family only has $1,000 worth of credit card debt but is still paying $180 of interest per year. My advice on this issue could not be clearer: do not have ONE CENT of credit card debt. I understand that debt is a part of life but look at that interest rate! Be sure to pay off your credit card at all times and if you need to carry some debt, use a line of credit. The rates are much lower. Assuming the above rates, on $10,000 of credit card debt, you are paying $1,800 of interest each year. Move that debt over to your line of credit and your interest payments drop to $350. That's a $1,450 savings just for being smart.
My only other thought here is the car. They are a depreciating asset (they go down in value over time), which means that we should look at our cars as an asset as well as an expense, even if we don't have any car payments to make. Because eventually, our cars break down and we will need a new one. We might as well plan for this over time, especially if we are thinking about retiring. That's why I've put it in as a loss, using 20% as my depreciation rate. In theory, if I drove new cars each year and made no money on my investments, my balance sheet would deteriorate because of the depreciation. The moral of the story is to keep this in mind when checking out cars; don't spend what you consider to be a lot of money on something that will eventually be worthless.
In Retirement
When you retire, my advice would be to have no debt. You want to be getting paid in your retirement and not worrying about paying anyone else. Your 'rates' column should be working for you as much as possible.
Also, when you retire, you will add your retirement income to your income statement. It might come from a pension or from your Registered accounts. Either way, it is what is replacing your employment income.
Wondering about how much you will need to retire? Look at how much you are spending each year right now, compared to how much your investments could make you, assuming 5%. If your investments can make you enough today (including pension income, etc.) that you could live off the income without touching the capital, then you can probably start thinking about it! Congratulations. Your income statement is in the black and your balance sheet isn't shrinking! You are looking good for retirement. You might even gross up your retirement spending by some amount, because you'll have a lot more free time for trips, golf, etc. Just keep this in mind when planning.
If you don't have enough money to live off of yet, you will need to keep working or adjust your spending habits. My advice would be to do the latter before you retire, just to make sure you are being realistic at whatever spending limits you are setting for yourself.
That's it for now. Please feel free to fire me any questions on this. If you want, I can also send you the spreadsheet. Excel is a handy tool for this type of thing and is surprisingly easy to use.
Cheers.
On a whole, I'm not entirely a fan of spending a lot of time with financial projections. I agree, they can paint a useful picture but I'm not sure they should be relied upon. What I would say, however, is that any time you want to use financial projections, make them as conservative as possible. The last thing you want to do is find out that you don't have enough money because your investments didn't grow at the expected 8% per year. I'm not saying 8% as a long-term return objective isn't reasonable but would you bet your life savings on it? I'm not sure I would.
I'm going to try my first attachment in this post as well, so you can get an idea of what my financial plan would look like. Yes, it's simple. It should be. I am going assume that my investments grow by 5% per year because that's the level of income I can get right now, without assuming too much risk. No, government bonds don't pay it but good corporate bonds and preferred shares do. I'm turning 32 this year so I'll actually have all my money in stocks anyway, but I'm still gonna stick with my 5% long-term return forecast. Most of my clients have been able to maintain this average over the past ten years (even despite what happened in the past few years) so I'm comfortable with that going forward.
In my opinion, you need two things for your plan;
1) A good income statement. This should tell you exactly what all of your sources of income are in a year (after tax), and what all of your expenses are as well (this should also be an after-deduction number, for those of us lucky enough to write off certain things against our income). If you're not exactly sure what your tax rate is, here is a quick and easy calculator to give you a ballpark amount. http://lsminsurance.ca/calculators/canada/income-tax (no idea how I got the thing to properly link this time).
I can't get a file to link, so here's an example of an income statement:
I've got my income sources and then my expenses. If I subtract the expenses from the income, that's what's left over for either saving or spending. If you do this exercise and you find that you are spending more than you are saving already, then it's time to make some lifestyle changes. Be sure to include everything you can think of. You're only cheating yourself if you leave out certain expenses. A good way to get an idea is to check your past few months worth of credit card bills or bank statements. They will quickly give you an accurate picture of what you're spending your money on.
2) A good balance sheet. This should show you what you own (assets) and what you owe (liabilities). Subtract your liabilities from your assets and you get your net worth. Hint: if your net worth is a negative number, you need to keep working. Here is a very basic balance sheet:
As you can see, this family has a nice cushion. They do have some debt but they also have some good assets, which gives them a net worth of $429,000 (assets minus liabilities).
You'd be surprised how you'll feel about your financial picture once you do these two exercises. Then, if you're feeling confident with excel, you can actually add another column so that you can include the interest rates that you are either earning from your assets or owing from your liabilities.
This paints a picture. For this example, the family only has $1,000 worth of credit card debt but is still paying $180 of interest per year. My advice on this issue could not be clearer: do not have ONE CENT of credit card debt. I understand that debt is a part of life but look at that interest rate! Be sure to pay off your credit card at all times and if you need to carry some debt, use a line of credit. The rates are much lower. Assuming the above rates, on $10,000 of credit card debt, you are paying $1,800 of interest each year. Move that debt over to your line of credit and your interest payments drop to $350. That's a $1,450 savings just for being smart.
My only other thought here is the car. They are a depreciating asset (they go down in value over time), which means that we should look at our cars as an asset as well as an expense, even if we don't have any car payments to make. Because eventually, our cars break down and we will need a new one. We might as well plan for this over time, especially if we are thinking about retiring. That's why I've put it in as a loss, using 20% as my depreciation rate. In theory, if I drove new cars each year and made no money on my investments, my balance sheet would deteriorate because of the depreciation. The moral of the story is to keep this in mind when checking out cars; don't spend what you consider to be a lot of money on something that will eventually be worthless.
In Retirement
When you retire, my advice would be to have no debt. You want to be getting paid in your retirement and not worrying about paying anyone else. Your 'rates' column should be working for you as much as possible.
Also, when you retire, you will add your retirement income to your income statement. It might come from a pension or from your Registered accounts. Either way, it is what is replacing your employment income.
Wondering about how much you will need to retire? Look at how much you are spending each year right now, compared to how much your investments could make you, assuming 5%. If your investments can make you enough today (including pension income, etc.) that you could live off the income without touching the capital, then you can probably start thinking about it! Congratulations. Your income statement is in the black and your balance sheet isn't shrinking! You are looking good for retirement. You might even gross up your retirement spending by some amount, because you'll have a lot more free time for trips, golf, etc. Just keep this in mind when planning.
If you don't have enough money to live off of yet, you will need to keep working or adjust your spending habits. My advice would be to do the latter before you retire, just to make sure you are being realistic at whatever spending limits you are setting for yourself.
That's it for now. Please feel free to fire me any questions on this. If you want, I can also send you the spreadsheet. Excel is a handy tool for this type of thing and is surprisingly easy to use.
Cheers.
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