How to Get Out and Stay Out of Debt
Part 8–Saving in the Real Sense of the Word
A few cases of extreme personal financial success have made headlines in Canada recently. About a year ago, there was the case of Toronto’s Sean Cooper, who paid off his mortgage in 3 years by age 30. More recently, there was the case of Kristy Shen and Bryce Leung, who opted out of home ownership and into retirement by their mid-30s.
Both those cases are admittedly extreme. That’s the reason they made headlines. However, I was struck by the number of haters these stories attracted. Some critics ridiculed Cooper’s choice to live almost as a pauper in the basement of his own house. Other critics assumed Shen and Leung must have had a head start and pointed out that they had far higher paying jobs than most people so it was “easy” for them to get rich so quickly.
On the opposite end of the spectrum, my reaction was, “Good for them!” Moreover, I can’t understand why some people can be so resentful of other people’s success. It’s as if they feel entitled to the same thing but without making the least effort or sacrifice to get it. That said, for me those cases demonstrate a point that my own mother taught me when I was just a kid or teenager, and that point is that you need to learn how to save — in the “not spend” sense of the word — if you want to get ahead.
You might find the anecdote I’m about to share with you really, really weird, but one year I got a $500 GIC (term deposit) from my parents at Christmas. I was perhaps 11 or 12 years old, so I remember not quite understanding what the gift was when I opened it, and I remember my mother looking over to me and saying as she continued distributing gifts from under the Christmas tree, “I’ll sit down and explain it to you later.”
It was at a time when returns on bonds and GICs were very high and government incentives like a registered education savings plan didn’t exist, yet my parents knew that I would be seeking a post-secondary education. I still remember that talk with my mother as we sat on the couch in the den, in front of the Christmas tree: “The gift is that your dad and I are giving you $500. That’s yours, but it’s for when you’ll be going to university. And since you’re still years away from university, we put that money for you in a certificate, which is like a special account, so that this $500 will grow to $850 in five years just for promising to leave it there and not touch it. Then, since you won’t be ready for university yet in five years, we’ll take that whole amount and put it into another certificate for another two years to make it grow even more.”
I understood her explanation — I totally got that $500 was a huge amount back then — but I admit it didn’t seem too sexy when my classmates were all comparing what they got for Christmas when we went back to school in January. When I look back to this gift today, I’m in awe because that wasn’t just a huge sum for me but for my parents as well back then. I only figured that out as a young adult when I discovered just how modest my father’s yearly income was. Clearly, having been children during the Great Depression and World War II had taught them valuable lessons.
My mom was also pretty good with math. She could do fairly complex mental calculations quickly. She also turned out to be an excellent bookkeeper in her senior years.
That said, she wouldn’t have been able to explain to you (or even know what was) exponential growth as explained so clearly here by the late U.S. physicist Albert Bartlett, but she understood it instinctively. While Bartlett applied this notion to express his concerns over population growth and the exhaustion of petrochemical resources, exponential growth, even if modest, is the cornerstone of generating wealth.
Listen to this clip. Pause and rewind as many times as you need to, but don’t plead that you just can’t get wrap your head around math. This is NOT a difficult concept.
So the deal is this: Put something aside and find a way of making that something grow, even modestly. Remember that even setting aside a little bit at a time adds up quickly, and the more you have saved, the more growth you can generate.
I tried mutual funds within my RRSP (see below) for a very short while but, even though I stood the chance of making a lot more money over 15 years if I stuck to them, I couldn’t stand two things:
- not knowing exactly how much I would have at the end of 15 years, and
- the possibility of having zero or even negative growth when I’d be ready to cash in.
In other words, as far as financial planners are concerned, I’m your classic scaredy-cat when it comes to investments, but I own that label and I’m fine with it. Maybe I wouldn’t have been that way had I started to save in my early-30s and thus had a 30-year timeframe to work with. But once I’d gotten out of debt and was ready to save, I only had 15 years to work with and I’ve since reduced that timeframe to only 10 years. In short, I had no tolerance for wild market fluctutions and what-ifs; I wanted certain results.
At this date, through looking carefully at how much I spend and on what, I have managed to set aside in 2016 just a hair under $14,000, which includes interest earned and tax refunds. From cash I could have spent had I not been paying attention and wrongly assumed to be my discretionary income, the figure is more along the lines of $8,500 — on average, one out of five dollars that I get in net pay. My plan is to repeat this in the next 9 years — that is, up to and including 2025, at the end of which I plan to retire. With numbers like that, however, if something comes up one year and I don’t get to save nearly as much, I will still be in good shape as long as I’m able to get back on track after that “bad” year. By eshewing credit, saving and paying cash even big-ticket items like my car, and investing all tax returns and unexpected income (like the estate from my mom), I will by retirement day have three times more than the sum of that one-in-five dollars from my take-home pay.
The sad truth is that, in today’s economy, savers don’t get the rewards they used to. After much research, the best rate I can find in Canada on a non-refundable (5-year fixed-term) GIC today is 2.3 percent — it was 2.5 percent at the beginning of 2016, which wasn’t extraordinary either — so using the formula to figure out how long it will take my investment to double, I come up with the figure of about 30 years (70 / 2.3 = 30.43). Right there, that makes many people throw in the towel, figuring there’s no use.
I disagree, of course. Some financial planners have told me, “You’re hardly keeping up with inflation,” as they tried to lure me into what I deem their Russian-roulette world of mutual funds. But in fact, exponential growth at a rate ranging from 1.7 to 2.3 percent will in fact keep pace with inflation, assuming it stays at roughly the same rate as we’ve seen in recent years. As to those who assume that there’s no point in saving for such paultry returns, I retort that I would rather have $100,000 (assuming near-zero growth) in 10 years than $0 to top up my two skimpy monthly pension cheques, thank you very much!
Safe Diversification for Scaredy-Cats Like Me
While retirement nine years from today is the main focus of my efforts, I would be foolish to stash everything into a registered (closed and inaccessible) retirement fund. On the one hand, I do plan to have a life before retirement and, on the other hand, I have to plan for a disaster before then, like losing my job.
From everything I’ve read, I gathered that you should have a minimum of three months of your current net income saved up in case you lose your job overnight. Six months would be better; nine to 12 months would be glorious. After careful study, I opted for six months and that’s excluding what would be in my “reserve account” at that point.
So here’s how I distributed my savings to balance enjoying life while having a calamity fund and a retirement fund at the same time.
(1) Dividends Sharing Plan (DSP)
This is an option your employer might not offer, but if it does, try not to ignore it, although I would argue that if you’re curerntly in debt, you should first get out of debt before entering a scheme like this one.
For the next nine years starting in 2017, my employer claws back 6 percent of my official annual salary that will be used to purchase common shares. Given that I’m opting for a non-registered plan, that 6 percent will be taken from my pay after deductions — I could have chosen 100 percent registered for retirement or 50/50 for savings and retirement, but I figure I had retirement covered already (see Points 3, 4 and 5 below) — but it’s amazing how quickly you get used to not having access to that 6 percent. For participating in this plan, my employer matches 50 percent of my contributions up to a maximum of 3 percent, effectively giving me a 3 percent pay increase, which also goes into purchasing common shares. Then, every quarter, dividends get paid.
Of course, that number could be postive or negative, but it would have to be a HUGE negative before it would start eating into my initial 6 percent and historically it hasn’t taken such a nosedive — even during the Great Recession of 2008-2009. That’s as much risk as I’m prepared to take and you have to admit: Given the 50 percent match up, it’s hard to even call that a risk!
There are a bunch of conditions governing when I can touch the money (i.e., when the employer’s share becomes “vested”) and what happens if I do, but I’m just viewing this thing as an account I can never touch until I retire in December 2025. Everything becomes vested when I do retire, so I’ll have a whack of shares to liquidate at that point but will only do so in January 2026 so that I’ll be taxed on capital gains only in 2026 — when my income will have taken a dive.
Also, the 50-percent match-up will be taxable but my employer won’t be making any tax deductions on that portion, so I’ll arrange to have Payroll take about $30 extra per paycheque toward income tax in an attempt to more or less break even at tax time. Dividends will also be taxable but at a totally different rate than income, so I’ll play it by ear for the first year or two and determine later if it’s worth having more than $30 retained each paycheque.
(2) Electronic-Only High-Interest Savings Account
When my bank introduced its electronic-only high-interest savings account, the annual interest rate was somewhere between 4.2 and 4.5 percent. That was before the Great Recession. Today it stands at only 0.5 percent. It was 1.1 percent as recently as two years ago today. Still, this is the bank account I use as my reserve account into and from which I move money each paycheque for near-future needs spending, plus a $1,000 contingency fund.
Given the ridiculously low “high” rate at my bank, I looked for similar accounts at other financial institutions to put away a good part of my “loose” savings (i.e., my “if-I-lose-my-job” fund). I opened an account at Tangerine Bank but then, about a month later, I found a credit union in Manitoba called Implicity that offered much better rates. The thing about deposits in a federally regulated bank is that you’re guaranteed up to $100,000 by the Canada Deposit Insurance Corporation (CDIC), but the guarantee for deposits in a credit union is determined provincially. In Manitoba, that guarantee is 100 percent, which is incredible but fantastic. On the other hand, twice and sometimes three times per year, Tangerine offers a considerably better rate than Implicity for a few months at a time on new deposits, so that motivated me to keep both accounts.
In late 2014, the rate was 1.1 percent at RBC, 1.3 percent at Tangerine, and 2.0 percent at Implicity, giving Implicity a 0.9 percent edge over RBC and a 0.7 percent edge over Tangerine. Since then, with the Bank of Canada’s prime rate having gone down twice by 0.25 percent in 2015 to settle at 0.5 percent, the rate at RBC has gone down 0.6 percent (more than the BoC) to 0.5 percent, Tangerine’s has gone down by 0.5 percent (same as the BoC) to 0.8 percent, and Implicity’s has gone down by 0.3 percent (less than the BoC) to 1.7 percent.
That gives Implicity a 1.2 percent edge over RBC and a 0.9 percent edge over Tangerine and it shows that banks are certainly meaner than credit unions! (Remember my rant in Part 3? “‘Loyalty’ is a word that has meaning to banks only if it helps their bottom line, so you owe banks shit in terms of loyalty [once you’re out of debt] when it comes to your financial health.”) However, whenever Tangerine runs one of its short-term offers that makes its rate at least 0.5 percent better than Implicity’s, I take the time to move my loose savings there since those funds are just as easily accessible from either account.
|Autumn ’14||1.10%||1.30%||2.00%||+ 0.70%|
|01 Jan–02 Feb ’15||1.10%||2.50%||2.00%||+ 0.50%||Worse differential so far.|
|03 Feb–31 Mar ’15||0.80%||2.50%||1.85%||+ 0.65%||Bank of Canada drops from 1.00 to 0.75 percent on 21 Jan 2015.
RBC’s normal rate drops from 1.10 to 0.80 percent.
Tangerine’s normal rate drops from 1.30 to 1.05 percent.
Implicity’s normal rate drops from 2.00 to 1.85 percent.
|01 Apr–30 Jun ’15||0.80%||1.05%||1.85%||+ 0.80%|
|01 Jul–22 Jul ’15||0.80%||3.00%||1.85%||+ 1.15%||Bank of Canada drops from 0.75 to 0.50 percent on 15 Jul 2015.
RBC’s normal rate drops from 0.80 to 0.65 percent on 20 Jul 2015 and from 0.65 to 0.55 percent on 2 Dec 2015.
Tangerine’s normal rate drops from 1.05 to 0.80 percent.
Implicity’s normal rate drops from 1.85 to 1.75 percent.
|23 Jul–30 Nov ’15||0.65%||3.00%||1.75%||+ 1.25%|
|01 Dec–31 Dec ’15||0.55%||0.80%||1.75%||+ 0.95%|
|01 Jan–17 Mar ’16||0.55%||2.50%||1.75%||+ 0.75%||Implicity’s rate drops from 1.75 to 1.70 percent on 18 Mar 2016 without any clear external factor.|
|18 Mar–31 Mar ’16||0.55%||2.50%||1.70%||+ 0.80%|
|01 Apr–30 Jun ’16||0.55%||0.80%||1.70%||+ 0.90%|
|01 Jul–30 Sep ’16||0.55%||3.25%||1.70%||+ 1.55%||Best differential so far and a full 1% more than RBC’s basic!|
|01 Oct–31 Dec ’16||0.50%||2.95%||1.70%||+ 1.25%||RBC’s rate drops from 0.55 to 0.50 percent on 9 Nov 2016 without any clear external factor.|
|01 Jan–?? ??? ’17||0.50%||0.80%||1.70%||+ 0.90%|
In late-spring 2016, seeing that I still found myself using my Tangerine account more than I thought I would after finding Implicity, I decided to deposit and maintain my annual $1,500 gas fund in the Tangerine account so that I can earn at least 0.8 percent on that amount, and I tabulate the “new” deposits separately in my Tangerine ledger so that I can easily identify the funds to move back and forth between Tangerine and Implicity. The Tangerine account is also where my monthly pay back on my new MasterCard gets deposited, so since 2016, those paybacks plus any interest from any of my three high-interest savings accounts go to replenish my gas fund.
Interest in such an account is considered income; therefore, it is taxable. Financial institutions do not emit a tax form if that income is under $50, but you are still responsible to report ANY income at tax time. So don’t be foolish: I declared the $28 I made last year in one of these three accounts because the last thing I want is to get in trouble with the Tax Man for a measly $28! It’ll only be about $13 on that same account for 2016, but again I’ll declare it. The trick is to move as much as possible into legal, totally transparent tax-sheltered accounts.
(3) Tax-Free Savings Account (TFSA)
“Account” is not the right word for this instrument introduced back in 2009. It’s more of an umbrella under which you can have a savings account, GICs, or any other types of funds. Whatever you earn in this account is, as the name suggests, tax-free. But the catch is that there’s a ceiling, and beware: a TFSA is not automatically a panacea. The returns can be lousy if you don’t shop around, so you could end up legally not paying tax on an insignificant amount — and what would be the point of that?!
When this instrument was introduced, the cap was $5,000. The following year, another $5,000 was added, giving a cap of $10,000. There were blips over the years, but the cap on January 1, 2017 is $52,000.
|In late-April, the Conservative government increased the yearly increment to $10,000 effective immediately, but the Liberal government that took power later in the year returned the yearly increase to $5,500 for subsequent years but let the 2015 increment stand.|
The cap is one’s contribution room, meaning that when I opened my TFSA in January 2015, I was allowed to start with a $36,500 deposit if I had it. Then, when $4,500 was added in April, I could top it up, too. The catch if you are able to max out your TFSA is that you cannot register deposits exceeding the annual amount between 1 January and 31 December. In other words, I’m free to withdraw from my TFSA, but given that I had reached the cap at the time of my withdrawal, I couldn’t deposit it back until 1 January of the following year.
I opened my TFSA at Implicity in January 2015 as a simple savings account earning 2.0 percent. Unfortunately. that rate dropped to 1.85 percent in February when the Bank of Canada dropped its rate by 0.25 percent and again to 1.75 percent in July after another BoC rate drop of 0.25 percent to 0.5 percent. By early-September, I drained that savings account and placed the whole amount in a 5-year GIC earning 2.5 percent per year, which will increase the capital not by 12.5 percent but 13.15 percent at the end of 5 years, meaning I will definitely have kept up with inflation. Subsequent deposits for 2016 and 2017 simply go in the savings account portion, whose rate is now 1.7 percent.
This one little move means that I will have earned $1,777 more in tax-free interest at the end of that 5-year period than if I’d just left that amount in the savings account. Then later, apply more exponential growth to the nearly $5,450 I will have earned just for swearing off spending that money… If yearly increments remain at $5,500 and I max out every year, and if rates remain roughly where they are now, I project that I will have increased my capital by 20 percent by the end of 2026 or by 29.4 percent by the end of 2030. It’s far from doubling but I’m fine with that.
What distinguishes a TFSA from a Registered Retirement Savings Plan (RRSP) (see below) is that TFSA contributions are made from after-tax money, which means you don’t get a tax break when you deposit into a TFSA. Your tax break is that you don’t pay any tax on the revenue your deposit generates under the TFSA umbrella.
A lot of people use their TFSA to save for big purchases or emergencies; others use theirs as a complement to their retirement savings. I fall in the latter group, but the part of my TFSA that isn’t locked into GICs forms a portion of my six-month if-I-lose-my-job fund, the other portion of said fund being in either of my high-interest savings accounts depending on which one gives a better rate at the time.
(4) Registered Retirement Savings Plan (RRSP)
Like a TFSA, an RRSP is an umbrella under which you can have a savings account, GICs, bonds, stocks, mutual funds, and so on. You pay no tax on whatever you earn under this umbrella while it’s under this umbrella, but that’s not all.
When you drop money into an RRSP, that amount becomes deductible at tax filing time. You then take that tax refund and reinvest it into your RRSP. When you retire and start withdrawing from your RRSP, you’ll have to pay the tax you’ve been given back but, by the time you retire, you’ll be in a considerably lower tax bracket than the one you’re in now, so you’ll pay less tax than you would have to pay today plus you will have considerably more to draw from than the amount you socked away because it will have grown.
You get a contribution room in your RRSP just as you do in a TFSA, but unlike the one-size-fits-all room under a TFSA, your RRSP room is determined by your income in that it increases by 18 percent of your taxable income in the year for which you’re filing, to a maximum (currently) of $26,010. But that amount is reduced by whatever you and your employer pay into its pension plan, if you’re so lucky as I am to have a pension plan at work (see below). I had some extremely bad years as a freelancer between 1996 and 2006, which means that there was about a decade when my contribution room didn’t increase very much, but there’s nothing I can do about that now and I just deal with it.
Some who have a pension plan at work assume they won’t need RRSP income upon retirement. That might be true for them. However, the question you need to answer to be sure is how much income do you need to sustain your current lifestyle. If you followed me this far, you should already know what you need (minus food).
The rule of thumb is that your income when you retire should be about 70 percent of what it was just before you retire. Based on that rule and what my current needs are, I realized that my work and government pensions wouldn’t quite cut it. However, I figured out that if I only contribute decreasing amounts to my RRSP until 2020, I could (a) fill about 70 percent of my projected RRSP contribution room, (b) still have a life before retirement, and (c) be ready in case of an employment disaster before the end of 2025 even if it’s unlikely to occur. Just like some people overspend in the purchase of a house and end up house poor, it’s possible to sock away too much into an inaccessible RRSP fund and end up deferring “life” until retirement, and I definitely didn’t want to do that.
As for which instruments you should have under your RRSP umbrella, most financial advisors will steer you toward managed mutual funds; however, because I have no risk appetite, I couldn’t stand them. Then in January 2016, Implicity got into the business of RRSPs with a simple choice that I could totally grasp: a high-interest savings account (currently 1.7 percent), GICs (currently 2.3 percent for five years), or a combination of both. If current rates stand until 2031, low as they are, I should still be able to add 33 percent on my capital by then, which is a whole lot better (and certain …and safer) than putting that capital under my mattress!
If I have a point in all of this, it’s this: I’ve done the math, and while bonds and GICs are a shadow of what they were some 15 or 20 years ago — let alone 30 years ago when they went through the roof — they do end up yielding more than what they seem to promise on the surface. However, if you have more risk appetite than I do, which most people do, then go for mutual funds for a while. For your sake, though, don’t go overboard!
(5) Employer’s Pension Plan (EPP)
If your employer offers a pension plan, it falls into one of two types: defined benefit or defined contribution, but no matter the type, it’s always registered. The former is the type that was standard until the last decade or so but is a fast-disappearing breed. Today, if an employer offers a pension plan, it’s the latter type. I would have the latter if I had joined my employer just a few years later, but I’m extremely lucky to have the former.
Under my defined benefit plan, my employer contributes to my pension and I have the option to contribute to it or not. If I decide to contribute (which I do), I do so at the rate of 6 percent of my official annual salary. My choice is all or nothing — 0 or 6 percent — no other figure — but, by contributing, my pension will obviously be better. But the reason it’s called defined benefit is that, come what may, the amount I’ll get is assured based on how much was contributed to it.
Under a defined contribution plan, my employer would contribute a lesser amount to my pension than under a defined benefit plan and I could choose to contribute any whole number from 0 to 10 percent of my official annual salary. The amount I would get would be determined on how well (or not) the contributions grow. I was given an opportunity to play out some scenarios in case I wanted to switch from defined benefit to defined contribution and found that even if I contributed the maximum of 10 percent, I would get only a little bit more than if I stuck to defined benefit and contributed 0 percent!
It was a no-brainer for me but, unfortunately, I have colleagues who didn’t do their homework and fell for the employer’s offer to switch and were influenced by other colleagues who aren’t risk-adverse and convinced them that defined contribution would be better. It never is for the pensioner; it only benefits the employer who pays in less and pays out MUCH less in pensions. A better name for this scheme would be undefined benefit but no one would fall for it because the negative would be in plain view, so an obfuscating term was coined for it instead.
No matter the type, your contribution is deducted from your gross (i.e., before tax) which is unlike the flavour for the Dividends Sharing Plan (DSP) I chose, so it’s like an RRSP in that you’re getting a tax break and that’s why what you and your employer contribute to it is counted against any RRSP contribution you can make. In other words, when I chose to set aside 6 percent on my DSP, my net (take-home) pay dropped by 6 percent; however, when I chose to contribute 6 percent on my employer’s defined benefit plan, the effect on my net was closer to 4 percent — and again it didn’t take long not to miss that amount on my net. My benefits won’t be as rich as some of my colleagues who got to contribute for 35+ years because I started my career at this employer at age 40, and that’s how I figured out that my employer and government pensions wouldn’t be enough — thus my need to save otherwise through an RRSP, a TFSA, my DSP and any other savings I could manage on my own.
But I’m not complaining! At least I have a defined benefit pension from my employer, for I’m of the last generation who’ll get that.
Add It All Up and You Get…
Three years ago, just two days after I officially dug myself out of debt, I asked myself, “Indeed, Now What Do I Do?” I think I knew that part of the answer was that I had to finally start thinking about retirement, but I didn’t really know where to begin on that front. It took my mom’s passing and finally getting my tax situation cleaned up to galvanize me into action, but now I actually get to enjoy my life and not worry about finances (other than keeping them organized).
I might be a scaredy-cat when it comes to how I invest what I have, but I’m no longer a scaredy-cat about my financial future. And boys do I sleep well at night because of that!