Monday, January 26, 2009

Lessons from Findependence Day by Jonathan Chevreau

The 12 steps to Financial Independence


This is adapted from a talk Jonathan Chevreau gave last week at the Financial Forum in Toronto. He summarized the 12 sequential steps that underline the structure of his financial novel, Findependence Day
Listen to my interview of Jonathan on AM 980


There are roughly 12 steps the novel’s protagonists -- Jamie and Sheena -- take in their journey towards Findependence, many of which occur in all our lives, often in the same sequence.

A typical person achieves financial independence after saving and investing a minimum of 24 years. In the novel, Jamie sets an ambitious target of 22 years but he hopes to leapfrog the system by building up a successful business and selling it. Sheena is more typical as a salaried employee with a good government-sponsored pension: for her, the classic Freedom 55 is feasible. But in Canada, the average retirement age for people in the private sector – many with less generous pensions or none at all – is closer to 60.

After the Crash of 2008, many boomers are pushing out their “Findependence day” even later: perhaps to the traditional retirement age of 65. There’s a lot to be said for this approach since five or ten years of additional saving and investing provides not only a bigger nest egg – it also means the portfolio won’t have to fund as many years of withdrawals. Given the expected gains in longevity, the prudent thing is to keep working as long as possible.

Here are the 12 key steps Jamie and Sheena took:


Step 1: Eliminate Debt
Pay off high-interest non-tax deductible credit card debt. This is how the novel begins. TV host Didi Quinlan is badgering Sheena for not being able to cut up her credit cards. She tells Sheena to first pay off the highest-interest cards: typically department store credit cards which often charge more than 20% and sometimes close to 30%. Next would be the traditional bankcards like Visa and MasterCard, which charge interest in the mid teens.

Almost any financial advisor will tell you that there is good debt and bad debt. Another book listed in the bibliography is Jon Hanson’s Good Debt, Bad Debt.

A home mortgage can be good debt and some even believe a business loan or investment loan can be considered good debt since you’re acquiring assets that may rise in value.

Bad debt, on the other hand, tends to be high-interest non-tax-deductible debt used for consumption: to acquire consumer goods or luxuries that depreciate in value: cars, hot tubs, swimming pools, large-screen TVs.

You can consolidate multiple debts incurring high interest charges with a single low interest loan or line of credit. Often, consumers in debt need help, which they can obtain at local credit counselling services like Credit Canada.


Step 2: Practice Guerrilla Frugality


Once you’re in the hole paying out interest, it’s that much tougher to dig yourself out. Recognize the quest for financial independence is a war: it’s the ordinary couple against the credit industry and all the advertisers of products and services.



The system is rigged to keep you broke. Taxes are high and marketers and advertisers do all they can do to separate us from what few after-tax dollars are left. They turn our wants into needs, a trick Jamie is familiar with in his job selling consumers their technological gadgets at Tech Heaven.


So how do you develop the lifelong art of spending less than you earn? Ideally, 12 to 25% less? Books like The Wealthy Barber and The Automatic Millionaire use the phrase “Pay Yourself First.” To do that means cutting expenses to the bone.

In the novel, Didi’s pet phrase of the required attitude is Guerrilla Frugality. This means digging deep and refraining from making frivolous purchases, such as buying lottery tickets, the daily Tim’s or Starbucks routine, eating in the company cafeteria or fast food joints instead of brown bagging it, quitting smoking, reducing alcohol consumption and generally trimming one’s spending sails.

Jamie and Sheena invent a term for themselves as they embrace frugality: froogers, which is short for frugality guerrillas. According to the Oxford dictionary, guerrilla is a noun: “a member of a small independent group taking part in irregular warfare, typically against larger regular forces.”



Clearly, Didi meant the large regular forces were modern consumer society, with the giant sales, advertising, marketing and credit industries conspiring to extract every last dollar from the ordinary Joe. To combat those forces required donning the fatigues of frugality guerrillas and doing battle against the consumption leviathan.

Guerrilla Frugality is a lifelong habit. Initially it is used to eliminate debt but once that is achieved the same approach is necessary to begin saving and investing. During one’s years in debt, the difference between what you earn and spend is used to pay down debt. Later, when debt-free, the difference is saved and ultimately invested in a number of vehicles as one travels further along the financial life cycle.


Step 3: Prepare a Financial Plan.

Find a competent certified financial planner (CFP) and ask him/her how the barebones plan outlined in the novel needs to be modified to adapt to your unique financial circumstances. Obviously, a novel is not a financial plan and while it does sketch out the skeleton of a life cycle that many investors will traverse, that doesn’t mean you don’t need a professional advisor or financial planner to help the investor navigate the choppy waters toward Findependence.


Step 4: Build Emergency Cash Cushion with TFSAs

Everyone should have an emergency cash cushion of 6 to 12 months living expenses – especially in tough economic times like we’re in, when job loss is an ever-present possibility.

The new Tax-Free Savings Accounts (TFSAs) were introduced in Canada on January 2, 2009. They’ve been hailed as the biggest thing in retirement since the RRSP was launched half a century ago. Think of the TFSA as a mirror-image RRSP. RRSPs give you a tax deduction up front but are eventually taxed in old age when they become RRIFs and are subject to forced annual withdrawals, which are fully taxable like earned income or interest.

The TFSA offers no upfront tax break but shelters investment income for your whole life. Because it is tax-paid up front, unlike RRSPs or RRIFs, when you want to take the money out of the TFSA to spend it, it will be totally free of tax.

But the TFSA is more than an auxiliary RRSP: it’s ideally suited to help young people save up for short-term savings goals like buying a new car, saving up for a down payment on their first home and other goals. In the first year, and given the shaky economy, I think the TFSA should hold interest-bearing vehicles like GICs, savings bonds or high-interest savings accounts. It can be used in subsequent years for longer-term savings objectives and ultimately as a supplement to RRSPs, especially for those with generous DB pensions who have only a small amount of RRSP room.

Step 5: Enrol in the Company Pension Plan/Maximize RRSP.

Notice that the early steps do not involve investing in the stock market. For those still in debt, Theo advocates putting debt repayment ahead of retirement savings and non-registered savings. The only exception is taking up employers on their pension plan offers, especially if they offer the “free money” of matching contributions. Since employer pensions are invariably invested in the stock market, this becomes the first participation many young workers should have to the market.

But not everyone is in a company pension and indeed so-called “pension coverage” is declining every year: especially the old-fashioned Defined Benefit pensions that guarantee you a set monthly income for the rest of your life.

That means more of us on our own, responsible for in effect creating and managing our own personal pension plans.

Fortunately, the tax authorities in Canada have equalized the playing field between employer pensions and what amounts to your own personal pension: the RRSP or Registered Retirement Savings Plan. The better your pension, the less you can save in an RRSP. Those with no pension can put in
$21,000 in 2009 if they earn enough: and with no pension you’d better be maximizing your RRSP contributions!


Step 6.) Buy a Home.

Theo says several times that “the foundation of financial independence is a paid-for home.”

We all need a place to live and if you’re renting you’re still paying a mortgage: your landlord’s mortgage! Eventually, he or she has built up equity with your rent payments: you get to live there month by month but have nothing to show for it. In fact, the landlord will likely increase the rent each year to keep up with inflation.

Once you own a home and pay if off, your property taxes and maintenance expenses should come in at less than half what you’re paying out in rent. Of course, condos may also charge monthly maintenance fees.

The fastest route to a paid-for home is putting up a large down payment rather than take on the higher debt of a low-ratio mortgage. Once the emergency fund is established, keep maximizing contributions to the TFSA in order to accumulate a down payment for first home, preferably putting up 25% down payment.

Step 7: Pre-Pay the Mortgage.

Once you’ve bought your first home, the next thing to do is to eliminate the mortgage on it as quickly as possible. In chapter 5, You can’t always get what you want, there is a long section where Theo explains how powerful it is to pay off a mortgage as quickly as possible. Take advantage of 15% to 20% annual prepayment options to pay down the mortgage: ideally in five to ten years. Avoid 35 or 40-year amortization schedules which will result in paying interest up to three times the cost of the house. You want to pay HIGH weekly payments and pay off the principal as quickly as possible; especially in the early years of a mortgage when most of the payments go to interest, not principal. In the book, Jamie and Sheena pay off their mortgage in 13 years; certainly no record but enough to shave 100s of thousands of dollars in interest payments.

Step 8: Protect Your Family.

For newly married couples, check with a financial advisor about term life insurance and drafting a will. In the middle of Chapter 8, Could It Happen to Me?, a whole scene depicts the kind of family squabbles that can ensue when a parent neglects to prepare a will. Whole books have been written about this subject, notably The Family Fight and The Family War, by estate lawyers Les Kotzer and Barry Fish. You discover that family heirlooms like paintings or jewellery are as apt to spark such inheritance disputes as mere money.

The other main way to protect young families is life insurance. In the book, Sheena gets pregnant and a subsequent scene describes the importance of term life insurance for new families. The argument for life insurance is the Human Capital one Moshe Milvesky outlines in Are you a stock or a bond?

The biggest asset a young person has is future earning potential. As the decades go by, we convert our “Human Capital” into “Financial Capital.” But if you’re a young breadwinner and are unlucky enough to die prematurely, your family never realizes that financial capital. Life insurance meets that need should the worst happen.


Step 9. Teach Your Children.

Begin a Registered Education Savings Plan (RESP) immediately upon birth of children: $2,500 a year will maximize the Canada Education Savings Grant (CESG). Ideally set up a pre-authorized chequing (PAC) and put aside $208.33 per month per child into a low-cost equity mutual fund or balanced fund. Also consider maximizing the RESP to the tune of $4,000 a year per child or check with financial advisor about the pros and cons of advance lump payments. If term insurance has not yet been purchased, obtain some coverage, checking first to see if one or both spouses are covered at work.

Once you’re within five years of needing the money for university, you need to start moving the RESP’s investments slowly to GICs or ladder strip bonds. Four years out, you should put 25% into a bond maturing in August just before the child is headed for post-secondary education. Three years away, you put the second 25% etc. so that by the time school starts, market exposure is zero or minimal.

Step 10: Save for Big Consumer Purchases by replenishing the TFSA.

Traditionally, financial planners have suggested clients should save in advance for big-ticket consumption items like appliances, automobiles and renovations. In the old times some financial planners actually suggested clients stuff cash into various envelopes allocated to key long-term purchases. In modern times, a similar strategy uses savings accounts but until recently the interest they earned was taxed at the top tax rate, just like earned income.

Enter again the Tax Free Savings Account! The TFSA is a great way to save for these intermediate-term savings goals, even after the emergency fund and home down payment is taken care of. Aim for $10,000 per year per couple ($5,000 for singles). Check with financial advisor as to how to invest money in TFSA once short-term consumption goals are achieved.


Step 11.) Fill The Leaky Bucket

Once the $10,000 in TFSA has been used up, as well as the other two main registered tax shelters, the RRSP and RESP, you may want to consider investing additionally in a non-registered investment plan. This can probably wait until your mortgage on your primary residence has been reduced to zero, or at least if the principal has been cut in half. I call this the Leaky Bucket, a term that Mercer’s actuary Malcolm Hamilton coined. Obviously, the registered plans like RRSPs and TFSAs are non-leaky buckets. The leaky bucket has holes in it: tax on interest, dividends and often capital gains. Emphasize Canadian dividend-paying stocks and non-dividend-paying foreign stocks. [Foreign dividends should go inside RRSP or TFSA]. These decisions should be made with a financial advisor or financial planner.




Step 12: Develop Multiple Streams of Income.

Diversify further with multiple streams of income.

In the novel, Theo likens the dual employment income of Jamie and Sheena to a two-engined airplane. If one conks out the second can take you to safety.

Apart from employment income you can work a second job, create a business on the side, buy investment real estate and earn rental income, and creative types can earn royalties on art, music and literary creations.

And of course there is investment income and ultimately pension income. When all these streams of income exceed the income stream from a single employer, you know you’ve reached Findependence Day. After that, you’re working because you WANT to, not because you HAVE to!

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