The Most Valuable 5 Words in Financial Planning

The 3 Savings Approaches

First, we need to recognize that if you’re going to save instead of spend your hard-earned money, there are fundamentally only three savings approaches.

  • ad hoc
  • automatic
  • forced

To illustrate the “MAX your RRSP Strategy” concepts, let’s consider Typical Ted. Like the majority of investors, Typical Ted uses an ad hoc savings approach. This means that he only invests when he has cash available and is in the mood to save.

But the ad hoc savings approach is the least effective, by a country mile.

If Ted is focused on retirement, but has already spent everything on Christmas or a trip down south, he saves nothing. Likewise, if Ted comes into some money but his priority is on renovating the kitchen, again nothing gets saved.

Unfortunately, the ad hoc savings approach is the most common. Partly because investors aren’t taught better ways to save. But mostly because of Newton’s first law of motion.

For those who found more interesting things to learn in high school than physics, Newton’s law of inertia basically means that things tend to keep doing what they’re already doing. If it’s not moving, it stays where it is. If it’s moving, it keeps going until something causes it to stop.

But Ted can use Newton’s law to his benefit.

The Most Valuable 3 Words

If saving for retirement is truly important to Ted, he could “Pay Yourself First” and use an automatic savings approach.

Without question, the most valuable three words in all of financial planning are to “Pay Yourself First,” now conveniently compressed to the acronym PYF.

Setting up a pre-authorized contribution plan to automatically save, say, 10% of your income each month, is the easiest way to build a retirement fund.

Once started, you can simply “set it and forget it.” Newton takes care of the rest.

A one-time decision to automate the implementation of any good idea is a great way to produce long-term benefits without any additional effort.

Since every good introductory book on financial planning appropriately hammers this point home, ’nuff said.

A one-time decision to automate the implementation of any good idea is a great way to produce long-term benefits without any additional effort.

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Locking in Savings Discipline

An automatic, Pay Yourself First savings approach is great. But it’s not perfect.

It’s vulnerable to, well, human nature.

If you own a boat, and your neighbour gets a slightly larger boat, let’s face it. You need a bigger boat! And your monthly savings plan is at risk.

But you’d continue to make your mortgage payments, and payments on other loans like a vehicle, because you don’t have a choice. These payments are “forced.”

A forced savings approach is where you pay off an investment loan. Like borrowing to own a house or a car, you borrow to own a larger investment that is paid off over time.

Like making mortgage payments, a forced savings approach locks in a higher level of discipline and commitment.

Once started, the probability that you stick to and finish the plan is very high.

As long as the amount borrowed is well within your financial and emotional capacity, a small forced savings plan can be a behaviourally effective way to reduce the risk that your retirement savings are “temporarily” suspended, perhaps because your neighbour gets a bigger boat.

A Simple Way to Boost Retirement Savings

Now let’s introduce MAXing Mary, Typical Ted’s inspirational role model.

After attending an investment seminar 10 years ago, Mary learned about the benefits of automatic savings and more importantly, ACTed on it.

She set up a Pay Yourself First plan a decade ago when she was earning $50,000 a year. She started saving 10% of her income, or $5,000 a year, with monthly withdrawals from her chequing account into an RRSP. For brevity, let’s call this a PYF 10% plan.

Now, through cost-of-living increases and a promotion, Mary was earning $60,000. Without realizing it, she was saving less than 10% of her income. She was still diligently saving $5,000 a year, but her PYF 10% plan meant she should have been saving $6,000.

She had unintentionally downgraded to a PYF 8.3% plan. And it was going down every year.

If Mary recognized this, she could have made ad hoc increases to her savings plan each year to maintain her initial commitment to save 10%.

But we know the behavioural risks of ad hoc approaches. On a good day, they are inconsistent and unreliable.

Just like it makes sense to automatically save, it makes sense to automatically inflate your savings plan each year, by default, to keep up with your income. This typically means following the inflation rate. More if you’re earlier in your career and advancing to higher incomes.

If you don’t, you end up saving less than intended. Inflating to maintain your initial savings rate is a simple way to boost your retirement savings — without sacrificing your standard of living.

In the last few decades, the inflation rate in Canada has averaged about 2%.

As valuable as the 3 words “Pay Yourself First” are, I think we can all agree that it’s time they were upgraded to the most valuable 5 words in financial planning: Pay Yourself First and inflate. Using our shorthand notation and recommended savings levels, PYF 10% should become PYF 10% and inflate 2%.

EXAMPLE

Mary was 35 years from retirement when she started saving. If she averaged 5% returns, her PYF 10% plan of investing $5,000 annually would have grown to about $460,000. By simply maintaining her savings commitment with a “PYF 10% and inflate 2%” plan, her retirement fund would be almost $600,000 — 30% more or about an extra $140,000. 

If Mary wanted to automatically boost her retirement fund, perhaps because she started late or was behind in her retirement plan, she could inflate her savings plan by more than 2%, with a negligible impact on her lifestyle.

Invest $5,000/yr initially, 25 years, 5% returns

Mary is now 25 years from retirement and the chart shows the impact of different inflate rates. Compared to the typical uninflated savings approach, this simple change of inflating 4% instead of 2% would increase her retirement fund by over 50% instead of 22%.

While the ability to automatically inflate her savings wasn’t available when Mary started her PYF plan, the good news is that several investment companies now have that option. Recognizing that this simple upgrade is a win-win that benefits both savers and investment firms, I’m optimistic that it will be available with all savings plans soon.

A Fundamental Change to Retirement Savings

It is important to note that adding “and inflate” to the Pay Yourself First concept does much more than provide a simple way to boost your retirement savings. It fundamentally changes how we think about long-term savings in several important ways.

First, while the idea to “PYF 10%” might implicitly assume that Mary increases her monthly savings as her income rises, this is generally not thought of when the savings plan is started. And in the past, it couldn’t be automatically implemented.

Defined Contribution plans and the like, where you save a specified percentage of your income through your employer, are the exception.

For these reasons, it almost never happened.

By changing our default thinking about long-term savings to include automatic inflating, the more natural way of saving a portion of one’s income becomes standard practice. Retirement funds are boosted, benefiting everyone involved.

Second, the current savings thinking that excludes inflating makes saving for long-term goals unrealistic and more difficult than it really is.

Countless investing articles about the power of compound growth illustrate saving a constant amount over a period of 30 or 40 years. Clearly, saving the same amount for decades is not reasonable, even in the most stable of economies where inflation is low.

Worse, the standard approach of not inflating savings erroneously exaggerates the initial savings amount required.

EXAMPLE

Let’s say you’re 25 years old and want to save $1,000,000 by age 65. If we assume 6% returns, you’d have to save $525 a month, or $6,300 a year, for 40 years. If you inflated your savings by 2% each year, you would only have to save $402 a month initially, or 23% less.

Automatically inflating your monthly savings is the easier, more natural way to save for retirement.

Not including inflating in a savings plan could cause some to conclude that the amount required is too onerous.  Based on this, some might defer starting to save or save less because they believe their retirement goals are not achievable.

And the opposite is equally true. By integrating the concept of inflating, achieving long-term savings goals is perceived to be, and actually is, easier than we previously thought. 

Automatically inflating your monthly savings is the easier, more natural way to save for retirement.

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I hope that I have made it clear that including the concept of inflating in every discussion and plan for long-term savings should become standard and the default way of thinking.

Unfortunately, there are barriers to this happening, despite the benefits to everyone.

It will take time for all financial firms to add an automatic inflating option to their savings plans.

It will also take time for the “new” approach of inflating savings to become understood and overcome the inertia of current practices.

Automatically inflating your Pay Yourself First plan was one of the 150 strategies in my first book “Financial Freedom Without Sacrifice.” See page 201.

The book was first published in 1993, over 25 years ago. Despite having sold over 145,000 copies, mostly to the financial industry, most investment firms still don't have this option for investors, even though it would benefit their clients and increase their business.

Please help me change this.

If you agree that inflating should be fundamental to long-term savings, spreading the word can speed up these changes.

In addition, the standard calculation tools used for financial projections do not currently include an “inflate by” parameter.

Every spreadsheet and financial calculator can easily determine what your savings will be worth in the future when contributions are the same forever. But none of them account for inflated deposits.

To help address this gap, I’ve created a simple “RRSP Gross Up Wizard” spreadsheet to do inflated financial projections, and more, for free. This free tool is a subset of the more powerful “MAX your RRSP Strategy” software that has to help you understand and quantify the benefits from all of the strategies in this blueprint.

Now that we understand the most valuable 5 words in financial planning, we can get back to pasta and introduce the “can’t lose” strategy that can increase your RRSP income 25-100%.