Monday, August 24, 2009

Sorry But I'm Taking A Break

As we approach the end of a "brief" summer, I am planning on taking a couple (few) weeks off to refresh and renew. See you in the fall...
Stay Well and Pay It Forward.

Friday, August 21, 2009

Financial Independence (FI)

Every person on this planet will have their own definition of financial independence. To many people in North America, it means a nice home, nice cars, fancy "stuff" and trips. To someone from the African interior, it could be defined as 3 square meals a day. Yet one constant remains - the most important things for those dreaming of financial independence (FI) is manage your cashflow. In the beginning people often get too bogged down in worries about if they have invested right or tax considerations or how much money they need, when in reality managing your cashflow is much more important.

You see in the beginning you likely have a small amount of investments so optimization of your investments and related taxes is a minor issue. A 1% lower rate of return on $50,000 is a mere $500 a year or equal to about $42/month. So you could either do a ton of research and self learning on taxes and investments to get that extra 1% return or just stop buying a coffee everyday on the way to work. Guess which one is much easier to do?

So that’s why I’m suggesting don’t worry about everything else in the beginning. Your first priority is to start using frugal ideas and reduce your spending to increase your amount of money for debt repayment and future savings. You start with the big stuff of paying off your credit card debt and work you way down to $2/month savings here and $5/month there. Every dollar counts so look at everything and ask yourself, "does this make me happy for the dollars I’m spending on it or do I require this". Not “would like” or "kinda enjoy it" but rather "I love doing this" and "I need to eat something to keep breathing" kind of thing.

In the beginning you will likely go over kill and cut back too much. That is fine, once you find those areas you really miss spending on go back and put some cashflow back in. After all
FI is a nice goal, but no one should be miserable on the way to getting there. Life is a once through processes so you might as well enjoy the ride.

In the end you will find out how much you really need to spend to make you happy which then you can use to build a real estimate of how much you need to get to FI. Also after this much time you would have likely had some time to slowly learn a bit more about investments and taxes so now you can go back and investigate doing better there. Just don’t try to take on too much all at once, it is recipe to fail to get anything done.

Read books, talk to successful people (make sure they really are successful and not living on time/credit), watch shows and educate yourself. Most people tend to learn from their parents - whether that advice is good or bad does not matter. Ask around and find out what others are doing. That doesn't mean you need to become an expert. Many people do fine as do-it-yourself investors. They don't need an advisor to hold their hands and seem to come out ahead. If you don't see your self in this category, then stick to the basics:

  • Pay cash whenever and wherever possible
  • Save 10% of your income for emergencies, retirement, child's education
  • Pay your bills and live within your means
  • Decide on whether an item is a need or want
  • Do a budget and stick to it

Stay Well and Pay It Foward.

Tuesday, August 18, 2009

Retirement Income - The Right Mix

Here is one of those great things you find on the net - it will help investors "approximate" how much of their investment holdings should be invested in equities and bonds.

The theory that you should ratchet back on risk as you age is generally a good one. A popular rule of thumb was to subtract your age from 100, the difference being the percentage of stocks you should keep in your portfolio. Then people started living longer, and the target number to subtract from became 110. For example, if you’re age 40, 70 per cent (110 minus 40) of your portfolio should consist of stocks when you're building towards retirement.

Even when you're done working, you'll still likely need to have at least some of your retirement portfolio in stocks to provide inflation-beating growth, however. In fact, some advisors believe the stock allocation shouldn't drop below 50% for many retirees.

But it’s important to realize that close to two thirds of your investment earnings may actually come from post-retirement returns, says Russell Investments Canada. Good news, considering that most investors haven’t been having much luck recently making money before they retire.

Based on Russell’s 10/30/60 ratio, the pattern of your investment earnings during retirement will likely be derived something like this:

- 10% from money you saved during your working years
- 30% from the growth of your savings before you retire
- 60% from growth that occurs once you retire

Because the scheduled withdrawals go up relentlessly every year, they take an increasing bite out of your nest egg. Withstanding that ever-growing bite requires stability, which means minimizing volatility and negative returns like those we’ve seen lately.

The key, therefore, is having the right portfolio mix in place during retirement – one that balances the stability of bonds with the continued growth potential of stocks. What’s the optimal mix? A relatively conservative blend of 35% stocks and 65% bonds, Russell suggests.

How does your portfolio match up?

Stay Well and Pay It Forward

Friday, August 14, 2009

Will CPP/OAS Be There When You Retire?

I often hear this question when talking to people. For some reason, the younger the person, the more it is assumed that there will be no Canada Pension Plan or Old Age Security. However, it is also interesting to see how many older people assume that it is their inherent right to receive OAS benefits. As you are about to see, they may both be very wrong.

While the information I am about to show you is old, rest assured it will explain the problem/crisis we face in the future. These numbers are from the 2003-2004 fiscal tax year. During that year, the federal government brought in $186B in revenue. The largest single expense that year? Interest payments on Canada’s federal debt (money borrowed by previous federal governments, which has not been repaid). These payments – to institutions and individuals who hold federal bonds, Treasury bills and other forms of the debt – cost $35.8 billion. This represents 19% of all tax revenue.

Transfer Payments are cash payments that go directly to individuals, to provincial and territorial governments, and to other organizations. Overall, these three categories of transfers combined make up just over half of all federal spending, or almost 51 cents of each tax dollar. Of this group, the biggest transfer category was Major Transfers to Persons. Altogether, these payments cost almost 23 cents of every tax dollar. These transfers included payments to eligible elderly Canadians through Old Age Security payments, the Guaranteed Income Supplement and the Spouses Allowance.

Here is a simple point - for every dollar the government brings in, 42 cents goes to pay the debt and provide OAS and related benefits. Now here is the crisis part - what happens when the first wave of baby boomers turn 65. This will lead to lower tax revenues and higher transfer payments. Over the past several years, the federal government has been paying down the deficit at the rate of about $10B per year. The past 12 months changed everything and it is expected to put us back where we began. The federal debt level was still substantial at $467 billion in 2006-07. expect to see a number in the $550 billion range next by 2010.

If you think we have it bad, the US is in much deeper trouble. I found this best illustrated their problems going forward.

Let's turn to the state of the Canada Pension Plan. Canadians currently receiving their CPP benefits have no cause for concern. The plans has a total (March 2009) of $105.5 billion in it's portfolio. In fact, it will be another 11 years before a small portion of the CPP Fund’s investment income will be needed to help pay pensions. Beyond that time, the CPP Fund will continue to grow for decades to come. The $105.5 billion CPP Fund is broadly diversified and structured to help secure Canadians’ CPP pensions over the long-term and the funding structure of the CPP means that it is able to weather an extended market downturn.

CPP contribution levels have increased dramatically over the past 15 years to their current levels of 9.9%. The reason for this was to preserve future benefits. According to the Office of the Chief Actuary of Canada, the CPP fund needs a real rate of return – that’s return after inflation – of 4.2 per cent, over the 75-year projection period in his report, to sustain the plan at the current contribution rate. Over this long time frame we expect that there will be periods where returns are above or below this threshold. In the ten years since the CPP Investment Board began investing, returns for the CPP Fund in all four-year periods prior to fiscal 2009 exceeded the 4.2 per cent real rate of return.

Public equities make up 44.0 per cent of the CPP Fund. The current asset mix is as follows:
Public equities: 44.0%
Fixed Income: 27.9%
Private equities: 13.4%
Inflation-sensitive assets: 14.7%

Interestingly, only 45% of the portfolio is actually invested within Canada. Don't think that makes sense? Here is a response from the CPP Investment Board to that question.

Our mandate is to contribute to the financial strength of the CPP by investing in the best interests of 17 million CPP contributors and beneficiaries and by maximizing returns without undue risk of loss.With approximately 45.5% of our portfolio (or $48.0 billion) invested in Canada, we will always have a large part of the fund invested here but we do not want to be overly dependent on the strength of the Canadian economy and so are systematically looking for opportunities to diversify internationally. But portfolio diversification by asset class and by geography is a fundamental part of the CPP Investment Board’s long-term investment strategy to manage the growing complexity of the fund. On its own, Canada does not provide sufficient diversification opportunities. Canada’s stock market is small, representing less than 2% of the world market capitalization, and it is heavily concentrated in a few sectors. The flow of contributions to the CPP varies directly with the health of the Canadian economy. By reducing the fund’s reliance on the Canadian economy, global diversification offers a source of returns for periods of weak performance by the Canadian economy.

Since the Canada Pension Plan is funded by contributions from it's "members", there are fewer issues of affordability. Nonetheless, as explained in a previous blog, there are changes pending to the plan and the amount of benefits people can/will receive. Expect lower benefits in the future, as well as possible increases in costs. If I were a gambling man, I would bet on CPP being around for 50-100 years. As to the Old Age Security (OAS) program? I think that the future definitely holds some snake eyes.

Stay Well and Pay It Forward.