Importance of Personal Money Management

Managing your personal finances is likely the most important determinant of whether or not you become wealthy. It's certainly more important than some factors that many Canadians focus on: great investing skills, having a high income, or buying a house as fast as possible to start "building equity".

It might be a symptom of our immediate satisfaction culture, or it might be bad guidance and examples shown by adults from the time we are very young. But the millions of Canadians who bumble along from paycheque to paycheque scraping together a few nickels and dimes here and there for extra expenses are largely victims of their own bad decisions.

We're different here on TRM, so lets state the obvious of why control of spending is extremely important and give you some tips on how to manage your spending while still having fun and dealing with those larger expenses like vacations or home maintenance.

Saving Money is the Foundation

To become wealthy, you must save money. That's really all there is to it; it is the foundation on which everything else is built. It is completely impossible to build your net worth if your spending exceeds your income for any extended period of time. Only once you have accumulated some savings, can you begin putting money to work for you in a more passive manner. Build wealth from your wealth.

Save Your Way to Wealth

I like to save money first. This means putting a healthy portion of every paycheque directly in my investment accounts. Start by filling up your TFSA, your RRSP (unless you have very low income), and finally your non-registered investment account. If you are a couple who works together for a secure financial future, just filling your TFSA accounts is an easy fail-proof way to accumulate significant wealth over time that's completely tax free. If you want to get a bit more technical and tax optimize, you can mix your savings between TFSA and RRSP accounts.

It doesn't take special investing knowledge to grow $500 or $1,000 a month in savings into serious wealth by standard retirement age. With the Vanguard Portfolio ETFs, a simple one-ETF solution that mixes stocks and bonds with three different styles depending on your risk tolerance, you can achieve investment returns of 6% annually over time. For a couple who saves $900 per month, that grows to $1.3 million if you save from the time you're thirty until you are sixty-five. $1.3 million in investments is no joke! That will generate you a safe annual income of $50,000 to $60,000 per year, every year, for the rest of your life.

If you learn a lot about investing and achieve higher returns, you may hit your net worth goals much sooner and you could become very wealthy. However, that doesn't replace saving. Always save a lot and count on moderate returns. Then let those big returns go to work for you, powered by a big savings rate.

Use Monthly Moving Averages to Manage Expenses

To save money successfully and sustainably, you must limit your spending. To help get a better grasp of your spending and savings rates, you should average your monthly income, spending, and savings over several months. This is similar to using a moving average to determine price trends in investing. By smoothing your spending and saving, you can see the impacts over time, make better decisions, and reduce the big swings in spending that can frustrate you.

I believe a very good Rule of Thumb is making sure your Spending does not exceed your Net Income minus Savings over any rolling 6-month time period. This allows some planning for vacations, dining and entertainment, and other extras that shouldn't fit into your regular expenses.

Example:

John and June are a married couple who earn a combined $6,000 a month after their taxes and payroll deductions. Their goal is to save 15% of their take-home income every month ($900). Their reoccurring expenses include their mortgage payment ($1,800), property tax ($250), insurance ($300), cell phones ($150), cable ($100), vehicle payment ($400), electric and gas ($300), fuel ($250), and groceries and household supplies for a family of four ($800). This leaves them with $1,650 per month for savings and "extras".

The family is planning a vacation in July, which they do once per year. How much should they spend on that vacation?

Well, we know they want to save $900 per month in their investment accounts. That leaves $750 per month for things like vacations, emergency funds, and entertainment. Over a year, that adds up to $9,000. Smoothed out over 6 months, the family can spend $4,500 on these extras. Since its not wise to spend all of the $4,500 on vacation alone--dining and entertainment is important as well--they might decide to spend $3,000 on their vacation. We'll assume in a regular month, John and June will spend $200 on eating out and other extras, but in December they spend $1,000 to pay for gifts, visiting family, and some fun days.

To help smooth the cost, they could pay for the hotel costs in March ($1,200). Then in May they might start setting aside money in a savings account every month for the remaining vacation spending ($1,800). From this money, they will pay for restaurants, passes for entertainment parks, kayak rentals, or whatever else is on their list of things to do. If they decide to splurge when on vacation, they might decide to stop eating out while at home in May, June, and August to put all that extra money towards their vacation. The family can limit their spending to $50 per month on extras when they are "living on a tight budget".

By thinking about their spending taking into account past months and future months, John and June's spending never exceeds their income over a 6 month period of time. They can average their costs and still keep their spending under control while enjoying their vacation.

Here's how their income compares to their 6-month average spending over a two year period with the $3,000 vacation happening in the second year.

Source: TheRichMoose.com

While the monthly expenses (including their $900 savings) exceeded their income in several of the months, when averaged over 6 months, they never had their expenses exceed their income. It always had a cushion ranging from $100 to $450 dollars. This money could be used for entertainment and to fund their emergency accounts. This type of responsible spending makes sure your finances can withstand those expenses that pop up from time to time without diving deeper into debt.

You can quickly make a graph similar to this to keep track of your own monthly income, savings, and expenses with a simple moving average by using Google Sheets or Excel.

Be Careful with Large Asset Purchases

When it comes to income and expense smoothing, you should exclude large one-time asset purchases from your spending. This might include buying a house, or doing a large renovation. It is very easy to over-reach when buying these big assets because their costs, from a cash flow perspective, are broken into relatively small monthly payments. However, these monthly payments can make huge dents in your savings rates. My wife and I chose to go down to one vehicle and rent a smaller rowhouse for exactly this reason. Maxing our free cash flow lets us save over $60,000 per year!

Houses, when purchased at reasonable valuations, typically hold their value roughly in line with inflation over long periods of time. This has been clearly demonstrated with academic research. But you shouldn't be buying if it doesn't make financial sense. Grit your teeth and rent, or move somewhere house prices are more reasonable. Buying overpriced houses will make you poor.

Renovations are a bit tricky to value. The research I've done on this--from back when I was a carpenter and bought and upgraded my own house--suggests you are lucky to add around 75% of your renovation costs in increased value to your home for a typical, frugal renovation. This varies from 90% or higher for simple things like insulation, paint, doors, and mouldings to barely 50% for bathroom or outdoor deck upgrades. Generally speaking, high-end upgrades have a lower return on investment. DIY renovations can increase that return, but only if your work is of professional quality! So, if you do a $10,000 bathroom renovation and upgrade, you can expect your house to increase just $5,000 in value.

To some extent you might exclude vehicles and RVs as well, but you should always buy vehicles with a huge dose of caution. Along with over-priced housing, vehicles are a major source of financial problems. They depreciate rapidly and are expensive to keep on the road.

It's also tricky to conceptualize the true cost of a vehicle when most purchases are financed. Monthly payments of a few hundred bucks can appear a lot more reasonable than cutting a cheque for $30,000 to the dealership. I think it's better to buy used vehicles with cash that you've saved up over time. You can often find good used vehicles just a few years old for half of the new sticker price.

Summary

Everything on this blog, and in your personal financial well-being, starts with saving. You need to cut your spending, manage those large expenses, and maintain a consistent surplus over any 6-month periods to put money into those investment accounts. After all, there's absolutely no point in reading about investment strategies and how to maximize your returns while reducing your risk if you've got nothing to invest in the first place.

Investing on its own will never replace the need to save. You should count on obtaining investment returns of approximately 6% per year if you are willing to take on quite a bit of risk. Anything higher than that is a bonus. The difference between investing and obtaining 6% returns and obtaining 12% returns is the difference between becoming rich or super-rich. That's completely different from trying to invest your way to success because you are unwilling to save enough money. Saving the right amount of money first is essential.

Use a spreadsheet application such as Excel or Google Sheets to keep track of your monthly income and expenses. You can keep separate columns for each expense category such as mortgage, groceries, clothing, utilities, and savings. A simple averaging formula can help you track those bigger expenses and make sure you are not in a perpetual deficit spending situation. You also might be amazed at how much money you spend on useless stuff that provides you with no real value.

Watch those large asset purchases. Houses, vehicles, renovations, RVs, boats, and other big purchases should be analyzed very carefully. Nearly everywhere in Canada right now you are better off renting than you are buying a house. Keep in mind that renovations are not as good for your bottom line as they are often promoted to be. Vehicles and toys should be bought used with cash so you don't fall for those monthly payment traps. Monthly payments cut deep into your ability to save money.

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End of Life Costs for Early Retirees in Canada

A question that often gets put to the early retirement crowd is how they plan to pay for end of life care.

This is based on the assumption that early retirees who live tight budget lifestyles are not properly accounting for very expensive health care costs near the end of their lives.

It raises the question of insurance vs. self-pay. If you purchase long-term care insurance to hedge end of life costs, are you accounting for expensive premiums in your budget? If you self-pay, how much should you count on having set aside for care?

These are important questions! But I'm afraid the truth is often skimmed over by insurance companies eager to sell a lucrative product using fear tactics. Smart early retirees have nothing to worry about!

Let's first examine my basic early retirement rules.

  1. If you retire younger than 50 years old, have 30x your annual spending in investments
  2. If you retire between 50 and 60, have 25x your annual spending in investments
  3. If you retire in your 60s, have 20x your annual spending in investments
  4. Adjust spending for CPP using a conservative estimate, don't count on OAS if you can't claim it yet
  5. Invest in a stock heavy portfolio (at least 60% in growth ETFs) with a cash cushion
  6. Keep investing fees low and use index funds where you can

End of Life Facts

In Canada there are numerous programs out there that prevent—or at least limit—seniors from living in abject poverty. We've got universal health care, pharmacy coverage for low income individuals, long-term care assistance, and many other programs. These programs do vary by province, but most are similar in nature.

The biggest, and most worrisome expense, is long-term care costs. This is basically full assistance living in a facility. While provinces will provide care facilities based on income (B.C. for example charges you 80% of your after-tax income and they pay the rest), a comfortable existence in a private facility will cost you $50,000 to $75,000 per year!

How do you account for this potentially massive expenditure?

Well, first it's important to look at the stats. One-third of Canadians over the age of 85 live in continuing care facilities. Most are in provincial funded and not-for-profit facilities. The average length of stay is less than two years with very few residents staying longer than 5 years. Most residents are single females.

An increasing number of elderly Canadians are choosing home care services rather than care facilities as it permits greater freedom and is significantly cheaper. Approximately 1 in 5 residents currently admitted to long-term care facilities in Canada could be treated through less expensive home care instead.

Home care costs are typically charged on an hourly basis. Depending on your area and the level of care required, the fees range from $20 - $90 per hour with full registered nursing care being the most expensive. Typical home care costs range from $15,000 and $30,000 per year. At a certain point, it is more economical to live in a facility for a fixed cost than hiring for elaborate care at home.

Life Expectation and Cost

Given that 1 in 3 people over 85 enter a care facility, I think it's wise to assume several years of care costs in your retirement plans. I'll use 90 as the age to enter a facility to be on the safe side. This means a retiree should have an ending portfolio value sufficient to cover at least $150,000 in care costs at 90 years old. That's enough for 2 - 3 years of full care at a moderate to high-end facility, or 5 - 10 years of home care.

Remember, most facilities are much cheaper, home care is a very valid option, and government assistance will likely cap your financial exposure. Also, the average life expectancy in Canada is currently 82 years so your chances of entering long term care for any significant period of time is actually quite small.

Also, if you need long-term care, chances are you won't be spending much money on anything else. Vacations, vehicles, entertainment, home maintenance, and other larger expenses are no longer serious factors. End of life existence tends to be pretty bleak; after all, that's the whole point of early retirement!

Insuring Against Your Risk

Long-term care insurance is expensive. An inflation-protected policy that would pay up to $3,000 a month for full-care benefits could easily cost $300 per month in premiums. Premiums are also subject to increase after an initial fixed period.

Let's not forget all the caveats embedded into each policy, payout limitations, and the likelihood of your kids or friends having to run you around to doctors and fighting with the insurance company to even start paying benefits. If you have a long list of pre-existing conditions, you can't even get insurance.

I am personally of the opinion that self-insurance is best for many reasons. Insurance companies are profit-driven enterprises (rightfully so); they don't work for free. The most likely people to obtain this type of voluntary insurance are those which are almost certainly destined to end up in care facilities. This drives up the premiums for healthier individuals.

The best insurance policy is exercise, a healthy diet, and mental stimulation! You are significantly more likely to end up in a facility if you are overweight and have mobility problems, you suffer from dementia, you have heart conditions, you are a diabetic, and so on.

Monte Carlo Simulations

Monte Carlo simulations are like stress tests for your portfolio. Using historical figures and setting portfolio and spending parameters, we can analyze your probability of a successful retirement. It's essentially a statistical tool to measure outcomes and it's very useful for early retirees.

Retire at 40 with 30x, Annual Spend $50,000

Source: cFIREsim, TheRichMoose.com

This simulation has a 99% chance of success of a 50 year retirement to age 90. The median ending portfolio value is $4.6 million (inflation-adjusted). The only year that failed since 1870 is a retirement starting in 1906!

Regardless, considering a median portfolio value of $4.6 million at age 90 with every year other than 1906 ending well over the required $150,000, it's pretty safe to say that a couple retiring at 40 years old with 30x annual spending is very safe to cover long term care costs and they don't need insurance.

Retire at 50 with 25x, Annual Spend $50,000

Source: cFIREsim, TheRichMoose.com

This simulation also has a 99% chance of success for a 40 year retirement ending at age 90. The median inflation-adjusted portfolio value at 90 is $2.3 million with a retirement starting in 1906 again being the only failing year in the last century and a half.

Every other year ended with with an inflation adjusted portfolio well over the required end of life costs. Again, it's safe to say a couple retiring at 50 years old with 25x expenses is safe to cover their own potential long-term care costs in the best facilities without insurance.

Retire at 60 with 20x, Annual Spend $50,000

Source: cFIREsim, TheRichMoose.com

This simulation has a 95% chance of success for a 30 year retirement ending at age 90. This time, several starting years failed: 1902, 1906, 1907, 1965, and 1966. While the median inflation-adjusted portfolio value at age 90 was $1.2 million, there are a number of years which resulted in a portfolio value below $150,000 at 90 years old.

This looks scary, but I should explain I didn't count OAS payments ($6,000+ per person annually). With this simple adjustment, the success rate would actually be 100%. Every simulation would have resulted in an ending portfolio value well over $150,000.

Retire at 60 with 20x, Annual Spend $30,000

Source: cFIREsim, TheRichMoose.com

This scenario has a 100% chance of success with a median inflation-adjusted portfolio value of $1 million at age 90. There are several years where the portfolio valued ended below $150,000.

This might imply failure and a sprint to your local insurance company, but that's really not necessary. Low spending is actually safer because government benefits offset a larger percentage of your retirement spending and portfolio withdrawals.

Again, I didn't count OAS or GIS payments and only a conservative CPP benefit in my calculations.

The Take-away

If you have adequately saved before retirement using 30x, 25x, or 20x  as appropriate, you will have a very comfortable end of life situation and realistically you won't need LTC Insurance.

These figures in the simulations don't include the value of your unproductive assets (your house). Proceeds from the sale of a paid-off home will more than cover long-term care costs in a facility.

The odds of success are so heavily in your favour that the only thing that could blow up your plan is a very poor investment plan, cancellation or severe reduction in seniors benefits (CPP, OAS/GIS), or a massive increase in the cost of long term care. Of these, the most likely scenario is bad investing, so focus on that first.

In the worst situation you can go into a government facility and your costs will be limited to your income level. These facilities might be less pleasant, but on the cynical bright side you're likely to have dementia if you are in a long-term care facility so you won't remember anyways.

I honestly don't know who would buy long-term care insurance rather than self-insure. Perhaps if you've saved no personal money, are renting and living from an inflexible but moderately lucrative government pension, are funding your retirement using your home equity, are generally unhealthy, demand a high-end facility, and are prioritizing leaving an inheritance over your personal care, LTC Insurance could be considered. Thankfully the Moose world is much more practical than that.

Comments & Questions

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