The Financial Pyramid – Assessing Where You Stand

So, you’ve been watching BNN constantly and you think you’re ready to start investing your hard-earned money in penny stocks and IPOs? Do you have an updated Will and proper insurance coverage? Have you started an RRSP? Are you struggling with credit card payments? Is the answer no? Then forget it!

Before undertaking any financial venture, you must have a good strong base from which to work to successfully reach the goals and objectives that you’ve set.

One tool that I came across while I was taking the Canadian Securities Course (CSC) that will help clarify your current situation and identify planning needs is the “financial planning pyramid”. Although the financial planning pyramid may appear simplistic, I can attest that is it a useful visual aid and used by many financial advisors. The financial planning pyramid helps to visualize your long-term goals and objectives and review your overall investment strategy.

(Source: CSI Global Education Inc., Canadian Securities Course. Vol.2. 2010. ch.26., p.11. Print/eBook.)

The remainder of this post will look at the foundation of the pyramid – “Security” and “Independence”.

The very bottom of the pyramid looks at protecting those closest to you from unavoidable risks (death, sickness, accidents, job loss, etc.) of which you can normally cover with insurance policies and wills. When it comes to insurance, I am not an expert and likely not too many of you are either. In which case, it might be prudent to find yourself a reliable insurance broker that will help you get the best insurance policies at the best possible price.

At the next level, you should identify the debts you now have or those which you are assuming day by day. For these your plan should include the reduction of these debts if they are now, or likely to be a problem in the future. Personally, I believe that any debts that you have that are on items that depreciate (i.e. car loans, consumer products, etc.) should be considered “bad debt”, while anything debts on appreciating items (i.e. a house or an education) is a “good debt”.

Next, you should start a Registered Retirement Savings Plan, or RRSP. What is an RRSP plan, you ask? RRSP is a personal savings plan that is registered with the Canada Revenue Agency which allows you tax shelter your investments. Any growth within your RRSP plan is tax deferred, not taxed until withdrawn, at which point it is taxed as an income.

RRSP was put in place to encourage Canadians to save for their retirement and lessen the burden on the government when Canadians retire. The idea is that throughout your working years you save a portion of your income in the RRSP plan and upon retirement you start withdrawing from it to supplement your CPP and OAS income. This is probably going to be more important now that the Federal Government has now proposed as part of their budget to increase the age of eligibility from 65 to 67 years old.

Any contribution you make to your RRSP account is tax deductible, you will get a tax refund based on your marginal tax rate. Generally your tax bracket would be lower after retirement, so you would be paying less tax while growing it tax free.

You should note that in your RRSP account you can hold variety of investments, such as a savings account, GIC’s, mutual funds, bonds, equities, gold or silver bullion and many more. However, I would advise you to place interest bearing investments into your RRSP account as it is more tax efficient since it will be tax deferred and place dividend stocks in your non-registered account where you can benefit from the dividend tax credit.

Finally, you should establish an “emergency fund” of cash in a high interest savings account or some other liquid investment (i.e. Canada Savings Bonds) which will address the risk of loosing your job or some other unforeseen circumstance. This should typically cover at a MINIMUM at least three months of your current wages.

My motivations

I recently took a look at the financial statements of a close family member to determine when would be the earliest date that they could retire. Much to my surprise and dismay, most of this family member’s investments were only marginally generating yields better than 91-day Treasury Bills (typically considered the safest, but one of the lowest returning investments in the market) and, more disturbingly, this poor relative did not know why.

In other words, I would like to help increase people’s “financial literacy”, which was defined by the Task Force on Financial Literacy as: “having the knowledge, skills and confidence to make responsible financial decisions.”

More precisely, I would like to share some key skills and knowledge that I consider necessary to make informed and educated decisions about your budget and your finances. However, I should note that reading my blog will NOT qualify you to be a professional day-trader anymore than any blog can make you qualified to be a brain surgeon (and no, I am not comparing traders to neurosurgeons!). I would like to equip you with questions and mental tools to go out into this crazy market and help you avoid some of the pitfalls and traps that have caught so many people.
Also, I am fully aware that the term “financial literacy” is somewhat of a loaded term. According to Barry McKenna of The Globe and Mail, there is no evidence that financial literacy leads to better financial outcomes, calling it a “smokescreen”. I am actually in agreement with Mr. McKeena on this point in that “financial literacy” is being used by the Government of Canada while simultaneously shifting the financial burden from government to individuals. This blog is a product of this experience. My goal is to address what economists call “information asymmetry” – what can be generally defined as a situation in which one party in a transaction has more or better information compared to another and can be harmful because one party can take advantage of the other party’s lack of knowledge.

Saul Schwartz, professor of public policy at Carlton University points out that the federal Task Force for Financial literacy is headed by the CEO of Sun Life Financial and the Chairman of BMO Nesbitt Burns – likening them to “foxes in charge of the chicken coup”. This is valid, as anyone should be wary of anyone wanting to “educate” them – especially when there’s money involved.

So, to be clear, I think “financial literacy” should be though of as a toolkit and a critical (or sceptical) approach with dealing with financial professionals (like myself), economists, politicians, and the like. It should be used in conjunction with an social activist approach were we put pressure on government to put more stringent requirements on the size of mortgages and credit lines, be way more clear about interest rates paid and fees charged on financial products, and having financial statements and prospectus’ written in plain English.

Phew! With that, I hope you enjoy my insights and let me know what you think – I love to hear about your insights, experiences and questions.