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Many people are surprised when they are told that they can have the same standard of living in retirement as their working years with only 50% of their working years income.

Thankfully, actuaries have researched the spending habits of working age and retired Canadians. I’d like to provide you some evidence of their 50% rule conclusions to help convince you of its accuracy.

First, we will look at the assumptions (taken from Fred Vettese’s The Real Retirement) made when coming up with the 50% rule.
Assumption#1: Married couple with 2 children who own their own home.
Assumption#2: Mortgage costs are averaged over a 30 year period. Child raising costs are averaged over 35 years.
Assumption#3: Income tax, Canada Pension Plan contributions and Employment Insurance contributions are 23% of gross income.

Let’s look at the family making $110,000 per year.

Gross Pay:                  $110,000
Taxes, CPP, EI:              25,000
Child raising costs:       13,000
Mortgage:                      20,000
Savings (6%)                    6,600

Remaining                    $45,400 or 41% of Gross Pay

What does this mean? Only 41% of your gross pay is available to you for regular consumption when you are paying off your mortgage, raising your children and saving for retirement. 59% of your income goes to fixed costs that will eventually disappear. If you managed to live for 35 years with only 41% of your gross income, think how wonderful you’ll feel living on 50% of your income in retirement!

 

In this blog, I tell my readers that the Vanguard low cost index funds VCN, VXC and VAB are highly recommended by our investing all-stars. I personally own both VCN and VXC. However, I have recently stopped buying both and have replaced them with a relatively new product that I’d like to tell you about. It’s also important for me to explain why I made the switch and why this change made sense for me but may not for you.

Because I am a teacher, I am obligated to contribute 12.5% of my pay to my pension. My employer also contributes to my pension to the point that I am not able to set up a meaningful RRSP. As a result, almost all investing I do is done in taxable accounts, except for the $5500 TFSA. That means that any dividends or capital gains I earn are fully taxed using the rates prescribed by government. In my case, dividends are taxed at 25% and capital gains at 21%.

Instead of paying these taxes every year, I found a product that works like a low cost index fund but is able to shelter my dividends and capital gains from taxes until I sell the product. This has the advantage of allowing my investments to compound tax free while I am still in the accumulation phase. This does not avoid paying tax, it just delays paying until a later date.

The product is called Horizons S&P 500 (HXS). It’s a specialized product utilizing a type of derivative so that I don’t actually own the S&P 500, but rather a product that almost exactly mirrors the performance of the S&P 500. Canadian Couch Potato does a fabulous job of explaining the product and the risks involved with HXS.

This product does have slightly more risk than a conventional index fund but I am comfortable with the small risk because I believe that the chances of a large Canadian bank, that guarantees the product, going bust is exceedingly small. I also am limiting my exposure to HXS to about 15% of my total portfolio so if in the highly unlikely scenario that the National Bank of Canada went broke and the S&P 500 was no longer trading freely, I would lose no more than 15% of my portfolio. If this scenario came to pass, I think the least of my worries would be my investment portfolio; what Warren Buffett called CNBC has probably happened (cyber attack, nuclear, biological or chemical disaster).

It many be true that Albert Einstein said that compounding is the most powerful force in the universe. The beauty of HXS is it keeps all my money compounding for as long as I hold it. This temporary tax sheltering strategy can have a reasonably significant effect on returns in the years and decades to come.

http://canadiancouchpotato.com/2013/10/15/more-swap-based-etfs-on-the-horizon/

Investing doesn’t have to be complicated.  It shouldn’t be complicated but bankers and financial planners want to complicate things so you need to go to them for advice. Here’s the newest thing I’ve heard of with respect to simplifying investing, something I’m trying to do with my blog.

The index card you see above came from a University of Chicago professor who was being interviewed on how the financial industry tries to overly complicate investing.  The index card was his brilliant response.

To translate for a Canadian audience:

Accept any employer matching contributions to your RRSP
Invest in low cost index funds
Save 20% of your income
Pay off all credit cards in full every month
Maximize your government assisted saving programs (RRSP and TFSA)
My only issue is the 20% savings rate.  This is very high and will mean you will have more income in retirement than you had while working and raising your family.  Our Canadian experts recommend a savings rate of between 6 and 10%  to achieve to same standard of living in retirement that you had while working.

If you are planning on retiring before age 65, then increasing your savings rate makes sense.   Your spouse and kids may not support you here, but that’s a decision that is up to you and your family.

One disagreement aside, this index card advice really does do a great job of visually showing that you can do it alone.  Take a few moments to consider how doable it is to become a DIY investor and how much money you will save over your working life.

I hope you will find it in you to go this route.  Happy DIYing!!

To see a clearer version of the index card:

https://www.washingtonpost.com/news/wonk/wp/2013/09/16/this-4×6-index-card-has-all-the-financial-advice-youll-ever-need/

If you listen to mutual fund sales people and most of the mainstream media, you will often hear that people need to replace 70% of their income when they retire. We’ve already discussed why that number is not accurate. The point of this post is to show you exactly why saving to make up 70% of your working income is not necessary.

Let’s consider the following example.

For a family making $110,000 per year. If they want to live on the same amount of money as when they were working , they will need to save 6% of their income from ages 30 to 65. That would work out to retirement income at 50% of their working income.

If, instead they strive for 70% of their income, they would need to increase their savings from 6% of annual income to 12%, or $13,000 per year. That would mean a significant reduction in spending in their working years (roughly $7800 a year for 35 years).

So during their working and child raising years, they would have only $40,200 a year to spend, after taxes, mortgage, childcare costs instead of $47,000.

When they retire, they would have $65,000 per year to spend, after paying 15% in taxes. That represents 62% more money per year available to them for spending after retirement.

But at what cost? For 35 years, they scrimped and saved, probably not spending on meaningful experiences so they could spend more in retirement. Does this make sense to anyone? Does someone really need to boost spending by 62% at retirement. I know retirees like to travel more, but you can end up saving too much and perhaps missing out on the pleasures that money can sometimes buy.

 

Below you will find a blog post I wrote in June 2014 questioning the “expert” prediction of a well known and respected Canadian economist. His book sold incredibly well and I’m certain many people believed his predictions about oil prices heading for the stars and loaded up on oil stocks and oil company debt. A year and a half later, oil crashed and many oil stocks are down 75% from their highs. Do you need any more proof not to listen to people who are trying to sell you something?

Please enjoy the post.

The End of Suburbs? Who knows and why do we listen to “experts”? June 24, 2014

Jeff Rubin was the chief economist at CIBC until a few years ago. Recently, he’s been writing books about how oil will only become more and more expensive in the future and how that will change life in North America. Some things he predicts are an increase in public transportation, increased urbanization, the return of far flung suburbs to farmland, and fewer private automobiles as only the well off will be able to own their own car.

He has every right to express and profit from his opinion. We should be very skeptical of his conclusions because he is trying to predict the future and everything I’ve ever read about doing this concludes it is nearly impossible to predict the future. This is especially true when you are making very specific predictions like the price of oil, or what will happens to suburbs.

Specifically on suburbs, the conventional wisdom is suburbs are bad and are doomed to extinction in the near future. Search suburbs on Amazon and you’ll notice lots of negative books on suburbia. The reality is suburbs have existed since at least the Roman Empire and nothing lasts that long unless it serves a useful purpose and is able to adapt. I don’t what will happen to the suburbs but I’m pretty sure no one else knows either. If history is any guide, and it usually is, then the suburbs will adapt to meet any new realities.

One reality check: in an interview I read with Jeff Rubin, he mentioned that he didn’t think anyone would make the trip from Newmarket (the furthest northern tip of the Greater Toronto area) to downtown Toronto for work when gas gets more expensive. As a result, Newmarket may revert back to farmland. I did a quick calculation using fueleconomy.gov to see what it would cost to drive a Prius C from Newmarket to Toronto and back home again for 250 days (1 work year) if the price of gas were to double to $2.60/litre (about $10/gallon). Yearly cost would be $3200 which is expensive but still manageable. In 5 years, gas mileage will be even better; perhaps much much better. So maybe the SUV will go, but I’m not sure anything will happen to Newmarket.

Yesterday, my neighbour’s son was over for a visit. He’s a twenty something living in Newmarket, ON and working in construction. He is doing quite well for himself and was recently chosen to be trained as a foreman. We started talking about how frustrated he was with the price of real estate in the Toronto area and how we was considering moving to Manitoba where the single family home that everyone wants was still affordable for a typical Canadian worker.

We also talked about how expensive things are in general from university tuition to food to cars and the difficulty young people have in finding traditional full time jobs.

His main argument was that Millennials were facing an unprecedented financial crunch on multiple fronts and this had never happened before in Canada. While I understand his frustration, I don’t think his view is entirely accurate.

I’m in my early 50’s and I’ve been paying attention to these sorts of issues for about 30 years. I’ve now been a part of 2 real estate booms and 1 crash. I paid university tuition in the late 80’s/early 90’s and have been buying household necessities and cars since then. I also was trying to find my first full time job in the early 90’s during an economic recession.

Looking back over these 30 years, I’ve gained some insight that puts the current conditions that millennials face into perspective. Let’s look at the typical big life decisions and expenses today compared to when I was in my early 20’s and facing the same situation as my young neighbour.

Real Estate

My parents moved to Markham Ontario in 1990. The house they bought was built in 1988, right at the tail end of the last great real estate boom in Southern Ontario. The builder (Great Gulf Homes) sold the house for $650,000 to its first owner (not my parents).

When you remove inflation, do you know how much this house has appreciated in value over the past 28 years? 14% or 0.5% per year (as a comparison, the S&P 500 total return, adjusted for inflation, was 628% or 7.32% per year in the same time period).

This house is almost as expensive today (it’s worth about $1.5 million) as it was in 1998. When you consider that mortgage rates today are about half what they were in 1998, your monthly (inflation adjusted) mortgage payment today would be less than it was in 1998.

So yes, housing is expensive but the baby boomers in the late 80`s faced the exact same issue as today. By the way, this house could have been purchased for under $400,000 in the late 90`s after the bubble burst, 39% less than its original selling price!

Cars

My brother’s first car was a 1992 Dodge Shadow. It came with automatic transmission and air conditioning and that’s about it. He paid $9,995 plus tax for this car in the early 90’s. At the time there was nothing cheaper on the market. If we factor in inflation, this same car would sell for $18,000 plus tax today.

So how does this compare with today? A similar sized car would be the Hyundai Accent, but that is where the similarities would end. The Accent today sells for about $15,000 but is much more comfortable, reliable, safe and feature rich. All this and $3,000 cheaper.

University Tuition

In my final year of university my tuition cost $1650. Factoring for inflation, similar tuition today would be $3500 today. Tuition is a lot more than $3500 (closer to $8000/year) so Millennials definitely have it tougher here. However, this doesn’t take into account the 30% discount available for lower income families in Ontario or the new program that begins in Ontario in 2017. Under this program, families with an income of less than $50,000 will pay no tuition.

Employment

This one is a bit tougher to compare. 24 years ago you probably didn’t need to be so well educated to find a good job. Manufacturing was a bigger part of the employment picture vs. today. However, I recently watched a program on TV  where the host traveled to Guelph Ontario to meet with community and business leaders. One main takeaway from the program was manufacturing jobs starting at $17/hour and free training were waiting for young people who were willing to work and learn.

Thinking back to the early 90’s, I have several friends who started off in temporary jobs that eventually turned into full time work. Canada was in the middle of a pretty brutal recession with unemployment rates reaching over 12%, which is a full 6% higher than today.

Many of us had the same worries as Millennials have today. Our parents were able to find good jobs without having to spend years in university or college. We weren’t sure if our degrees in psychology or political science would help us or leave us with debt and low paying jobs. There were concerns about Canada breaking up and the destruction of the world’s oceans and rain forests.

Despite these similarities, I will be willing to accept that things may be tougher for the “poorly educated” today, but that is about as far as I’d be willing to concede. Finding full time work has always been a challenge for young workers but I’m not sure it’s tougher now for well educated Millennials.

Cost of Food

This one is a no brainer. The cost of food as a percentage of disposable income has been declining since the 1960s. According to NPR, the total cost of food in 1992 was 12.5% of income. Today, it is below 10%. In 1960, people spent 18% of their income on food.

Others

Computer technology is cheaper today. Same for car rentals, air travel, clothes, music and many other consumer goods. Other items like entertainment, health care (orthodontic care, eye glasses), home renovations may have increased in price in the past half century but many of these items are near luxury wants not needs.

It is because we have more disposable income and greater expectations that we are able to buy more of these high priced services that would have been unaffordable to many a generation ago. It is only our expectations of what we should be able to buy that have changed since I was a 20 year old.

Conclusion

Perhaps it is every young generation’s right to feel worried that they will not be able to have the same quality of life as their parents. If history is any guide, Millennials should eventually overcome this worry and fit in well to our consumer driven society. Perhaps things will be different this time, but those are pretty dangerous words to believe.

One last point: I heard Warren Buffett say he’d rather be a young man walking the streets of Paris with a few Euros in his pocket than an 80+ year old with a few billion dollars in the bank.

One of the best books I’ve read on passive or index investing is The Elements of Investing by Burton Malkiel and Charles Ellis. The book is full of proof that buying mutual funds is a losers game for us, the investors.

One point they discuss that is not widely considered is the significant capital gains taxes that mutual fund investors are responsible for. Mutual fund managers are very active in buying and selling stocks in their fruitless attempt to beat the market.

Every time they sell a stock for a gain, you the investor have to pay tax on that gain. Many mutual funds turn over their stocks 100% in any year; that means the stocks they hold at the beginning of the year are completing different from the ones they hold at the end of the year.

Compare this to index funds which own the whole market. Unless a company declares bankruptcy or is bought by another company, the turnover is very low. This tax efficiency becomes a major advantage of whole market index funds. Mutual funds can create large tax liabilities if you hold them outside your tax-advantaged retirement plans (that’s a fancy word for outside your RRSP or TFSA accounts).

To overcome the drag of high fees and taxes, a mutual fund would have to outperform the market by 4.3 percentage points per year just to break even with whole market index funds.

The odds that you can find an actively managed mutual fund that will perform that much better than an index fund are virtually zero.

The financial industry likes to scare people into saving more money than necessary. The pitch goes something like this: If you don’t save 15% of your working income, you may run out of money before you have the good sense to die. They do this because every dollar you save, they shave off 2 or 3 percent for themselves. It’s not wrong to encourage people to save more, but as we’ve talked about on this blog it means you will have to make real sacrifices when you are younger and raising a family.

There are ways to reduce people’s fear of running out of money and still not over save for retirement. You probably won’t hear any of these recommendations from banks and mutual fund salespeople.

1. Buy your home and have the mortgage fully paid off before you retire. In a pinch, the equity in the home can be converted to income.

2. Keep your investing costs low. Instead of purchasing high cost mutual funds that rarely beat the market, purchase low cost index funds instead. The cost differential is huge and can mean tens and possibly hundreds of thousands of dollars more for you when you retire.

3. Keep your employment skills sharp. If you stay valuable to your employer, you significantly reduce the risk of being forced out of a job before age 65.

4. Start collecting your Canada Pension Plan later in life. 65 years old is the standard age when most start collecting CPP. Each year you delay CPP, your payment increases 8.4%. So if you wait until age 70 to collect, your monthly payment will be 42% higher. Remember CPP is guaranteed for life and fully indexed for inflation.

5. Start collection Old Age Security later. Instead of starting to collect at age 65, wait until age 70 and your monthly payment increases by 21.6%.  The incentive to start OAS is not as good as CPP so it should only be considered for the very concerned (paranoid?) amongst us.

6. Consider part time work or small business after age 65. Many people find full time retirement less fulfilling than expected. You could find part time work in a field that you find interesting. Even earning $11 or $12 an hour part time can add up to $12,000/year.

Short answer. YES!

Here’s the math. According to Morningstar, a financial website that knows everything about mutual funds and index funds, the average mutual fund in Canada has a Management Expense Ratio of 2.5%. That means for every dollar you have invested with this fund, they take 2.5% away each and every year.

So if you give them $1000 in 2016, and the fund doesn’t make any money during the year, you lose the 2.5% or $25 and end up with $975. In 2017, if they make a 5% return, you get to keep 2.5% and they keep the other half.

Half of your profit is gone. Many market watchers expect future returns to be in the 5-7% range per year. If that’s the case, do you really want to give away almost half your profit each and every year?

Now if the mutual fund can do much better than the expected 5-7% and beat the market by a lot every year, then it’s a good deal to pay them 2.5%. Problem is, it’s really really hard for the mutual fund people to beat the market by enough so that you are better off compared to buying a low cost index fund offered by a company like Vanguard.

In fact, around 75% of mutual funds don’t beat the market and of the other 25% that do, it’s next to impossible to predict if they will be there 5 years from now. Chances are they’ll start to under perform the market, right after you gave them your money.

So you have a choice, gamble on finding that fund that consistently beats the overall market and pray you don’t pick wrong, or buy the low cost index fund that clobbers the odds and lowers your risk.

For example, Vanguard’s VCN – Canada All Cap Index fund owns the 231 largest public companies in Canada. That includes banks, insurance companies, cable and telephone companies, grocery stores, tech companies, oil and mining companies, health care companies and so. You are buying the best and brightest that Canada has to offer.

And how much does it cost to buy Canada? Would you believe .05% or 50 times less than the average mutual fund! No wonder Vanguard’s fund beats the vast majority of mutual funds.

So how do we get to the $250,000 figure? Here are the assumptions. Your family income is $90,000 year and you set aside 10% or $9000/year for retirement for 40 years.

You invest in low cost index funds like Vanguard’s VCN and you beat the high fee mutual funds by 1.6% per year, which according to The Economist magazine, is the amount that mutual funds have lagged the market in the USA over the past 20 years.

If you take the yearly $9000 contribution and suck out the 1.6% average loss you can expect by buying the average performing mutual fund, you end up with $250,157 less vs. buying the low cost index fund.

For folks with a family income of $150,000 who save 10% a year for retirement, the savings is close to $400,000!

There’s a reason why many call buying mutual funds a loser’s game. You lose and the mutual fund companies laugh all the way to the bank.

Lots of people dream of being able to retire before age 65. Not only can working be stressful, it may not be that much fun. It definitely can’t compare with your vacation time, which for many people, if how they imagine retirement will be.

If you are convinced that early retirement is for you then you will need to save more money while you are working to make sure you have enough money for the rest of your life. Not only will you have less time to save money, you’ll also spend a longer time depleting your savings.

In The Real Retirement by Fred Vetesse and Bill Morneau (Fred is an actuary and Bill is now the Minister of Finance for the Government of Canada), the authors spelled out the extra costs of retiring early. Their conclusion is: It’s quite expensive to leave the work force before age 65. Here’s why:

You will receive a smaller Canada Pension Plan payment because you don’t have as many qualifying years. Remember C.P.P. is guaranteed for life and indexed for inflation so this will affect your retirement income for the rest of your life.

You will need to significantly increase your savings rate while you are working and raising your family to pay for your decision to retire before age 65. Remember according to our experts, you need to save 6-10% of your family income for 40 years to have as much money in retirement as during your working years (minus fixed costs like mortgages and child rearing expenses).

So how much extra will you need to save for those 40 years? Vetesse and Morneau concluded you would need to increase your savings rate by 3% for every year you want to retire early. See the chart below for some examples.

If you want to retire at age:                          Your yearly savings rate will be:
65                                                                        10%
62                                                                        19% (10% + 3 years x 3%)
60                                                                        25% (10% + 5 years x 3%)

Remember, this calculation is to balance the amount of money you have to spend while retired with the amount of money you have to spend while working. So if you want out by age 60, plan to save 25% of your family income for 35 years.

People who plan to retire by age 50 or earlier really have to dramatically increase their savings during their working years. On some “Retire at 40” sites I’ve visited, people are saving 50 or 60% of their incomes in order to get out at a young age. Many of these folks don’t have children or have 1 child. I’ve already mentioned, let’s hope not everyone follows their life plans, or we won’t have much of a country in 50 or 60 years.