Financial situation

How much do you spend each year?

A person's cost of living is made up of all expenses calculated on a monthly or annual basis. Knowing your cost of living is an indispensable tool if you want to know where your money is going. An excellent way to determine your cost of living is to set up a budget that shows where your money comes from and what expenses it has to cover. Doing this exercise will help you separate your basic expenses, your discretionary spending, your taxes and your other deductions.

Basic expenses are those that are hard to avoid without affecting your standard of living: housing, food, clothing. Discretionary expenses are those you have greater control over: restaurants, vacations, gifts.

There are other ways to evaluate your cost of living if setting up a budget seems too complicated. For example, you can estimate your cost of living as the difference between your after-tax income and the amount you have saved in the last 12 months.

We encourage you to speak to your financial planner, who will be able to help you determine your cost of living.

Do you know your annual savings capacity? Do you know whether it will allow you to meet your short-term, medium-term and long-term goals?

Your savings capacity is calculated by subtracting all your expenses (basic and discretionary) and other deductions (taxes and other) from your gross income.

These savings can be used to create a contingency fund, to repay debts, to create a reserve for future acquisitions or to invest.

To evaluate whether your savings capacity is adequate, your financial planner has to work with you to determine the details of your current situation and your short-term, medium-term and long-term goals, personally, family-wise, financially, and in terms of retirement, risk management and estate planning. From there, your financial planner will do certain analyses and projections to track the probable direction of your cost of living (paying off the mortgage, financial independence of your children, different budget in retirement), and the other factors that can influence your financial situation. Your financial planner can then present the results of the analysis to you and recommend different strategies or actions to ensure that your savings over time will meet your short-term, medium-term and long-term goals.

Do you know whether you should repay your debts or save?

Well, it depends!

On what? On several things, but mostly interest rates – that is, the rate of your loans compared to the rate of return on your investments and (you can never escape them!) your taxes.

Let's start with the classic "Should I pay down my mortgage or contribute to my RRSP?" It's all the same if the interest rate on your mortgage is the same as the return you'll get in your RRSP.

Here’s an example: let’s compare a one-shot contribution of $5,000 to your RRSP to a $5,000 capital down payment on your mortgage. If you have $5,000 available, you can, in fact, contribute $8,333.33 to your RRSP, because after the 40% tax rebate, the real cost is $5,000. In other words, you borrowed $3,333.33, which you repaid immediately with your tax refund, or you contributed using salary deductions, which gave you an immediate tax reduction. That’s why it’s important to compare apples to apples!

We're assuming an interest rate of 5% on the mortgage, and an equivalent rate of accumulation in the RRSP. We're also assuming a marginal tax rate of 40% at the time of contribution and at the time of withdrawal.

You can see from the chart that the difference between the mortgage balances and the value of the RRSP after taxes is very small. The RRSP would be more beneficial if the tax rate on withdrawal was lower than the tax rate on contribution, or if, as we said, the rate of return in the RRSP was higher than the cost of borrowing. That means that the higher your risk tolerance and the more aggressively invested your RRSP, the higher your potential return and the greater your chances of getting a return on your RRSP that is higher than your cost of borrowing. The opposite is also true.

Which debt should be paid down first?

It is best to pay down debts with the highest interest rate first, and those bearing interest that is not tax deductible or that provides no tax advantages.

Should I contribute to my RRSP or make non-registered investments?

We have taken the same example from above with the same assumptions to illustrate the difference between saving in an RRSP, in a non-registered account, and in a Tax-Free Savings Account (TFSA).

The RRSP is clearly more advantageous than the non-registered investment. You can see that in 5 years, the RRSP investment will be worth $6,381 after taxes, while the non-registered investment will be worth $5,796. Over a longer period, this is a clear advantage. TFSAs can be very interesting when the marginal tax rate is higher at the time of withdrawal from the RRSP. In our example, the TFSA is equivalent to the RRSP because we're using the same tax rate at the time of contribution and the time of withdrawal. The RRSP is the preferred savings vehicle when the tax rate is lower at the time of withdrawal, which is what we're hoping for!

Another important factor in all this is the human element. If you put the priority on your mortgage, once it is entirely paid off, will you have the discipline to put the entire mortgage payment into your RRSP, or will you be tempted to spoil yourself a little?

During market corrections, people tend to repay their debts because market returns affect them. But the reasons for your decisions shouldn't be based on short-term economic conditions – you should take a longer view. The important thing is to increase your wealth, not your expenses! Paying down your debts and saving are both ways to increase your wealth.

Do you know the net worth of your assets?

Preparing a personal balance sheet gives an individual (or a household) a snapshot of their financial situation. It's a portrait that shows their assets, liabilities and the net worth of the property they own.

Assets

If you want to determine the net worth of your assets, you have to list all your property and determine the market value at the date in question. These assets are divided into four main categories:

• Cash and near-cash assets
  ⇒ Bank accounts, non-registered investments, TFSA, etc.
• Personal assets
  ⇒ Principal residence, secondary residence, automobiles, etc.
• Income-producing assets
  ⇒ Rental buildings, shares in a private corporation, etc.
• Deferred tax plans
  ⇒ Registered Retirement Savings Plans (RRSP), Registered Retirement Income Funds (RRIF), registered pension plans (RPP), Locked-In Retirement Accounts (LIRA), Registered Education Savings Plans (RESP), Deferred Profit-Sharing Plans (DPSP), etc.

Liabilities

In terms of liabilities, you have to list all your debts, which can be divided into three main categories:

• Accounts payable
  ⇒ Credit purchases, overdue bills, etc.
• Personal loans
  ⇒ Line of credit balances, bank overdrafts, consumer loans (for cars, furniture, RRSPs, investments, but not buildings)
• Mortgage loans
  ⇒ Loans used to acquire buildings (principal residence, secondary residence, rental buildings)
• Future taxes

Net worth

Your net worth is the difference between the assets and the liabilities. It is what you will have left after all current and future debts are repaid. Periodically calculating your net worth helps you determine whether you are getting richer or poorer.

Your financial planner is the right person to help you create a personal balance sheet. He can also help you estimate your future taxes. Future taxes are the taxes that will eventually have to be paid on certain of the assets in your balance sheet, such as a withdrawal from your RRSP or the sale of a rental building. This estimate aims to provide a more accurate picture of your net worth at any given moment. Because of the tax payable, a $10,000 RRSP withdrawal does not generate $10,000 in purchasing power, whereas pulling this same amount from a TSFA will let you buy $10,000 worth of goods.

Do you know your investor profile? Your risk tolerance? Your investment horizon?

As an investor, you are unique. Your objectives and constraints determine which investments are right for you. Depending on how you intend to use your assets, the level of risk you are willing to take (your risk tolerance or, to put it another way, your loss tolerance) may vary. Consequently, you may not worry the same way over an amount invested for the next year and an amount you will only need in 10 years. We are talking about the investment's time horizon. What return are you hoping for? Will you lose sleep over daily fluctuations in the value of your investments? Other factors, such as your knowledge of investment products, liquidity, taxation, legal aspects like your family situation, will also have an impact on the investment policy established in accordance with your objectives and constraints.

To help them establish an investment policy that matches your investor profile, financial planners can use two tools: a questionnaire and the life-cycle model.

Questionnaire

The questionnaire is an assessment approach that uses a point system based on the investor's answers to questions related to their return expectations and their level of risk tolerance. This type of questionnaire should be completed for each of your different projects. Because if you want to invest in your child's education, for example, your anwers may not be the same as those related to your retirement savings account. You should have an investment policy tailored to the objectives and constraints related to each investment account you own.

There are typically five to seven investor profiles, ranging from "convervative" to "aggressive" and including the so-called "balanced" and "growth" profiles. The names and attributes of each profile can vary between financial institutions, but the basic concept remains the same.

For example, the "balanced" profile could be right for you if you want your investments to provide modest income and capital appreciation and you won't lose sleep if their value fluctuates.

For purposes of comparison, the "growth" profile is typically appropriate for investors who prioritize long-term growth of capital. They expect the value of their investments to fluctuate over time. They accept these fluctuations because they have a long investment time horizon and don't need their investments to earn income in the short term.

Caution should therefore be exercised in interpreting the results of this type of questionnaire, because a slight difference in scoring can swing the profile from "balanced" to "growth". This is a tool that has limits and can't be used alone. Financial planners must use it in conjunction with the all the information they have gathered about you.

Life-cycle model

This tool applies to the behaviour of the general population. A person's life can be divided into four different phases in terms of wealth:

• Accumulation (early career, net worth generally low, debts)
  ⇒ Because people in this stage of the cycle have more time ahead of them and their income is growing, they can usually take a little more risk with their investments. The portfolio can be growth oriented.
• Consolidation (middle career, children are independent, good equity in home, etc.)
  ⇒ Since retirement is still generally far off (10 or 20 years), but these people have already accumulated substantial retirement assets, this is no time to take foolish risks. The portfolio should be balanced.
• Financial independence (end of career, living expenses covered by replacement income or retirement income)
  ⇒ Since the investment horizon is shrinking and living expenses are covered by the return on existing investments, the portfolio should be conservative.
• Transfer (more assets than needs)
  ⇒ Since people at this stage have more assets than they need for their own security and personal expenses, they begin to consider transferring part of their wealth to the later generations or to a charitable cause. The same portfolio type as in the previous phase is appropriate.

The personality of each individual also influences these phases. Here again, the financial planner will have to use good judgment to make the necessary adjustments.

Do you understand the allocation of your assets?

There are three main asset categories, each of which offers different investment vehicles with different characteristics: liquid securities, fixed-income securities and growth securities. Asset allocation accounts for 90% of a portfolio's volatility.

Liquid securities

Liquid securities can be quickly turned into cash, without a significant loss of value (for example, treasury bills, bonds maturing in less than 1 year, guaranteed investment certificates maturing in less than 1 year, etc.).

Fixed-income securities

The main feature of fixed-income securities is that they provide regular income (for example, bonds or guaranteed investment certificates that mature in more than 1 year). When you have a registered pension plan, you generally consider the current value of your membership as a fixed-income security. This means that your other investments could, for example, be more weighted toward growth securities.

Growth securities

The main feature of growth shares is the potential for capital growth (for example, Canadian and foreign shares). These securities can also result in a capital loss.

Some investment products, such as alternative investment products and hedge funds, are sometimes considered as a separate asset class, but we classify them with growth securities. Ownership in a private corporation (in the form of shares or shareholder loans) or in a general or limited partnership is usually classed as a growth security. This means that the investor's other investments should be weighted toward fixed-income securities.

When we talk about a balanced portfolio, we are referring to the allocation of the assets among these three major asset classes. A "balanced" portfolio generally has between 40% and 60% growth shares.

Do you know what the return was on your portfolio last year? For the last five years?

Everyone agrees that past returns are no guarantee of future returns in an investment portfolio. But despite this, it is very important to know the return your portfolio generated.

A distinction should be made between past performance and expected performance. Expected performance is the performance it is reasonable to expect given the allocation of your assets. To this end, the Institut québécois de planification financière publishes Projection Assumption Standards every year, as a tool for financial planners. These standards suggest assumptions to use for long-term planning for retirement projections or other evaluations of financial needs. Past performance, on the other hand, refers to the real returns that were earned.

People often tend to look solely at short-term past performance. This information is relevant, but long-term return is also very meaningful.

Analysing the return on your portfolio will let you assess the quality of the work being done by the person who is taking care of your investments. It lets you determine the theoretical return you would have earned if you had invested in market indexes that closely mimic your asset classes and reflect the allocation of your assets among these different asset classes. For example, the reference index for Canadian shares is the S&P/TSX.

Your financial planner can help you do this exercise. If the return you earned is not equal to your theoretical return, we encourage you to speak to your investment advisor or your financial planner to determine why.

Do you know what a TFSA is? What rules apply to TFSAs?

A TFSA, or Tax-Free Savings Account, is a registered savings account that lets residents of Canada aged 18 or over (except trusts) shelter their investments from Canadian taxes. TFSA contributions are not tax deductible.

This type of account was introduced on January 1, 2009, and is recognized by the federal and provincial governments.

Contribution ceiling

You can contribute up to your contribution ceiling to your TFSA. For the years 2009 to 2012, people at least 18 years of age who lived all year round in Canada accrued $5,000 in TFSA contribution room each year. Annual contribution limits are indexed each year at the rate of inflation, rounded to the nearest $500. For the years 2013 to 2018, the yearly contribution room is $5,500, except for 2015 when the contribution room was $10,000. Since 2019, the yearly contribution limit is $6,000. Unused contribution room can be deferred to subsequent years. Sums (including investment income) withdrawn from a TFSA one year are added to their contribution room for the next year.

Tax treatment of TFSA income

The income, gains and losses from TFSA investments, as well as sums withdrawn, are not included in the calculation of income for tax purposes and not taken into consideration for the purposes of determining eligibility for income-based benefits or credits granted under the income tax regime (such as the Canada Child Benefit, the GST tax credit and the age credit). Likewise, these amounts are not taken into consideration in the calculation of other benefits based on income, such as Old Age Security, Guaranteed Income Supplement (GIS) and employment-insurance benefits.

RRSP or TFSA?

• If the client can afford it, it is best to contribute to both.
• If not, the important variable is the tax rate at the time of withdrawal in comparison with the tax rate at the time of contribution:
  ⇒ If the tax rate at contribution is the same as at withdrawal, the TFSA and the RRSP are equally beneficial from a tax point of view
  ⇒ If the tax rate at withdrawal is lower than at contribution, the RRSP is the better choice
  ⇒ If the tax rate at withdrawal is higher than at contribution, the advantage lies with the TFSA
  ⇒ Remember to consider the cost of social tax programs such as GST tax credit, solidarity tax credit, Old Age Security pension, Guaranteed Income Supplements, family allowance, etc.

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