We are continuing with the theme of debt repayment. Last month we reviewed how to choose between debt repayment and investing. This month we’ll explore two different debt repayment methods: the snowball method, and the avalanche method.

Snowball Method

The snowball method approaches debt repayment from a psychological and human nature basis by providing positive reinforcement. You repay the smallest debt balance first while making minimum payments on the rest. Then once you have repaid the first debt you tackle the next smallest debt and so on. You do not consider the interest rate of the individual debts. The snowball method focuses on providing wins and positive reinforcement as individual debts are paid off.

Avalanche Method

The avalanche method approaches debt repayment from an efficiency basis. You repay the debt with the highest interest rate first while making minimum payments on the rest. Once that debt is repaid you focus on the next highest interest rate debt. This method aims to minimize your interest costs and get you out of debt as quickly as possible.

Example

You have an extra $500/month you can use to repay debt (after minimum payments). You have the following debts:

• $4,000 student loan debt at 3.50%
• $1,000 line of credit debt at 7.00%
• $5,000 credit card debt at 19.99%

Using the avalanche method the debt is paid off in 22 months and total interest paid is $805.15. Under the snowball method the debt is paid off in 24 months and total interest paid is $1,729.37.

The avalanche method results in less interest and a quicker payoff period. The downside is that it takes about a year to pay off the first debt which may cause you to lose motivation and miss payments. The loss of motivation is even more likely when the debt balances are larger and the payoff periods much longer than what is shown in this example.

Under the snowball method you pay off the line of credit in just over two months and pay off the student loan in under a year. Paying these off provides positive reinforcement and keeps you motivated to repay the remaining debt.

Conclusion

Choosing between the two methods comes down to knowing who you are as a person and what motivates you. Honestly assess yourself. Will seeing individual debts being eliminated motivate you to stay on the journey? Or will knowing you are using the most efficient method be enough motivation for you?

Although we are partial to the most efficient debt repayment option (avalanche), the goal is to continually make progress paying off the debt and putting yourself in a better financial position. Having a good plan that you can stick to is more important than having the perfect plan.

Over the last 15 years this has been an easy question to answer. Unless it was credit card debt (or other high-interest debt) the answer was to invest and only make the required payments on your debt. Interest rates on mortgages were so low there was little financial benefit in paying them off early. With the rapid increase in interest rates over the last year the answer may not be quite so simple anymore.

In general, the best place to deploy excess cash is where it can get you the best long-term rate of return. This has usually been the stock market, for example the S&P 500 has an annual return of 9.0% since 1996 (source: McKinsey).  Over that period, it would have been a better decision to invest excess cash rather than to make extra mortgage payments.

The Financial Impact

Let’s examine what happens if you used $5,000/year to make extra mortgage payments or invested over the 15 years from 2008 to 2022.

	Mortgage repayment	Invest
Excess annual cash flow	$5,000	$5,000
Interest rate/rate of return	3.20%*	9.50%**
Number of years	15	15
Change in net worth	$94,400	$146,800

You would be $50,000 better off at the end of the 15 years if you had invested the money instead of making extra debt payments. This is 50% more net worth on the same $5,000/year.

While the decision to invest was easy over the past 15 years, things have become more nuanced with the increased interest rates. A five-year fixed mortgage is now at 4.50% or higher (source: Ratehub) and at the same time the average home price in Canada fell 12% in 2022 (source: Canadian Real Estate Association).

Other considerations

1. Risk-free return – The “return” from repaying debt is risk-free but the return from investing is not. If you make an extra debt payment you are guaranteed to pay less interest in the future but the return you get from investing can fluctuate and even be negative.
2. Anxiety/Stress – Large amounts of debt can cause anxiety and stress. There is often great relief knowing that all your debts are paid off.
3. Liquidity – If you have an emergency or opportunity, it is easier to liquidate your TFSA then to go and refinance your home.
4. Diversification – If all your net worth is tied up in the value of your home you are exposed to a large amount of risk if the housing market declines in your area. Meanwhile having a diversified investment portfolio protects you from industry specific or asset class specific risks.

Conclusion

Investing and paying down debt are both good uses for excess cash. Paying off your high-interest debt, such as credit card debt, is the priority. Afterwards the decision becomes more nuanced and personal.

Consider your personal appetite for risk and your relationship with debt. If having a large mortgage causes you anxiety and repaying it aggressively brings you peace and confidence, then that may be the best option for you. If holding mortgage debt does not bother you then investing has almost always been the better option to maximize growth.

The decision also does not need to be either/or, in fact it may be best for you to do a bit of both at the same time.

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* Average Canadian fixed mortgage rate from 2008 – 2022 (source: Ratehub)

**S&P 500 rate of return 2008 – 2022 (source: officialdata.org)

In our August 2022 blog post we reviewed the details of CPP and OAS. Now we can address one of the most frequent questions we hear from pre-retirees:

When should I start taking CPP and OAS?

This is an important question for those approaching retirement and the decision can dramatically change the chance of running out of money in late retirement.

Impact of Start Date on Benefits

Old Age Security – Benefits can begin anytime between ages 65 and 70

• For every month after age 65 that you start your benefits, your monthly payment is increased by 0.6% (7.2%/year). Maximum increase of 36% if started at age 70.

Canada Pension Plan – Benefits can begin anytime between ages 60 and 70

• For every month before age 65 that you start your benefits, your monthly payment is reduced by 0.6% (7.2%/year). Maximum reduction of 36% if started at age 60.
  • For every month after age 65 that you start your benefits, your monthly payment is increased by 0.7% (8.4%/year). Maximum increase of 42% if started at age 70.

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The benefits of delaying CPP & OAS are significant, yet most Canadians do not take advantage. In fact, the 2020 paper Get the Most from the Canada & Quebec Pension Plans by Delaying Benefits noted that:

• Over 95% of Canadians have consistently taken CPP at age 65 or earlier. Less than 1% of Canadians delay till age 70. Historically the most popular age to take CPP is age 60.

The author also calculated that:

• An average Canadian receiving the median CPP income who takes their benefits at age 60 rather than age 70 is giving up over $100,000 (in today’s dollars) worth of secure lifetime income. 
• By delaying CPP from age 60 to age 70 the average Canadian will receive over 50% more CPP income over the course of their retirement.

The results are similar with OAS. Most Canadians begin taking OAS as soon as they turn 65 and therefore give up a significant amount of lifetime income.

Why Don’t Canadians Delay Their Benefits?

There are many reasons that Canadians choose not to delay their CPP and OAS benefits, including:

Lack of advice – a 2018 Government of Canada poll found that more than two thirds of Canadians nearing or in retirement do not understand that waiting to take their CPP benefits will increase their monthly pension payments. (Employment and Social Development Canada, 2020)

Bad advice – much of the financial planning advice focuses on the “breakeven age” which is the age you need to live till to receive more money by delaying.

• This approach is misleading and doesn’t consider the largest risk for most retirees – the risk of outliving their savings (longevity risk).

Stability of CPP and OAS pensions – Canadians are concerned these pensions will not be around in the future

• CPP is one of the most stable pension plans in the world. Significant changes were made in the 1990s to the structure and funding to ensure stability. The most recent report on CPP (completed by the Office of the Chief Actuary) said the pension is sustainable for at least the next 75 years.
• OAS comes from general government revenues, so it is more vulnerable to cutting by the Canadian government. Yet seniors are one of the most important voting blocks in elections and reducing OAS benefits would be politically disastrous.

Fear and uncertainty – no one knows how long they will live so many opt to think in the short term and secure the money now rather than consider the long-term impact.

• The greater risk to most retirees is that they outlive their savings. The average life expectancy of a 60-year-old in Canada is now 86 years old. This means retirement savings need to last 20-30 years. Delaying CPP and OAS locks in a much higher secure income, thereby reducing the chance of outliving your money.

General Recommendations

1. Delay the start of CPP and OAS while fully employed.
2. It is more beneficial to delay CPP after age 65 than OAS.
   • Delaying CPP – increases benefits by 0.7% per month after age 65
   • Delaying OAS – increases benefits by 0.6% per month after age 65
3. High-income seniors should seriously consider delaying OAS due to the OAS clawback.
   • For every dollar of taxable income above the threshold ($81,761 in 2022) you must repay $0.15 of OAS income. By delaying OAS, you can avoid the 15% OAS clawback until age 70.

Conclusion

Most Canadians in reasonable health who can afford to delay their CPP and OAS benefits should do so. The biggest risk for retirees is not having secure income for life and delaying pension benefits can help address this risk. 

We encourage you to seek advice from an expert on your personal situation as the decision should be considered within the broader context of your retirement plan. Each situation is unique and deserves specific contemplation. We would be happy to help you if you have any questions or need help analysing this decision.

Citations

MacDonald, B.J., (2020). Get the Most from the Canada & Quebec Pension Plans by Delaying Benefits: The Substantial (and Unrecognized) Value of Waiting to Claim CPP/QPP Benefits. National Institute on Ageing, Ryerson University.

Employment and Social Development Canada (ESDC) (2020). Summary – ESDC Survey on Pension Deferral Awareness. Ottawa, ON: Government of Canada.

Office of the Chief Actuary. (2019). 30^th Actuarial Report on the Canada Pension Plan as at 31 December 2018. Office of the Superintendent of Financial Institutions.

The Canada Pension Plan (CPP) and Old Age Security (OAS) form the base of Canadian retirement income. If you are entitled to the full CPP and OAS pensions you can receive roughly $23,000/year at age 65 (as of 2022). These programs are not meant to supply your full retirement income and will need to be supplemented by retirement investments or other pension plans.

What is OAS?

Old Age Security is a monthly payment out of general government revenues. You can begin collecting OAS at any time between age 65 and 70.

Eligibility

If you are living in Canada, you must:

• Be 65 years old or older
• Be a Canadian citizen or legal resident at time of OAS approval
• Have resided in Canada for at least 10 years since the age of 18

If you are living outside Canada, you must:

• Be 65 years old or older
• Have been a Canadian citizen or legal resident of Canada on the day before you left Canada
• Have resided in Canada for at least 20 years since the age of 18

To receive full OAS benefits you need to have lived in Canada at least 40 years after age 18.

How much can you collect?

The 2022 payment is $666.83/month (8,004/year) if you began collecting at 65 and are eligible for the full amount. If you are 75 and over, an automatic 10% increase to your OAS was enacted July 2022.

For every month you delay OAS the benefit payment increases by 0.6% (7.2%/year) up to a maximum increase of 36% at age 70. If you delay benefits till age 70 the monthly benefit is $906.89 ($10,883/year).

Guaranteed Income Supplement (GIS)

GIS is an additional tax-free monthly payment for low-income seniors. Low-income in 2022 is considered below $20,208 if single or $26,688 as a couple (not including OAS/GIS income). The amount of benefit received depends on the net income of the previous tax year. To calculate your exact eligibility refer to the Government of Canada website.

OAS pension recovery Tax (clawback)

OAS clawback refers to the repayment of OAS benefits at net income levels over $81,761 (2022). For every dollar of net income above this threshold 15 cents of OAS is repaid. OAS is fully repaid at $134,253 (under age 75) or $136,920 (age 75 and over). Effectively this is a 15% additional tax on income between these thresholds, resulting in some of the highest marginal tax rates in Canada.

What is CPP?

Canada Pension Plan (CPP) is a contributory pension plan. All employees and self-employed individuals in Canada (except Quebec, which has QPP) contribute to CPP. These individuals then receive pension income in retirement.

Contributions

Employees contribute 5.70% of employment income with the employer matching the contribution. The maximum contribution for an employee is $3,499.80 (2022) and there are no contributions on employment income over $64,900 (2022). A self-employed individual must pay both the employee and employer portions; therefore, the rate is 11.40% to a maximum of $6,999.60 in 2022.

Investment Fund

Unlike OAS, the Canada Pension Plan is an independently managed pension fund. It is separate from government revenues/expenses and is managed by an arm’s length organization, CPP Investments. The mandate of CPP Investments is “to invest the assets of the CPP Fund with a view to achieving a maximum rate of return without undue risk of loss.”

As of March 31, 2022, the fund value was $539 billion, and the fund had a rate of return of 10.8%/year over the last 10 years. The investments within the fund are wide-ranging, from Canadian farmland to publicly traded companies and private equity.

The CPP Investment Fund is subject to actuarial review every 3 years by the Office of the Chief Actuary. This is a fully independent office that reviews various pension plans and social programs, including CPP and OAS, to ensure that they are stable, secure and being managed appropriately. The most recent report on CPP was issued December 2019 where it was noted that CPP is sustainable for at least the next 75 years.

How much can you collect?

The CPP benefits you collect in retirement are determined by three main factors:

1. Amount contributed annually
2. Number of years contributions were made
3. Age that pension withdrawals begin

To receive maximum CPP you need to have contributed the maximum amount for 39 years between 18 and 65. You can refer to your My Service Canada Account for your CPP estimate.

The maximum monthly amount you could receive if you started your pension at 65 is $1,253.59 (2022). Meanwhile the average benefit is $727.61/month in 2022.

CPP benefits can be started at any time between age 60 and 70. For every month before your 65^th birthday that you begin CPP benefits your pension is reduced by 0.6% (7.2%/year) for a maximum reduction of 36% if taken at age 60. Each month you delay CPP after your 65^th birthday increases your pension by 0.7% (8.4%/year) for a maximum increase of 42% if started at age 70.

Refer to the CPP website for further details such as post-retirement benefit, disability pension, survivor’s pension and more.

Differences

Although Canada Pension Plan and Old Age Security are pensions to support Canadian retirees, they have significant differences.

In our next post we will explore the benefits of delaying your pensions.

If there is anything we have learned the past few years, it is to expect the unexpected. From a worldwide pandemic to war in Europe to the highest inflation in decades; we have been confronted with large, unexpected events. This has driven home the importance of having a safety net to protect from these shocks.

An emergency fund is intended to protect you and your family from these shocks and help you weather financial setbacks without getting pushed off course. 

It will keep you from entering debt to cover unexpected expenses or tapping into your retirement savings to cover a work absence due to a month-long accident/illness. It is also there to provide peace of mind and free you up to be more aggressive with your other investments. 

An emergency fund is typically suggested to equal three-to-six months of basic living expenses. Depending on your situation it may make sense to have even nine or twelve months worth.

Figuring out your monthly spending means tracking your expenses for a few (at least three) months. If you cannot bring yourself to complete a full tracking of your spending then just average three months worth of your income (paycheque, pension, RRIF withdrawals etc.) to get a rough estimate of monthly needs.

Now you must decide how many months of expenses to cover. This depends on your personal situation and risk tolerance. Here are questions to consider:

• Is your job and pay stable? If no, then the higher end of the range would be better.
• Do you often worry about money? If money is a significant stressor for you, then have a larger emergency fund.
• Are you a one-income household? If yes, then yet again, have a larger fund.
• If retired, is most of your income from guaranteed sources (pension, CPP, OAS)? Yes, then a smaller emergency fund is reasonable.

These are just a few of the relevant considerations when determining the size of your emergency fund. Keep in mind your emergency fund shouldn’t be too large either. It is only to provide safety for financial shocks, it is not meant for long-term investing goals.

Where to Keep your Emergency Fund

The most important characteristics for the emergency fund are liquidity (easy accessibility) and safety from loss. If you can earn a small return, even better. For these reasons keeping it in a high interest savings account is ideal. In a chequing account you won’t earn any (or much) interest. Also, a locked-in product is not a good fit. An emergency fund is useless if you can’t access it when an emergency arises.

Most banks will offer a high-interest savings account and online banks tend to have the best rates. There are also mutual fund and ETF high-interest savings accounts available.

Don’t keep your emergency fund inside of your RRSP/RRIF as you will need to pay taxes when you withdraw the money. If you have TFSA room, it can be kept there, but you will eventually use your TFSA to hold long-term investments.

NexT Steps

To begin building your emergency fund, start by setting up automatic weekly, biweekly or monthly withdrawals from your chequing account that go straight into your high-interest savings account.

​Once your emergency fund is fully funded move on to paying down debt or investing for other goals. Do not skip setting up an emergency fund, it is an essential step towards healthy finances and reduced financial stress.

Even if you have not heard of dollar-cost averaging there is a good chance you have used it in your investment portfolio or through an RRSP at work. It is a powerful investment strategy during the accumulation stage of your financial life.

What is Dollar-cost averaging?

It is the system of investing a fixed dollar amount at regular intervals (monthly, weekly) to purchase investments. Here is a quick example to explain:

You decide to save $500/month and set up an automatic contribution to your investments. Here are the purchases for the first three months.

Month	Contribution	Cost per unit	Number of units
January	$500.00	$50.00	10
February	$500.00	$30.00	16.67
March	$500.00	$40.00	12.50
Total	$1,500.00		39.17

After the purchase in March, you have 39.17 units and a total investment of $1,566.80 (39.17 * $40.00). Seeing the unit price decline 20% from January to March, you might assume that you lost money. In fact, you are up almost $67 or 4.45%. This is because dollar-cost averaging automatically makes you purchase more units when an investment is “on sale” and buy less when it is expensive. This is the beauty of dollar-cost averaging, it uses the volatility of investments to your advantage.

Other Benefits

A big benefit of dollar-cost averaging is the simplicity to implement, all you need is to determine the amount you can regularly contribute and then you leave it on autopilot. It also helps form the habit of regularly and automatically contributing to your investments.

Dollar-cost averaging helps to control the emotional response when volatility inevitably strikes your investments. When your investments decline in value you can know that you are taking advantage of this decline by buying more “on sale”. This reduces stress and regret through the volatility inherent in long-term investing.

Most importantly dollar-cost averaging removes the decision on when to invest because it is on aut0pilot. It is no longer necessary to spend time wondering “is now a good time to invest? Or should it wait till next week or next month?”. This automatic approach reduces the stress around the timing of contributions and stops the futile attempts to time the market.

The Other Option

Without the scheduled contributions of dollar-cost averaging you must make the decision on when to invest each contribution. This inherently leads to trying to time the market with your contribution. Using the same investment as above; here is an example of what can happen when not using dollar-cost averaging.

The first month you don’t want to put the money in as you don’t know where the market is going, so you save the $500. In the second month you don’t want to invest in something that just lost 40%, so again you wait. Now you have $1,000 in cash and no investments. In the third month you see the investment increase to $40. Now that it is moving in the right direction you invest. Good thing you didn’t buy at $50, too bad you didn’t buy at $30.

In this example you end up investing the same $1,500 but you only have 37.5 units at the end instead of 39.17 units. You also missed any dividends or interest paid out by the investments in the first two months. The worst part is that each month (or week or day) you must decide if you are going to invest or wait for the market to drop/increase. This is a mentally exhausting way to invest. It is impossible to consistently invest at the “right” time, so there will inevitably be regrets on the timing of your investment.

Conclusion

Dollar-cost averaging is a high-impact contribution strategy that is simple to implement and reduces stress and regret. It is a great fit for long-term investment goals that require regular contributions over an extended period of time (ex. retirement).