Step three creates financial resources that supply income.
Even while you were busy laying the ground work for your plan in Step 1 and reducing debt in Step 2, this area has been growing. Employer and government pensions. People tend to see these charges to their paycheck as expenses and that is a mistake. To get some sense of value, you must learn a little arithmetic. In particular the net present value of future payments idea.
Use numbers to help you understand meaning.
For example. I offer to pay you $1,000 per month beginning next month and I further agree to do it for as long as you live. If you are male and 65, I will assume you will live 17 years and if I make the same deal with 100,000 or so other people like you, it will work out. How much capital today is equivalent to the value of all those payments?
The idea is that money receivable next year is worth less than money to be received now. If interest is 4% then $1,000 a year from now is worth $961.54 today. With a 17 year life span, (204 months) there would be a lot of calculating to do, but there are tools available. A spreadsheet or a financial calculator can do the calculation in seconds. The pension is worth $148,647.29.
If you are 30 now the value of that pension today is $37,670. When you are keeping track of your progress be sure to include pension and other similar benefits. You must keep track! The results will encourage you a little because your financial world can look pretty bleak while you pay off debt.
There is an ongoing question about which is better. Pay off a low rate mortgage or invest in a personal pension plan. (RRSP in Canada) The answer is, it depends. You can analyze the decision but it is a little too sterile for real life. The general parameters are you must invest in the RRSP to yield more than the mortgage interest rate and lower rate tax payers tend to be better off paying down mortgages.
In real life there are two factors to consider.
- If seeing your investments grow motivates you to save, then the RRSP is a better choice.
- If getting the technically highest, riskless, rate of return matters, then paying down debt is likely better.
You should know the answer to this question. If you have $100,000 in your RRSP and owe $100,000 on your mortgage, would you be happy or sad if rates became 10%?
Investing the money is a different question. Investing depends on what you want the money to do and when you need it. What works at 30 is likely wrong at 60.
The stock market works well and produces higher and more predictable returns than do bonds, but only if you have a long reference frame. You will need to do some research. Andy Martin’s book Dollar Logic is a good place to start.
When you know what you want, what you have to get it with, and when you need it, the question becomes solvable. Do not forget the Step 1 requirement to develop a team of advisors. Have them help you with the decision and the arithmetic.
It is just organized common sense, but sometimes a little fussy on the data collection side. Be brave.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
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