“Giving up” on saving? Don’t embrace this kind of defeatism

From time to time I see some in the media asking the question whether people are “giving up on saving.”  This was the thesis of a Maclean’s cover story last year and a version came up this week in the Financial Post.  It’s not a stance I sympathize with, which is why  I wrote a version of today’s blog earlier this week at www.moneysense.ca.

Here, I’ve reproduced and expanded on that blog.

It’s a free world of course and everyone can choose to maximize consumption today, even if it means paying more tax because of foregoing contributions to tax-assisted retirement plans (RRSPs in Canada, or in the United States, contributions to IRAs or 401(k)s.)

But giving up on saving does have consequences. This choice means you’re also giving up on more consumption in the future, and giving up the chance for freedom (or financial independence) while you’re still young enough to enjoy it.

People are perfectly free to spend to the full extent of current income but leaving no margin for error for job loss or other emergencies is just plain foolish. Any financial planner will tell you that enough savings to last six to nine months without employment income is the minimum prudent emergency cushion—an amount that can now be well taken care of by the cumulative $25,500 in TFSA contribution room now available to any Canadian 18 years of age or older. (For the benefit of any American readers, the Tax Free Savings Account is the equivalent of Roth plans, although TFSAs were only introduced in 2009. Same idea but different rules. See also note at end of blog).

Alternative is working till you drop

Beyond the customary emergency savings, giving up on saving for longer-term goals like retirement really means resolving to stay in the workforce (employers and circumstances permitting) right until 65, or 67 in the case of younger people. Indeed, the November issue of MoneySense did show how people can retire in luxury merely by finding a low-cost place to live (most of them outside the country) and living off such government income sources as CPP, OAS and GIS (in Canada) or Social Security (in the US).

While such a strategy is theoretically possible, “luxury” is a relative term and relying only on government money in old age strikes me as dangerous from a diversification point of view. In the U.S. in particular, given the nation’s parlous finances, putting all your eggs into the basket of Social Security seems an overly optimistic gamble. Not for nothing do the financial gurus counsel a three-legged stool that also includes employer pensions and private savings and investments, not to mention part-time work, real estate income and other “multiple streams of income.”

Frenzy of Rationalization

In the end, taking a defeatist attitude to saving is just making excuses. Blaming low interest rates or volatile stock markets is what my wife and I dub “a frenzy of rationalization” or FOR. It’s true that young people today have far more financial temptations than did the baby boomers: we never had to budget for cell phone plans or Internet access, nor were we under pressure to constantly upgrade to newer and better smartphones and other technological gadgets.

But again, if your perceived “needs” exactly equal your income, then the best you can hope for is to break even financially as the years pass, and that assumes steady employment. Lose that source of income and the trouble soon begins. Saving and investing means ultimately benefiting from the magic of compound interest (or compounded reinvested dividends). Giving up on saving and falling into debt should unemployment strike means the reverse and negative outcome: being subject to the disaster of compounding debt—and unfortunately, the interest rates that seem so minuscule if you’re a creditor turn out to be very high if you’re a debtor.

Far better to be a net beneficiary of even modest interest and dividend income than a victim of it. And that’s why, even though I’m personally on the cusp of Findependence I’m still not giving up on saving.

US edition of Findependence Day nearing publication

If you’re reading this blog, you shouldn’t need an explanation of the word Findependence, since this entire web site is dedicated to the book, Findependence Day. The original novel described here can be considered North American in scope but it has a lot of Canadian content with just a sprinkling of U.S. material. This will be rectified in a few months time when I’ll be releasing a new all-U.S. second edition of the book.  Watch this space for  updates on that.

New year, new TFSA room & giant step to Findependence

A belated Happy New Year to all readers and a reminder that every adult Canadian can take a big step this week towards their ultimate financial independence. I refer of course to the fact we can all contribute another $5,500 to our Tax Free Savings Accounts (TFSAs), bringing the total cumulative room to $25,500 (going back to the program’s launch in 2009). For the benefit of any American readers, Canada’s TFSA is the equivalent of the U.S. Roth plans, albeit with different rules.

In other words, if you acted at this time each year, you’d have contributed $5,000 in each of 2009, 2010, 2011 and 2012. Now that it’s 2013, the annual limit has been raised to $5,500, the first time the limit has been adjusted to accommodate inflation.

Of course, assuming you invested wisely in each of those years, your balance should by now be well north of $25,500, and in some cases may have grown past $30,000.

TFSAs a particular boon for young people

I truly believe that maximizing the TFSA is the single biggest step Canadians can take in their quest for financial freedom. As we noted in Julie Cazzin’s “Make Your Child a Millionaire” feature in the current issue of MoneySense, the TFSA is especially a boon to young people because they have such a long investment time horizon ahead of them.

Unlike RRSPs, which require earned income the prior year, an 18 year old can qualify for the full TFSA $5,500 limit this year (they may need parental assistance to come up with the money, but that’s permitted by the rules. Think of it as a tax-effective early inheritance!). Not only that, but they can contribute to TFSAs well into old age, unlike RRSPs, which end after age 71. You better believe that half a century of maximizing TFSAs and investing wisely will mean multi-millions down the road.

Do this right from the get-go and you may not even have to worry about RRSP contributions, although those in higher tax brackets should probably do both.

But how to invest wisely? For the young in particular, but also older people seeking income, I think equities are the only way to go in TFSAs, especially with interest rates being so low as they are now.

I’m all for international investing but if you already have lots of RRSP contribution room, I’d use the RRSP for US dividend-paying stocks, since the tax treaty shelters Canadians from the 15% foreign withholding tax.

Despite the “tax-free” moniker, TFSAs won’t stop you from being dinged by that tax on foreign securities. For this reason, I like TFSAs for Canadian dividend-paying stocks. Yes, I realize the dividend tax credit makes Canadian dividends a good choice for non-registered (taxable) accounts, since the tax is roughly half what it is on interest income. However, Canadian dividends also result in the annoying “gross-up” calculation come tax-time, and such phantom dividend income can ultimately hurt you on the OAS clawback. And to me, zero tax is preferable to even a “low” rate of tax, especially if you plan to reinvest those dividends.

Canadian Dividend ETFs are my choice

For all these reasons, my personal choice for TFSAs this year are Canadian dividend-paying ETFs. A year ago, when it was part of the Claymore family, I publicly stated that the iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ/TSX) was a tempting choice, at least for those who already have plenty of exposure to the big Canadian banks.  To be included in that index a stock has to be a common stock or income trust listed on the TSE and have increased dividends for at least five consecutive years.

This year, there is a valid new alternative from Vanguard Canada: the Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY/TSX). The management fee on VDY is just 0.30%, half the 0.60% of CDZ. (MER is 0.67%, we don’t yet know what VDY’s MER will be). But keep in mind that VDY amounts to a big bet on the major banks: a whopping 59% of the ETF is in Canadian financials and in fact the top four holdings are all the big banks.  CDZ has much less exposure to financials (just 21%) and minimal exposure to the big six banks in particular.

Half and half is one compromise

One way to go might be to split your contribution between both ETFs: say $2,750 in each. Remember, though, this assumes you have plenty of US and foreign stock exposure in your RRSP. Younger people for whom the TFSA comprises the lion’s share of their wealth should strive for plenty of US and foreign stock exposure through similar types of ETFs. We’ll be looking in depth at these in the next issue of MoneySense, currently in production.