Creating a Financial Plan
A financial plan makes recommendations in a number of areas. Financial planning is not about amassing a pile of money. The initial and most important step is identifying objectives (in a family, agreeing on shared objectives), e.g. buying a house, retiring early, ensuring that children get an excellent education, and so on. Determining what the objectives are is primary. Since what usually requires money in the modern world, financial planning then proceeds methodically to lay out how.
Elements of a plan
|I Need A Plan?|
|“Whatever failures I have known, whatever errors I have committed, whatever follies I have witnessed in private and public life have been the consequence of action without thought.”|
|— Bernard Baruch|
A financial plan usually begins with a summary of the current financial situation, including net worth, a list of income and expenditures, and perhaps a budget. Following this snapshot, the plan may address issues and make recommendations in seven key areas:
- Day to day finances (budgeting, expense control, mortgages, other debt, emergency funds, etc.)
- Insurance (life, health, disability, property)
- Education (Registered Education Savings Plan (RESP), Lifelong Learning Plan)
- Taxes (exemptions, deferrals, income splitting)
- Investments (asset allocation, security selection, risk management), Tax-Free Savings Account (TFSA)
- Retirement (pensions, Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), annuities, etc.)
- Estate (wills, powers of attorney, use of trusts, planned giving, etc.)
Not all financial plans cover all of these topics. For example, a retired person with a mortgage-free residence and a pension that covers day to day expenses may want and need advice only with respect to investments, taxes, and estate planning.
Doing It Yourself
DisclaimerThe advice hereafter is generic and not targeted specifically to any individual's circumstances. You may have personal or financial issues that must be handled specially, in which case you will need to learn more or consult a professional.
For many people, reading financial material or carrying on a financial discussion is a baffling and humbling experience. Jargon flies, everyone but you seems to know what's being talked about, and you don't know how to distinguish good information from noise.
The purpose of this article is to provide good information, simplified enough that the average person is able to handle their finances on their own and at minimal cost. For the most part, each section stands alone. You need not understand everything from the word go and you need not do everything immediately. Work at your own pace and within your own comfort zone, but do work at it.
If you don't want to do this yourself or don't have the time, then consider paying for someone to look after it for you. Just don't let yourself be taken for a ride. Financial planning is not an annual inquiry during RRSP season about how much you're going to contribute this year and a quick review of the flavour of the month mutual fund. If you're paying a fat fee, get some real financial planning for it.
The information presented below is necessarily abbreviated and not tailored to your own circumstances. Complexities and subtleties have been glossed over. However, the following simplified recipe is 80-100% of what the average person needs to know about personal finance. Following the recipe will allow you to achieve 80-100% of what you should achieve financially. This is a significant improvement over the 50% you are likely to get if you consult the typical salesperson at a typical financial services firm. The typical salesperson is not incompetent or a thief, but their fees - often well hidden - will consume half your wealth over time. Too often, what you get for the fees charged does not advance your objectives. Too often, your objectives are not even considered. (A "big pot of money" is not an objective.)
The super condensed recipe
If you're already fed up and can't stomach reading the rest, here is the one minute version:
- Spend less than you earn.
- Save and invest a percentage of every paycheque, not what is left after expenses.
- Don't put all your eggs in one basket.
- Watch the pennies and the dollars will look after themselves.
No one cares as much about your finances as you do. You will not realize your financial goals, and no one else – not the most skilled advisor – can help you realize your financial goals if you are not engaged. While you can delegate some of this work, you cannot wash your hands of finance completely.
There is nothing complicated about basic finance. The guiding principle is avoiding self-destructive behaviour. If any of the following apply to you, fix them before you even think about investing:
- Spending more than you make
- Not paying off your credit cards in full every month
- Not opening mail from your bank or broker because you don't want to know
- Failing to take every free penny that comes your way, whether it be a matching contribution to a savings plan by an employer or a tax deduction from the government, because you don't want to put some money into the kitty yourself
- Leaving your family exposed to a loss of earnings due to death or disability
- Gambling (unless you're really good at it, in which case it's not gambling)
- Buying a house or car more to impress than to use
- Paying non-deductible interest on anything other than your home mortgage (and a good case can be made that you are better to pay off the mortgage than invest, which you are not likely to hear from someone who gets paid a commission to sell you investments)
Eliminate non-deductible or high-interest debt
The first step, before establishing an emergency fund or setting up an investment portfolio, should be to eliminate high-interest or non-deductible debt. That generally means paying off credit card balances and ensuring that future credit card charges are paid in full. Pre-payment penalties may negate any advantage in paying down a mortgage, and the investor may be fortunate enough to have low interest rates on some types of debt like student loans. However, there is no net benefit to making, say, 6% taxable on a balanced portfolio while paying 18% or more on a credit card.
In Canada, most interest charges (except those for borrowing to invest) are not tax deductible, so should be addressed first.
Before establishing an investment portfolio, you should first set up a "rainy day" fund with three to six months expenses for emergencies. An emergency fund is aptly named because it's purpose is to provide a source of cash when the unexpected happens. You should setup your savings based on the time required to obtain the funds.
There are 3 time frames to consider.
- Immediate needs - Car problems and home repair are the typical uses of urgently needing cash.
- Needs within a few days to a few months
- Needs longer than a few months
The guiding principle for insurance is to use it only when a loss would be financially intolerable.
You pay for insurance when:
- It is legally required (e.g. liability insurance for a vehicle)
- It is contractually required (e.g. your mortgage lender insists you have fire insurance)
- A loss would cause serious financial hardship to your family (e.g. a paid for house burns down and you cannot afford to rebuild out of other resources; your family depends on your earnings from a job or business, and you are unable to work because of death or disability)
You do not pay for insurance when:
- A loss is immaterial to your well being (e.g. an extended warranty on a $300 television is a waste of money)
- No third party can be harmed by an event (e.g. life insurance for a person with no dependents)
- A loss cannot be compensated with money (e.g. life insurance on a child)
- The risk is not really avoidable (e.g. segregated funds guarantee a minimum market value, but if the market really goes into the tank, are the insurance company's finances robust enough to make good?)
- The all-in cost is similar to the loss you're trying to avoid (e.g. paying fat fees to life insurers to avoid paying fat taxes at death, but your children will end up with about the same amount either way)
No matter what, do not let a salesperson make you feel guilty about a non-existent or trivial risk. Never buy insurance for emotional reasons.
An excellent introduction to insurance and annuities for the layperson is Milevsky's Insurance Logic. The original edition is now out of print but may be available at your public library.
The costs of higher education and in particular, tuition, miscellaneous fees and books, are such that they must be included in any financial planning if higher education is a possibility. The primary vehicle for saving for higher education in Canada is the RESP.
See Tax Planning.
To most people, investing looks unbelievably complex. Jargon runs thick. The news never stops. Fobbing the whole task off onto someone else is very tempting. Don't do it!
In truth, investing can be a fundamentally simple process. You can do it yourself by following these simple guidelines:
- Most news is noise. The biggest risk for most people when investing in securities is paying too much attention to the news. What is in the business news today is totally irrelevant if you follow the rest of these guidelines. If you want to read the business pages or watch BNN for amusement, that's fine. Just don't invest that way.
- If your time horizon is really short and money is being invested that will need to be used within a few years, STOP! Putting your house down payment in the stock market is folly.
- Don't make the opposite mistake either by underestimating your need to invest for the long run: A person starting to draw on an RRSP today may have 30 years of retirement ahead, so keeping that RRSP in cash is a mistake as well.
- You must be willing to take some risks. While you may do fine just buying Guaranteed Investment Certificates (GICs) at your bank, you can do much better. Even the most conservative investor is well advised to own at least some stocks, even if not individual stocks.
- Do not be stupid about taking risk. Historical evidence is that even aggressive risk-seekers get scant extra return from going wild.
- Write yourself an Investment Policy Statement (IPS). Very conservative investors should probably have 75% of their portfolios in fixed income like GICs or bonds (or preferred shares) and 25% in equities. Very aggressive investors should have 20-25% in fixed income and the remainder in equities. If you're in the middle, a 50-50 or 60-40 mix is quite reasonable. Or you can use one of the many online questionnaires to help you determine whether you are a conservative or an aggressive investor.
- Make adjustments to the policy mix if your job, hence your salary, is highly correlated with one type of investment. Tenured university professors with generous indexed pensions probably should not own inflation indexed bonds. Software engineers with vested stock options should lighten up on high tech stocks.
Don't put all your eggs in one basket. Once you have an investment policy with an asset mix, your job is mostly done. The asset mix goes a long way to providing a diversified portfolio. Now go the rest of the way. Nowadays, you need not buy a single stock or bond in order to invest. For every asset class in your investment policy, there is a low-cost and tax-efficient vehicle that will work for you.
Some investors may choose to invest directly in stocks and bonds for all or part of their portfolio. If done wisely, this can be an effective strategy. But such direct investments must be carefully monitored and are not for everybody. If you doubt your ability to "stock pick", you should either avoid direct stock purchases or limit such investments to amounts you can afford to lose. Further discussion of stock selection procedures is beyond the scope of this guide.
For those who prefer not to select individual securities, here is a list of possible investment choices. Exchange Traded Funds (ETFs) are listed with symbols in the lists below and should generally be used because their costs are lower. If you are accumulating funds, say by depositing funds regularly from a pay cheque, then it's often better to use open-ended funds like the low cost TD e-series, because there are no commissions to buy or sell them.
- Individual bonds through an investment dealer
- GICs purchased through an investment dealer or deposit broker
- iShares DEX Universe Bond Index ETF (XBB), and DEX Short Term Bond Index ETF (XSB)
- Vanguard Canadian Aggregate Bond Index ETF (VAB) and Canadian Short-Term Bond Index ETF (VSB)
- PH&N Bond and Short-Term Bond and Mortgage
- CIBC Canadian Bond Index [for clients with more than $150k at CIBC]
- TD Canadian Bond Index-e (TDB909)
- Diversified Preferred Share Trust (DPS.UN)
- iShares S&P/TSX Canadian Preferred Share Index Fund (CPD) - formerly known as Claymore CDN Preferred Share Index Fund
Equities - Canada:
- iShares Composite Canadian Equity Index Fund (XIC)
- iShares S&P/TSX60 Index Fund (XIU)
- Vanguard FTSE Canada Index ETF (VCE)
- iShares S&P/TSX Completion Index Fund (XMD)
- CIBC Canadian Index Fund [for clients with more than $150k at CIBC]
- TD Canadian Index Fund-e (TDB900)
Equities - U.S.:
- Vanguard Total Market VIPERS (VTI)
- S&P depositary receipts (SPY)
- iShares S&P 500 Index Fund (IVV)
- Vanguard Extended Market Index VIPERS (VXF)
- CIBC US Equity Index [for clients with more than $150k at CIBC]
- TD US Index-e (TDB902)
Equities - Overseas:
- Vanguard All World ex-US (VEU)
- Vanguard Europe Pacific (VEA)
- iShares MSCI EAFE Index Fund (EFA)
- Vanguard European Stock Index (VGK)
- Vanguard Pacific Stock Index (VPL)
- Vanguard Emerging Markets Stock Index (VWO)
- iShares MSCI Emerging Market Index (EEM)
- TD MSCI EAFE Index-e (TDB911)
Watching your pennies
Costs matter. Many of the investment products commonly used by Canadians - mutual funds, segregated funds, pooled funds, separate accounts, principal protected notes, index linked GICs - carry extremely high fees. A large fraction of the fee pays the salesperson who sells it to you. Avoid such products as much as possible.
Be wary of marketing. Mutual fund companies tout last year's winners but neglect to mention the fees. Banks tout the skill of their portfolio managers but neglect to mention the fees. The fees are what will kill you in the end. The average mutual fund in Canada charges 2% a year, the average wrap account about 2.5%. It sounds innocuous. Yet paying those fees for 35 years, the average working life, will result in a large fraction of your retirement savings ending up in the hands of the mutual fund companies and the adviser they paid to sell you the products. That's hard to believe but you can check for yourself using the OSC's Mutual Fund Fee Calculator.
These are your choices but you can pick only one. It's up to you.
- You can pay no attention, like most Canadian investors. (See curve A below.)
- You can retire with a portfolio that's half again as large. (See curve B below.)
- You can retire years earlier. Five years earlier. (See point C below.)
Tuning out the static
It's not news; it's noise. Pay no attention to news. Not the paper, not the TV, not your golf buddy's hot tip. Read Chapter 22 of Frank Armstrong's excellent Investment Strategies for the 21st Century instead.
See Estate Planning.
If you can't or won't DIY
It doesn't bother us to hire plumbers to fix a leak or to pay someone to change the oil in the car. Modern economies are built on Adam Smith's division of labour and are better for it. There is no shame in paying a reasonable fee to have someone look after your finances. The shame only comes from letting yourself pay far too much.
If you have a small portfolio, say under $100,000, then the advice you're getting - if it's a financial plan, not just "Buy this fund" at RRSP time each year - is reasonably balanced against the average mutual fund's fees ($1,500-2,500 a year). But if you have a $400,000 RRSP, all invested in mutual funds or wrap accounts, you could be paying $10,000 a year. At a million dollars, it would be $25,000 per year. It's too much. That money belongs in your pocket.
If you really don't want to invest on your own, ...
Contact a professional
Books We are occasionally asked to recommend good books about personal finance and investing. There are many, although finding the good ones among the hundreds or thousands of titles at the book store can be difficult. We try to keep this list very short. Most people have a limited appetite for such material and want something simple but not simplistic. All are commonly available at libraries. The first two can often be found in used book stores or on garage sale tables, not because they are only worth a quarter but because people don't recognize good value when they see it.
- The Wealthy Barber, David Chilton. ISBN 978-0761513117
- Your Money or Your Life, Joe Dominguez and Vicki Robin. ISBN 978-0143115762
- Risk is Still a Four Letter Word, George Hartman. ISBN 978-0773761100
- The Four Pillars of Investing, William Bernstein. ISBN 978-0071747059 . William Bernstein (Bernstein's Efficient Frontier website is not often updated but highly recommended)
- Winning the Loser's Game, Charles D. Ellis. ISBN 978-0071545495
- Insurance Logic, Moshe Milevsky. ISBN 978-1-55322-088-6
Articles Two very readable academic articles on investing are Nobel Prize winner Bill Sharpe's The Arithmetic of Active Management and Brad Barber's Trading is Hazardous to Your Wealth. Spend half an hour reading and absorbing the lessons of those two articles and you will be a better investor than most. Cost conscious investors will also find John Bogle's historical review of mutual funds in the United States and the importance of minimizing costs interesting.
Good investing technique is not flashy and does not sell papers or magazines. The popular press exists as much to satisfy advertisers as it does to inform the public. The result is magazine covers that scream "10 Top Funds for Next Year" and the business section of the newspaper that tells you what happened yesterday when you want to know what will happen tomorrow.
In Canada, three finance columnists worth reading regularly are Rob Carrick (Globe and Mail), Jon Chevreau (National Post), and James Daw (Toronto Star). In the U.S., consistently good information comes from the pens of Jason Zweig (Wall Street Journal) and the now retired Scott Burns (Dallas Morning News).
The first two-thirds of How to Completely Avoid Outliving Your Money provides a good introduction to annuities.
If you are interested in serious studies of financial matters, a very comprehensive list of worthwhile articles can be found at Altruist FA. For recent and upcoming publications, check the links at Research Finance occasionally.
- Financial Webring Forum, Financial Planning, extracted Feb. 14 2009 and modified to Wiki format
- InsuranceHotline.com, Insurancehotline.com, viewed February 18, 2009.
- Kanetix, Kanetix, viewed February 18, 2009. Registration required.
- Statistics Canada, University tuition fees, September 1, 2006
- Rothery, N.The Stingy Investor Asset Mixer, viewed Feb. 18, 2009.
- BMO Financial Group, BMO Investor Profiler, viewed Feb. 18, 2009.
- Edmond Financial Group, Edmond Financial Group Risk Tolerance Questionnaire, viewed Feb. 18 2009.
- TD Asset Management, TD Waterhouse Portfolio Planner, viewed Feb. 18, 2009.
- Blackrock Announces Fund Name Changes Following Acquisition of Claymore Investments, viewed March 29, 2012
- Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. London: W. Strahan and T. Cadell.