Category: LinkedIn

My 3-reserve approach: Emergency–Bridge–Buffer

[This article also posted to Linkedin here]

Last week I posted a comment on social media linking back to an FP Canada survey that noted, among other interesting observations, that “almost four in 10 (37%) Canadians say they rarely or never put money aside in an emergency account.”

In my cover comment, I mentioned that I myself had three types of such funds or reserves – emergency, bridge and buffers – and that they served me well recently when I was going through career transition. (For those not familiar with the latest lingo, that means I was between employers.)

Someone asked me what I meant, and how I quantify those. I gave a short response (it being fleeting social media), but thought I’d provide here a bit more detailed explanation of how I view and use these three types of reserves.

What’s your emergency?

The problem with a blanket emergency fund is that most people don’t define what constitutes an emergency.

The classic  ‘I’ll know it when I see it’ view is no help. That could make it anything from just a slush fund – as in literally, ‘I could really go me a slush on this hot day’ – all the way up to it never being touched because it would require worldwide armageddon.

In my 3-part distinction, an emergency is something that is truly unexpected due to its nature and/or timing, that demands an immediate and significant financial response. It’s a medical diagnosis no-one expects, or property damage beyond what you reasonably insured for, or maybe even a new addition to the family well after you’ve auctioned all the stuffies on Kijiji.

So, mea culpa, I’m not giving it a specific definition myself. I am however setting aside an amount every week (which was reduced but not paused during career transition) so that we’re prepared for that non-ventuality. If that emergency doesn’t come as we’re nearing our work-optional threshold, it may accelerate that date a bit, keeping in mind (and keeping in reserve) that emergencies can happen at any life stage.

A bridge to … when

I started with the emergency fund above, in keeping with what people expect to discuss as the primary reserve. I too have written using this umbrella reference. Getting more nit-picky on how I parse it out personally, what many people call an emergency fund, I call a bridge fund. So despite that I’m writing on it second, I believe this to be the first priority topic and target among the three.

It’s a bridge fund because it allows you to keep moving forward in your life journey when the road beneath you has been washed away.

With all due respect to thumbnail wisdom, an arbitrary target like 3 or 6 months has nothing to do with specific circumstances, though I wouldn’t argue against this as impetus to begin funding one’s reserve.

Ideally your bridge fund is based on how much time it takes to get re-situated or re-employed, based on a clear understanding of yourself, your skills and the state of your industry. That’s on the income side, or more aptly the absence of income.

Express that in terms of weeks and multiply it by your ‘lean budget’ (deferring discretionaries and luxuries), and there you have your accumulation target. Now determine how much you can devote to that from your current weekly budget and that tells you how long it will take to get your bridge fully funded.

Buffering up the budget

The last component – buffering – is a practical application of the budget categories we use to keep our financial lives in order. I’ll assume here that you are not just using a single current/chequing account for all purposes.

For me, there are about 10 major categories, with 50 or so individual line items. Of these, a couple dozen warrant their own distinct sub-account at your favourite financial institution. Though I’m paid bi-weekly, there is an auto-transfer from my main account to each of these sub-accounts, regardless whether I expect to spend anything that particular week. For example, my electric bill is paid monthly, but the account gets a weekly drip.

Now here is where the buffering comes in. My spreadsheet sums actual past monthly amounts in each category to arrive at an average monthly cost. (I update about quarterly.) This then is divided by 4 for the weekly drip. The benign deception (to myself) is that though I’ve effectively divided by 48, the drip occurs in every one of the actual 52 weeks. Thus each account is modestly indexed by about 2% over the year.

It’s a small and almost unnoticeable cost for me to pay (myself) over the year. In truth, I started doing this as a way to slowly index for year-to-year inflation, rather than having an unpleasant surprise that shocks the budget and knocks my resolve every January.

And yes, I do skim out some from the accounts occasionally, but I haven’t been compelled to top-up any of them in any serious way. In fact for the larger ones, like the appliance account, it’s a couple months ahead of need, despite having to use it for its intended purpose twice this last year.

That’s it, three ways that I use reserves to create comfort space in my finances.

3 thoughts on establishing your emergency fund

Published version: Linkedin

For a long time, we didn’t have an emergency fund, though we’ve had a line of credit (LOC) for quite a while.

Our household budget was within our means. We were operating fine in our regular spending routine without having to check when payday was coming. There was also a fair amount of reserve that had built up in the separate accounts we’d established for each of the major expenses.

It wasn’t for fear of holding money in no/low-interest cash that might otherwise be making investment income. No, that’s exactly the effect of those individual accounts anyway. Rather, we were confident in the arithmetic, and didn’t think there was a need to have that one account.

It wasn’t until we had to dip into one of those reserves to replace an appliance that our perspective shifted: Large though that reserve had become, it had a defined purpose and calculated amount that would eventually deplete it. Emergencies aren’t like that.

1. The why of an emergency fund

An emergency fund isn’t about being budget-conscious; it’s about potentially being UNconscious, indisposed and/or impecunious at a time when there remains a budget to be serviced. It’s about you and your ability to be the continuing funding source for your household.

It’s also about being able to respond to large, unexpected expenses. Be careful though not to confuse that with the major expense reserves mentioned above. Years will pass before those needs may arise, but while the exact timing may be unexpected, those remain inevitable.

At the other extreme from normal budgeting are unlikely things such as catastrophic property damage, permanent disability or death. Insurance is for those remote-risk/high-peril events. Between those two is where an emergency fund is situated.

2. LOC or emergency fund – What’s your gut feel?

Part of my own early confidence lay in the fact that as the mortgage was being knocked down, we’d set up a substantial line of credit. It was more than sufficient for the 3 months – or even 6 or 12 months – worth of accessible funds variously suggested to bridge until things would be expected to normalize after an emergency might hit.

But over time I became more familiar with my own emotional relationship with money. Ever since I had a mortgage … I didn’t want one anymore. Though we lived contently and made appropriate allocations to retirement and children’s education savings, the extra dollars were put toward trimming that large liability. That was the mindset and routine while in the midst of stable finance and balanced emotion.

So, how might I feel in a future time of monetary and mental stress, being compelled to dive deeper into debt? Not good in all likelihood. In fact, that prospect could easily exacerbate the impact of any emergency that may in fact arise, and extend out the recovery time. For us, that was when the formal emergency fund took shape, while maintaining the line of credit as the next line of defence.

That’s our family, not necessarily yours. Still, you would do your future-self a great favour by taking the time while things are rosy to contemplate how you will feel when things are not.

3. Deciding your __ months of money?

Assuming you’re committed to the purpose, the first action question to address is how much will you accumulate in that fund? The commonly suggested proxy is, as mentioned above, a certain number of months’ worth of accessible funds. But how many for you: 3, 6, 12, more?

As the timing and extent of an emergency is unknown, there is no formula to provide you with a definitive number. A practical approach is to focus on the most likely of those unlikely events: an employment gap, whether of your own choice or initiated by your employer. Knowing yourself and the industry where you work, how long do you think it would take to get re-situated? Other factors will come into play, like severance pay and employment insurance, but start here as a rough target.

Second, be clear about what this number of months means. In theory it is lost income, but more importantly in an emergency situation, it is the amount of spending that has to be replaced. The two are connected, but the latter continues even in the absence of the former.

Fortunately, unless you’ve been living excessively, your spending will be less than your earnings. Look back at your bank and credit statements over the last year. Take out the truly extraordinary things, and deduct items you can suspend or defer, at least in the short term. This is the monthly average to multiply by your chosen number of months to give you a target.

Third, how much will you regularly deposit into your emergency fund? By “regularly”, I mean weekly or in alignment with your pay cycle, which brings us back to your budgeting. As remote as an emergency may be, you need to assign a percentage or dollar amount that you can commit to, even if that’s a small figure.

Here then is another gut check: Divide your accumulation target by your weekly deposit commitment to tell you how long it will take to get there. If you’re feeling a knot forming in your abdomen, you may want to bump your commitment. Balance that against the discomfort of the current budgetary sacrifice to arrive at a manageable medium.

With a line of credit at your back along the way, you now have a process, timeline and dollar target to get your own emergency fund in place.

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

Published version: Linkedin

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.