# #5 Income Volatility - Financial Planning Habits - Part 5 of 5

"The impact of income volatility on Canadians" survey was conducted by Ipsos for TD Bank in 2017.

In Part 1 we learned that income volatility affects 10 million Canadians. And the way to combat it is to either **A. Spend only as much as the lowest income month ***or*** ****B. Spend the average of your income every month.**

Option A is more conservative, easier to execute and better for your savings. But option B is better than going into debt to live.

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In Part 2 we learned that 54% of Canadians are not savings at all, and 16% are actually going into debt. With the average credit card debt in Canada at $4,000, at 20% interest, these Canadians are paying $800 a year in interest payments.

The way to combat this debt spiral is to **1.**** Figure out how much all your necessities cost.** Rent/Mortgage, utilities, gas, water, maintenance, insurance, transportation, food, internet/phone. **2. Until your debt is paid off, try to only spend what's on the necessity list.** Eating out should be restricted. Choose social events that are free or very cheap. **3. Increase your luxury spending to bring your total spending up a little but no higher than the lowest income month you expect throughout the year. **

The most important step is to not go further into debt. The next most important step is to get out of debt. Don't let compound interest work against you, especially at 20% per year.

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In Part 3 we learned that 24% of Canadians don't save. 39% try to save and 37% save regularly. And 30% of those surveyed have less than 1 months of emergency savings.

There are a couple ways to go about life. **1. Live paycheque to paycheque** or **2. Live below your means.** Spend less than your income every month. Save the rest. Let that money earn interest in a savings account or invest it. This is preparing for the worst before it happens. Letting your money work for you instead of working for someone else. This is preparing for life before life comes flying in your face.

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In Part 4 we learned that 49% of Canadians, almost half of Canadians, carry super crazy high-interest credit card debt. These are rates that can be as high as 26.99% per year for a "basic" rate with a "preferred" rate at 19.99%.

Once you've gotten out of the debt spiral, you can start thinking about how to use debt as a tool rather than a crutch.

The best way to build up your credit score is to use credit cards. They are the only credit where you have an "interest-free grace period" which is usually 21 days. You can borrow money from the bank and pay your credit card statement in full every month and never pay a penny of interest. Meanwhile, your credit score becomes better and better with each fully paid month that passes.

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In Part 5 we are going to talk about financial planning habits of Canadians.

Only 35% of Canadian have a short-term budget, spending plan, or financial plan.

Even fewer, 27%, have a long-term plan.

Seems like most Canadians are playing the game of life like a bad sports team. Imagine if two hockey teams face each other, one has a plan, the other is a bunch of randoms put on a team just 5 minutes before the game. The randoms without a plan go out on the ice and just chase the puck, while the team with a plan spreads out and draws circles around the randoms. The scoreline is almost certainly in favour of the team with a plan.

A plan is critical to success.

Everyone knows that a plan will change in real life. But imagine a chess player. The best chess grandmasters have already thought of 10-15 moves ahead and planned for different scenarios of what the other player is going to do (the unknowns).

A plan doesn't have to be so complex. Simple can work just as well.

**For the short-term:**

1. Know what is the minimum you need every month to keep the "lights on". This is your rent/mortgage, property taxes, maintenance, gas, electric, water, garbage, insurance, food, transportation, phone/internet.

You need all of these things to different degrees. You need to know what these will cost you every month and make sure you are at least prepared to pay for these.

2. Know what luxuries you really don't want to live without. Figure out how much those will cost to make you happy. If it's something like coffee or restaurants, then figure out how many times a week you can afford to spend on these luxuries. 3 times a week eating out could cost $60 per week for one person. 5 lattes a week could cost $20-$30 a week. If those numbers are too high for you to afford, you need to be more realistic and maybe cut the meals out to 1-2 a week, and 2-3 lattes a week. $90 a week is over $4,500 a year.

Do this exercise with everything you spend on. Eliminate things you don't really use.

Make trade-offs (i.e. eating out 1 time = drinks after work 1 time or biking one day = latte's for a week)

If $4,500 a year is worth more to you with something else, then maybe you can eliminate eating out and lattes altogether. You can buy almost 3 top of the line iPhones with $4,500. You can go on a pretty good vacation to Europe or Asia for $4,500. You can get a high-end handbag for $4,500. You can pay 2-3 months rent with $4,500. You can get a really nice couch from King St East in Toronto and still have money left over for a West Elm mid-century hazelnut dining table plus matching chairs. Or you can tuck that $4,500 away in an investment account. If you invested $4,500 in Apple stock on January 1, 2017, one year later on January 1, 2018, it would be worth $6,674. Almost 50% more. Over $2,000 more than it was worth a year before.

What are you giving up?

*Consider the alternatives. *

If you don't track your spending. Then use your frequency as a way to budget.

If you set your budget at 2 meals out a week then when you reach 2 meals that week you need to restrain yourself for the rest of the week. This can work with a lot of other things that have a relatively consistent cost per use.

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**For the long-term:**

**1. Decide how long until you want to retire. **5, 10, 20, 35 years...

**2. Add up what you expect your annual expenses in retirement will be if you retired TODAY then minus the cost of a mortgage* then minus any pension benefits you expect to receive. Then calculate the number after inflation.**

*We are assuming you have paid off your mortgage before you decide to retire. If you choose to rent in retirement, then include that in your annual expenses.

To do this step, you need to learn how to budget. This article shows you the logic behind how I budgeted for 2018. The only difference is you will have to imagine your life in retirement. What will you do, what will you eat, where will you live, and how will you live. Think about what luxuries and comforts you want in retirement.

Example: $60,000 annual expenses today, minus $20,000/year in mortgage payments annually, minus $1,000/month pension benefits = $12,000/year = $28,000

Then calculate the number after adding 2% annual inflation on these expenses.

In 5 years: $28,000 x (100%+2%)^5 years = $31,000

In 20 years: $28,000 x (100%+2%)^20 years = $42,000

In 35 years: $28,000 x (100%+2%)^35 years = $56,000

*For those not familiar with the math formula. (100%+2%) = (1.02). *

*The "(100%+2%)^5years" is therefore same as (1.02) x **(1.02) x (1.02) x (1.02) x (1.02)*

**If you are eligible for a pension from your company or the government then figure out how much that will be after tax and deduct it from the annual expenses you calculated in this step.

***If you are planning to retire earlier than the average person. Before you are 55 years old, then you may not be able to rely on pension benefits and therefore need to rely solely on your own savings to achieve your retirement goal. Those with defined *benefit* pension benefits may find themselves in this situation. Those with defined *contribution* pension benefits may be able to transfer the pension benefits into a personally managed investment account after retiring early.

**3. Calculate how much you need to retire.** Easy math.

If you want to retire in under 25 years and before you are 50 years old, then divide your future annual expenses by 0.04. This should be more than enough.

If you want to retire in 30-40 years and before you are 65 years old, then divide by 0.045.

Example:

In 20 years: $42,000 inflation-adjusted annual expenses (as calculated above)

$42,000 divided by 0.04 = $1,050,000

This is the target savings number you should try to achieve in 20 years.

If you are conservative, you can exclude the equity in your home from this target. This is a good option if you plan to leave your home as an inheritance.

If you are a bit less conservative, you can include the equity in your home in this target. Because ultimately you can live off the value of your home through a reverse mortgage with the bank, or you can sell your home in your old age, downsizing or renting, and living off the remaining equity.

**4. Calculate how much you need to save every year.**

Some easy rules:

10 years: 2.3x your annual expense every year. This means if you need $28,000 to retire, you need to save $65,000 a year for 10 years.

15 years: 1.5x (i.e. $41,000)

20 years: 1x (i.e. $28,000)

25 years: 0.75x (i.e. $21,000)

30 years: 0.5x (i.e. $14,000)

35 years: 0.4x (i.e. $11,000)

40 years: 0.3x (i.e. $8,500)

For every multiple of annual savings you have already saved, subtract 1 year from the time to retirement.

Example: If you are 30 years old and want to retire in 20 years, this means you want to retire at age 50. If you have saved $100,000 then subtract 4 years from your target retirement age. If you follow the plan, you can retire in 16 years at the age of 46.

**5. Get your short-term budget in order** so you can save the amount you calculated in step 4.

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Plans change. Situations change.

You may start to make more income year after year which will change how much you can save or how much more luxurious you want to live your life.

You may start a family which means money needs to be reallocated to raising your family.

You may see the results of your investments are better than expected. This can change how much you need to save every year or shorten the time to get to your goal.

The only thing you can be certain of is that something will change in your plan.

That's why you need to revisit your plans every year.

Save Money Retire Early is written by Jon Lo, a barely 30 something change optimist, and personal finance guy. I believe anyone can be rich or poor, it's what you save that makes the difference.

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