Retirement taking a backseat to present: BMO

Why are Canadians dragging their feet when it comes to retirement planning?

BMO says the answer can be found inside their minds. Using behavioural finance research, the bank believes it has uncovered clues as to why Canadians are procrastinating the way they are.
A report from BMO Retirement entitled Retirement Planning: Can I Get Back To You On That? and based on a survey conducted by The Strategic Counsel reveals that Canadians are more mindful of their present financial circumstances rather than their future.

The concepts of "immediate gratification" and "paralysis of choice" have severely affected retirement planning in Canada.

Delving into the psychology behind the competing priorities, the report states that although 82% of respondents understood that saving early for retirement is important, more than 81% are more concerned with their present needs than their retirement.

Canadians are also overwhelmed with too much information and too many options involving retirement planning. This has resulted in frustration and paralysis when action is required.
Thirty-six percent of non-retirees said they are overwhelmed by too much information and this has been an obstacle to them moving forward with retirement saving plans.

"While it's often hard to act against our natural instincts, it's critically important that Canadians take an active role in planning for their future and start as early as possible," says Tina Di Vito, Head, BMO Retirement Institute. "Understanding the psychological barriers to effective retirement saving is the first step to overcoming them."

The report also points to other contributing factors that are delaying many retirement plans. Those who have children under the age of 18 are unlikely to see saving for retirement as an immediate priority, as post-secondary education may take precedence. It is also difficult for those with a heavy debt burden to focus on retirement. Lower income respondents are overwhelmed by the volume of information available.

For those who are interested in saving for their retirement, BMO suggests the following steps:
Save early

• Create a budget
• Set financial goals and monitor your progress
• Sign up for your company's pension plan
• Make full use of tax-favoured investment vehicles
• Set up an automatic savings program
• Seek out financial help

The report was based on a poll of 2,034 Canadians, 35 years of age or older and was conducted using The Strategic Counsel's web panel between May 26 and June 2, 2010.
(07/29/10)

Filed by John Powell, john.powell@advisor.rogers.com
Originally published on Advisor.ca

Personal Finance and Home Purchasing

Something that I haven't quite got my head around is how so many (thousands per month) people can seemingly 'afford' to purchase homes in the Vancouver area considering the prices at which local homes seem to be sold at. Greater Vancouver benchmark for all dwelling types is just about $520,000 as of June 2009.

Let's look at a sample first time home buyer.

Let's imagine John and Jenny want to get started on the property ladder after getting married last year. They have saved $10,000 over the past couple years and they have about $25,000 in their RRSP accounts which they intend to use toward a property purchase under the Home Buyer's Plan. Jenny's parents have offered to help them purchase their first home as well with an extra $20,000 'loan' to be used toward a down payment that may never need to be paid back. They don't have any credit card debt but are making payments of a combined $900 per month on two car loans which have 3 years left on them. Combined down payment = $55,000.

John makes $60,000 per year working in the technology field and his job prospects are very good given his education and work experience. Jenny works in sales and her income has averaged $50,000 per year over the past two years. Although she does okay at work, her job prospects are sketchy as the company she works for has seen business drop off considerably and has laid off a few people in the last few months. Gross Annual Income = $110,000. Net Monthly Cashflow = $6,000.

They are wondering what they are able to afford (apparently they don't have a budget) so they go talk to a mortgage broker about their situation. The mortgage broker punches some numbers into the computer and comes up with a preapproval amount of $430,000. John and Jenny are amazed, they wonder what they have done to make the bank love them so much! This pre-approval emboldens them.

They call up a realtor and begin looking at homes in the $400,000 to $500,000 price range. The realtor shows them several condos and a few townhouses which meet their criteria and they settle on a nice townhouse and make an offer for $450,000 which is accepted and the deal is drawn up.

John and Jenny put $45,000 down by using the parent's money and withdrawing from their RRSP accounts under the Home Buyer's Plan. They have paid CMHC and legal fees of $9,000 which gets added to their mortgage so they owe a total of $414,000 and they have decided to amortize over 35 years (they will be 65 when it is finally paid off if they stick to the original plan with the original rate) with a 5 year term and a rate of 4.5%. They will be making principal and interest payment of $1,950 per month, they have added life insurance to the mortgage ($50) and are paying property tax monthly with their mortgage payment ($200). They now get to pay strata fees of $200 per month as well.

Let's have a look at John and Jenny's monthly budget.

John and Jenny's total monthly obligations are:
Mortgage - $1,950
Life Insurance - $50
Taxes - $200
Strata - $200
Car Payments - $900
Food - $600
Fuel - $400
Home and Auto Insurance - $400
Telephone/Internet/Cable - $300
Clothing/Other/Misc - $300
Entertainment/Vacations - $500
RRSP contributions - $200
Total = $6,000

This couple can have a 'reasonable' lifestyle based on these numbers but let's look a little closer.
Let's test this for several common risks:

Death - The mortgage is life insured, the survivor would be financially okay so long as the life insurance remains in place.

Divorce - They are in bad financial shape if this happens. Neither one of the two could afford the townhouse if they split up and the townhouse would need to be sold quickly.

Children - They are in bad financial shape if they have kids. Not only would they have extra monthly expenses, which they don't have room for in the budget, they would also have less income for a period of time as it is typical for the mother to take some time off work after giving birth. Even if mom went back to work there are daycare costs, which are not small.

Job Loss - They are a financial disaster if one of the two loses employment of any extended period of time. They would be forced to make some significant life changes and likely sell the home.

Interest Rate Rise at Renewal - If interest rates rise by 100-200 basis points they would be extremely rough financial shape. Unless they had an increase in income, they would likely be forced to re-amortize the mortgage and/or make other lifestyle changes. If rates increased more than 200 basis points, they would not be able to maintain their current lifestyle in any shape or form.
1) 100 basis point rise to 5.5%, maintain original amortization, payments rise to $2180 / month
2) 200 basis point rise to 6.5%, maintain original amortization, payments rise to $2420 / month
3) 300 basis point rise to 7.5%, maintain original amortization, payments rise to $2670 / month

Time - This is the most insidious risk of all and the least recognized. As a financial planner, I see many people who have put themselves into this type of scenario and they manage to muddle through life, manage to pay off a modest home by retirement and save a very modest sum of money. They retire at 65 and have a fairly low standard of living since they have no real significant savings and no pensions. If none of the above risks occured and they both managed to work a full career, get regular raises, contribute to CPP, receive OAS and have some modest RRIF withdrawals, they would make it through life without severe financial hardship but as a debt slave. The bank would have made over $400,000 from them in interest payments and they would have never saved much. They would live month to month their entire life and financial freedom would be a mere dream as they play the lottery each week hoping their number is drawn.

The reality is that the risks noted above are very real and for John and Jenny's situation to work out they need everything to work perfect, with no hitches, glitches or problems. This seems unlikely to me. It would be far better for them financially to leave themselves more room in their monthly budget so that they could:
1) Live / survive with only one income
2) Maintain mortgage amortization if interest rates rise
3) Speed up mortgage pay down by making extra payments as they receive raises if things work out well.
4) Increase their personal savings to RRSP and/or TFSA to ensure they have money for the unexpected and for retirement.

There are only two ways for John and Jenny to make the above work in a sustainable manner:
1) Continue renting and saving aggressively
2) Buy a much cheaper home and aggressively pay down the mortgage

What are your thoughts? Do you know John and Jenny? I do.

Canadians not Saving Enough for Retirement

From the Globe and Mail:

"When the stock market was soaring and the economy was stronger, one hardly heard of any worries about private pensions. Many baby boomers were confidently facing retirement since they were thought to be healthier, better educated and wealthier than their parents' generation.

But now, with the collapse of the stock market as well as the economy, the boomers' easy coast into retirement has changed.Not surprisingly, a number of prominent organizations, including the C.D. Howe Institute, have recently concluded that Canadians are not saving enough for their retirement.

This basic conclusion is correct and seems even more relevant today because the economy is in recession and Canadians are losing their jobs.Simple economic theory, such as the life-cycle savings hypothesis (that individuals should put aside savings in their productive working years to maintain their standard of living in retirement), is useful in framing the policy choice for individuals, but it is not very practical with respect to telling them what they should do when everything goes wrong.

But how much should a Canadian actually save for retirement? The answer is: Who knows? We have no idea how long we'll live. Should we save enough to last until 75 or 95? If we save for a 95-year lifetime, the amount needed is obviously much greater.

One could save enough to buy an annuity at the time of retirement, an annuity that would provide an adequate income for life. But how much should we put aside to buy this annuity?

The amount of income an annuity will provide at retirement depends on the interest rates at the time the annuity is purchased and the income stream begins. Will one save enough to buy an annuity assuming the current level of interest rates? Canadian government bonds now yield from 2 per cent to just over 3 per cent. Or should one presume at the time of retirement that interest rates will be at the level they were in the early 1980s, when Canadian bonds yielded more than 16 per cent? If one assumes the high rate of interest, then the amount of saving needed for retirement would be a fraction of the amount needed with today's much lower rates.

All of these reasons demonstrate the inability of any person to know how much to save for retirement. So what's the public policy response? Do we need more registered retirement savings plan room? Do we need more defined-contribution pension plans? (A defined plan is one in which both the individual and employer contribute a set amount, with the individual investing those funds in some form until retirement.)

The problem with RRSPs and defined-contribution pension plans is that the amount needed for a set retirement income is always unknown. The additional problem is that the whole investment risk is carried by the individual saver. If the investment is successful, more funds are available at retirement; if it isn't, there's less to count on.For the baffled individual trying to plan for retirement income, private defined-benefit pension plans are very attractive, assuming the company that sponsors the plan remains solvent and the plan is adequately funded. (A defined-benefit plan is one that provides a set pension amount at the time of retirement usually based on both years of service and level of income. The costs to the individual and employer are based on those factors as well.)

There is also enormous cost savings and economic efficiency in very large defined-benefit pension plans such as the Canada Pension Plan when they are adequately funded.

The large pension plan knows how long we'll live because it deals in large numbers of people and uses averages for life expectancy. Thus, large defined-benefit plans can estimate fairly precisely the amount of savings one needs for the lifespan of the average pensioner in their plan. The large defined-benefit plan can also take a long-term view of interest rates and market returns, a perspective not often available to the individual investor. This again increases the economic efficiency of such plans as the CPP.

Three obvious public policy conclusions flow from this analysis:

Substantially increase the size of the CPP so it provides for a much larger proportion of income replacement on the retirement of Canadians. Many studies have recommended this idea. An increase in CPP contributions and coverage could be done over several years in a way that ensures the CPP remains fully funded.

Develop a system whereby companies and their employees can buy additional defined-benefit pension coverage from the CPP. These supplementary pensions would need to be fully funded and would be fully portable (as they are held in the CPP). An add-on plan to the CPP would provide companies and individuals with the economic efficiencies and the substantial cost savings that only a large plan can generate.Develop a strategy to get companies that have lost the incentive to provide defined-benefit plans back into the business of offering them. This will not be easy. Companies have moved away from such plans because of complex pension laws designed to protect workers, and their experience that such plans are costly and difficult to manage. In addition, employees are wary of such plans when they see large companies fail to fully fund their plans or go bankrupt with their pension plans underfunded.

A policy of both increasing the CPP and allowing companies and individuals to buy supplementary pensions from the CPP is one acceptable policy move. Another is a much closer monitoring of pension plans by regulators. A positive move in this direction would be the establishment of the proposed national pension guarantee system.Another feature of such a system would be to require underfunded pension plans to pay higher premiums for coverage. In other words, any company that requests relief from its required funding - that is, additional time to make up a pension deficiency - should pay an additional premium for such forbearance."

Doug Peters is former chief economist of the Toronto-Dominion Bank. Arthur Donner is a Toronto-based economic consultant.

The Debt Snowball Method

I have seen this work very effectively in several instances where I have done credit counselling for people.

From Wikipedia, the free encyclopedia

The debt-snowball method is a debt reduction strategy, whereby one who owes on more than one account pays off the accounts with the smaller balances first, proceeding to the larger ones later.

Overview
The debt-snowball method of debt repayment is a form of debt management that is most often applied to repaying revolving credit — such as credit cards. Under the method, extra cash is dedicated to paying debts with the smallest amount owed.

This method has gained more recognition recently due to the fact that it is the primary debt-reduction method taught by many financial and wealth experts. However, it has always existed, as people have a tendency to want to take care of smaller, easier-to-take-care-of things first.

Methodology
The basic steps in the debt snowball method are as follows:

List all debts in ascending order from smallest balance to largest.

This is the method's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.

Commit to pay the minimum payment on every debt.

Determine how much extra can be applied towards the smallest debt.

Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.
Note that some lenders will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction.

Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.

Repeat until all debts are paid in full.

In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).

The theory works as much on human psychology as it does on financial principles; by paying the smaller debts first, the individual, couple, or family sees fewer bills as more individual debts are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.

A first home mortgage is not generally included in the debt snowball, but is instead paid off as part of one's larger financial plan. As an example, many financial plans pay off home mortgages in a later step, along with any other debt which is equal to or greater than half of one's annual take-home pay.

The issue of whether one should make retirement contributions during the debt reduction process is a matter of dispute among proponents of this method:

Some argue that all contributions are to be halted during the debt snowball, thus freeing up more money to pay down the debt snowball.

Others dispute this practice, citing the cost of compounding interest to be greater than the gains of paying off debt.

Some compromise by arguing that retirement contributions should be reduced to only the minimum amount that the employer will match with an employee, but not eliminated completely.

Many financial and wealth experts teach that this halting of retirement contributions should last no more than two years.

Simple Example
An example of the debt-snowball method in action is shown below.
A person has the following amounts of debt and additional funds available to pay debt (the debt is listed with the smallest balance first, as recommended by the method):
Credit Card A - $250 balance - $25/month minimum
Credit Card B - $500 balance - $26/month minimum
Car Payment - $2500 balance - $150/month minimum
Loan - $5000 balance - $200/month minimum

The person has an additional $100/month which can be devoted to repayment of debt.
Under the debt-snowball method, payments for the first two months would be made to debtors as follows:
Credit Card A - $125 ($25/month minimum + $100 additional available)
Credit Card B - $26/month minimum
Car Payment - $150/month minimum
Loan - $200/month minimum

After two months (presuming the person has not added to the balances, which would defeat the purpose of debt reduction), Credit Card A would be paid in full, and the remaining balances as follows:
Credit Card B - $448
Car Payment - $2200
Loan - $4600

The person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next three months as follows:
Credit Card B - $151 ($26/month minimum + $125 additional available)
Car Payment - $150/month minimum
Loan - $200/month minimum

After three months Credit Card B would be paid in full (the final payment would be $146), and the remaining balances would be as follows:
Car Payment - $1750
Loan - $4000

The person would then take the $151 previously used to pay off Credit Card B and apply it as additional payment to the car loan balance, which would make payments as follows:
Car Payment - $301 ($150/month minimum + $151 additional available)
Loan - $200/month minimum

It would take six months to pay the car loan (the final payment being $245), whereupon the person would then make payments of $501/month toward the loan (which would have a $2800 balance) for six months (with the last payment at $295).

Thus in 15 months the person has repaid four loans, with two of them being paid in a mere five months and three within one year.

Benefits
The primary benefit of the smallest-balance plan is the psychological benefit of seeing results sooner. A secondary benefit of the smallest-balance plan is the reduction of total amount owed to lenders in a single month. This is a risk reduction in the event of a lost job or emergency.

Criticism
People with more financial discipline can get ahead quicker by paying off the credit cards and loans with the higher interest rates first. This will minimize costs to become debt-free faster than the smallest-balance approach. Dave Ramsey, a proponent of the debt-snowball method, concedes that "the math" leans toward paying the highest interest debt first; however, based on his experience, Ramsey states that personal finance is "20 percent head knowledge and 80 percent behavior" and that people trying to reduce debt need "quick wins" in order to remain motivated toward debt reduction.

The Debt-Snowball method is only for those on high enough incomes to be able to meet all the minimum repayment requirements on their debts. This method could instead lead to problems for those who are struggling to meet these minimum payments demands. In this circumstance, an individual should not be advised to pay creditors differing amounts as this could count as non-equitable repayment, leading to problems (e.g. with going bankrupt, or with maintaining non-equitable repayments over longer periods).

Debt, debt, and more debt . . . .

From the Financial Post.

VICTORIA - Many Canadian households carry debt loads in the "danger zone," says the executive director of the Ottawa-based Vanier Institute of the Family.

Average household debt rose to more than $90,000 in 2008, Clarence Lochhead told a recent meeting of Victoria's Association of Family Serving Agencies. The Vanier Institute is a non-profit agency promoting the well-being of Canadian families.

The total debt-to-disposable income ratio rose to 140% last year, Mr. Lochhead said, referring to the Institute's report, The Current State of Canadian Family Finances.

Last year, the average household income was $65,200, up by 11.6% from 1990. In that same period, spending jumped by 24.4%, total debt went up more than six times faster than incomes, and annual savings shrank, he said.

The median (mid-point) real earnings of Canadians, when adjusted for inflation, show little increases between 1980 and 2005, he said. Meanwhile, many citizens are overloaded at work.
The reward: "We got credit. We got a lot of credit," he said in reference to interest rates dropping in the past several years.

"But there was a whole, I think, really big cultural shift too in the way we think about spending, the way we feel about money, the way we feel about availability of credit - the push to spend when you don't have money," he said.

When spending outpaces income, families end up close to the edge of their monthly budget. Mr. Lochhead said it can be financially painful if they hit a bump in the road, whether it is due to the fallout from today's recession or a personal reason.

It is not irrational behaviour to pull back on spending, Mr. Lochhead added. He said that not all debt is bad, but rising consumer debt as a percentage of annual income is "problematic."
Looking at the examples from past recessions, Mr. Lochhead said it could take a long time to recover from this recession.

He also had advice for governments that plan stimulus spending, "At the provincial level, why don't we do something about social assistance rates?" That money goes immediately back into the local economy, he said.

"Any analysis of spending at the lower income end will show you that every marginal dollar received will be spent and there is a very high probability that it will be spent locally."

When we are talking about infrastructure, Mr. Lochhead urged looking at more than roads and bridges. "Let's talk about providing supports that are going to help families."

2009 Family Budget

It was time for annual family meeting to discuss the budget for the upcoming year.  Click on the chart above to enlarge.  Every year since we've been married, my lovely wife and I discuss our annual goals and limits on our spending for a few hours on New Years Day.  This is the result of this year's meeting.

Some notable changes for this year is the aggressive mortgage paydown strategy.  We currently have a fixed rate mortgage for the next 4.5 years with fairly liberal repayment terms and our goal is to have the mortgage paid down to a level that could see us having it paid completely off through the following five year term.  In fact, if my pay rises and no unforeseen events occur, we could easily pay of the mortgage over a total of 6 years thus allowing us the freedom to use the cash flow for other purposes.  This is extremely ambitious and probably unrealistic but it is something we have set our sights on.

We are attempting to strike a balance between an ambitious RRSP contribution strategy and our aggressive mortgage paydown plan.  We also have allowed for some large one time purchases like a new television and some new furniture.  

Regarding our balance sheet, we expect that the value of our investments will not rise this year and we have planned that the value of our home will fall by 10% or more this year.  We bought it at 20% off peak pricing and I expect it will fall another 10% or more during 2010.  We have an extremely long time horizon (20+ years) for our investments so I am not concerned about the short term value of my retirement savings.

We have also increased our allotment to 'life and health insurance' and 'food and consumables' to account for our increased needs this year with an additional child coming.

Any comments?