Creating a financial plan

A financial plan is a document that "assesses an individual’s current financial situation and includes the relevant personal and financial assumptions, information analysis, evaluation of financial strategies and recommendations to assist in achieving an individual’s personal goals, needs and priorities".

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). For example, being ready for financial emergencies, buying a house, retiring early, ensuring that children get an excellent education, and so on. Ideally, goals should be attainable within a reasonable time, so large goals can be broken into smaller steps. In the presence of several competing goals, ranking them can help.

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. Financial planning tends to proceed in three stages:

(a) Gathering information

- Including net worth (assets and liabilities); list of income and expenditures; perhaps a budget

(b) Analysis

-Assessing the individual's situation and evaluating strategies

(c) Recommendations on the following areas:

1. financial management
2. investment planning
3. insurance and risk management
4. retirement planning
5. tax planning
6. estate planning and legal aspects

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. Ideally, the plan "provides a list of action steps, including what needs to be done, by whom and when".

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, I Need A Plan?

The following article has evolved from a series of Financial Wisdom Forum posts.

Doing it yourself, or not

DIY encouragement

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. 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.

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 -- including the links to other relevant articles -- is perhaps 80-100% of what the average person needs to know about personal finance.

Financial advisors

Main articles: Financial advisor and Types of financial advice

If you don't want to DIY or don't have the time, then consider paying for someone (a financial advisor) to look after it for you. 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: 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 flavor of the month mutual fund.

In the context of this article, advisors recognized as financial planners by a major credentialing body are generally able to provide advice on all aspects of financial planning. Some financial planners charge by the hour, or offer financial plans for a fixed total cost (fee-only or "fee-for-service" planners). Fee-only planners should probably not be selling you financial products, both because they may not be licensed to do so and more importantly, because this is not what you've hired them for.

Fee-only planners can be difficult to find; you can also get financial planning services from advisors and planners working on a commission-based model, or a percentage of assets model (a.k.a. "fee-based"). However, this brings on potential conflicts of interest, especially with the commission model.

If you're paying a fat fee, get some real financial planning for it; you might not get that from 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 a significant portion of your wealth over time. They might also have misguided beliefs, for example about actively managed mutual funds or the importance of fees. The financial advisor article has sections on standards of care, compensation models, credentials and designations, and finding an advisor.

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 (and start saving early).
• Don't put all your eggs in one basket.
• Watch the pennies and the dollars will look after themselves.

The basics

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 (see living below your means)
• Not paying off your credit cards in full every month
• Not opening mail (or viewing online statements) 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 (See Insurance, below)
• 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 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)

Avoid common behavioural pitfalls

Main article: Behavioural pitfalls

If you want to see the greatest threat to your financial future, go home and take a look in the mirror.

— Jonathan Clements, Wall Street Journal

If you let your emotions control your investing decisions, your investing plans will quickly go off-track. As an example, if you select an asset allocation without taking into account your emotional capacity for risk, you’re unlikely to stay the course in a down market or market crash.

Poor decisions are not always caused by emotion or stress, other types of behavior can affect decision making as well. It is essential that investors recognize the behavioural pitfalls before committing to decisions which can affect portfolio or investment goals.

Financial management

Main article: Financial management

Financial management, in the context of a personal finance, is about managing household money, mostly on a relatively short term basis.

Income versus expenses

Main article: Living below your means

If your expenses are greater than your net income, you are either burning up existing savings or getting into debt. So you might need a budget to reverse the trend. There is a positive correlation between budgeting and perceived financial wellbeing.

Eliminate non-deductible or high-interest debt

Main article: Managing 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; no guaranteed investment will ever return the 18-20% interest rates charged by many credit cards.

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. See paying down loans versus investing for more discussion.

In Canada, most interest charges (except those for borrowing to invest) are not tax deductible, so should be addressed first.

Emergency fund

Main article: Emergency fund

Before establishing an investment portfolio, you should set up a "rainy day" fund with three to six months expenses (or more) for emergencies. An emergency fund can increase your peace of mind and feeling of control.

An emergency fund is aptly named because its purpose is to provide a source of cash when the unexpected happens. Without it, you may either have to go into debt, or sell longer term investments, perhaps at an inopportune time.

The general recommendation is to have your emergency fund in cash (e.g., high-interest savings account).

Insurance

Main article: Insurance

The guiding principle for insurance is to use it only when a loss would be financially intolerable, and the probability of loss is low. When those conditions are met, you can pool the risk with thousands of other people, and cover the risk for a reasonable premium.

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 home 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
• 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)

The insurance industry is well aware that marketing based on emotions sells better than that based on rationality. 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: buy the insurance you actually need.

Rates for insurance can be obtained online, see insurance quotes.

Educational expenses

Main article: Financing an education

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, which comes with government grants. See also the Lifelong Learning Plan.

Taxes

Main article: Tax planning

Tax planning is about organizing your affairs to minimize (or reduce) your tax burden. The average person will be well served by knowing and taking advantage of some simple and common tax saving opportunities. Strategies include:

• Claim all available deductions
• Defer taxes
• Income splitting with a spouse

Retirement

Main article: Retirement planning

Retirement is one of the major events in many people's lives, involving not only a change in lifestyle (see retirement living) but in many cases a reduction in income or change in sources of income.

Canada's retirement income system has three main tiers or "pillars". Tier 1 consists of government benefits, namely old age security and the guaranteed income supplement for low-income seniors. Tier 2 is composed of mandatory public pension plans, i.e. the Canada Pension Plan or the Québec Pension Plan. Tier 3 consists of mandatory to voluntary savings schemes such as workplace pension plans, registered retirement savings plans (RRSPs), and other accounts (see tax deferred and tax free savings plans) which can be used for retirement savings, including the Tax-Free Savings Account (TFSA).

A major component of retirement planning for most Canadians is saving money regularly when they are working (the third tier). The importance of saving early shows how compounding returns will help you to reach your savings goal. The article Savings rate is about determining "optimal" savings rates during the accumulation phase that aim to maintain the standard of living of the retiree.

There are two main schools of thought when it comes to retirement planning: conventional retirement planning and safety-first retirement planning.

After retirement, RRSPs are eventually converted to a Registered Retirement Income Fund (RRIF) and/or annuities.

Investing

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. But in truth, investing can be a fundamentally simple process. You can do it yourself by following these simple guidelines:

• Most news is noise. A major 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: risk and return are linked. You can do better than just buying Guaranteed Investment Certificates (GICs) at your bank. 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) and determine your asset allocation. Very conservative investors should probably have 25% of their portfolios in equities and 75% in fixed income like GICs or bonds (or preferred shares). Very aggressive investors should have 75-80% in equities and the rest (25-20%) in fixed income. If you're in the middle, a 50-50 or 60-40 mix is quite reasonable (a 'balanced' profile). Or you can use a few of the many online questionnaires to help you determine whether you are a conservative, balanced or 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.

Implementation

Main article: Portfolio design and construction

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.

For investors in accumulation mode, there are now all-in-one, automatically rebalanced, extremely diversified exchange-traded funds called asset allocation ETFs that are very popular on the Financial Wisdom Forum. These combine all the main asset classes, including Canadian investment-grade nominal bonds, Canadian equities, and foreign equities (such as US equities, International equities and emerging market equities) in a single fund that you buy or sell using a discount brokerage account. Slightly lower costs can be achieved by using 3 to 5 index ETFs or index mutual funds to create simple index portfolios, but those require rebalancing.

Some investors may choose to invest directly in stocks and bonds for all or part of their portfolio. For fixed income, a popular strategy is called laddering. Such direct investments must be carefully monitored and are not for everybody, especially on the equity side. 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 article.

Watching your pennies

Main article: Low cost investing

Many of the investment products commonly used by Canadians - most actively managed mutual funds, retail 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. Be wary of marketing and avoid high-fee products as much as possible. If you pay 2% more in fees than what is achievable with, for example, asset allocation ETFs, and pay those fees for 35 years, the average working life, then a significant fraction of your retirement savings will end up in other people's pockets. That's hard to believe but you can check for yourself using the Ontario Securities Commission's 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.

Estate planning

Main article: Estate planning

Estate planning is the process of anticipating and arranging for the disposal of an estate during a person's life. Estate planning typically attempts to eliminate uncertainties over the administration of a probate and maximize the value of the estate by reducing taxes and other expenses.

Typical elements of an estate plan are: last will and testament; power of attorney for finance; and living will (power of attorney for personal care). High net worth individuals and blended families may find trusts a useful estate planning tool.

Further reading

See also: Recommended reading and Recommended podcasts

Books

Financial planning

• The Wealthy Barber, David Chilton. ISBN 978-0761513117
• Your Money or Your Life, Joe Dominguez and Vicki Robin. ISBN 978-0143115762

Investing

• 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 978-0071813655

Insurance

• 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.

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. Yet in Canada, Rob Carrick is worth reading in the Globe and Mail, and so is Nicolas Bérubé in La Presse. In the U.S., consistently good information comes from Jason Zweig (Wall Street Journal).

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.

See also

• Getting started

External links

• Financial Wisdom Forum
• Selected Books of Interest to Independent Investors