Today we tell the story of a fictional (but realistic) man named Eugene. Eugene has a job that pays him a decent salary. Eugene is a follower of this blog, and because he is a smart guy and wants to improve his personal finances, Eugene started "Doing his numbers" right after reading the onfilandtime.com blog post on the Doing the Numbers.
Eugene spends less than he earns. He sees a growing surplus every month in his bank account, and he sees from his monthly numbers practice that this surplus will keep growing if he keeps doing what he's doing. Also, he maybe continues to look for a few more places to make his finances even more efficient. The problem is, Eugene doesn't know what to do with this growing surplus of money. All he knows is that he wants his savings to grow so that he can eventually afford to retire, or perhaps fund some major purchase down the road.
His bank sends him advertisements to put his money into a "high interest savings account", and that sounds like a good thing because he knows that over time, interest could help his balance grow, and he doesn't want it to just sit in a checking account earning no interest.
But wait! Interest rates of HIGH interest savings accounts aren't high at all! In fact, they are abysmally low! After comparing the interest rates on the best savings accounts in Canada (Ratehub.ca), Eugene finds that the best published big bank high interest savings rate is 1.25% per year1. He sees that he could do a bit better at 1.55% by opening an account with "Saven Financial"2, but he has never heard of that bank before, so he decides not to make a decision on that right away.
"Besides", says Eugene, "I'm trying to put my money somewhere it will grow! Isn't 1.55% still lower than inflation?"
Yes smarty pants Eugene. 1.55% is lower than inflation. In fact, from June 2020 to June 2021 the Canadian Consumer Price Index (meaning inflation) rose 3.1%3. In other words, even if you put your money in the savings account with the highest published interest rate in Canada, that interest rate is only HALF of the amount of inflation, so your hard earned savings will still be getting less and less valuable over time. Clearly a savings account is not the solution Eugene is looking for.
Before we go on, I want to dissect that 1.25% big bank savings rate that was published because I find it's rare for a big bank to have a rate that competes with some of the online banks [Like EQ Bank, which is known for it's higher savings interest rate and also happens to be posting 1.25% on ratehub.ca. On further inspection at the bank website4, it appears that 1.25% is a PROMOTIONAL interest rate, and in fact that rate only applies for the first 120 days (4 months) of the account being open. Thereafter, the interest rate on the account drops to only 0.05%. Which means after the promotional period is done, you'd get a whopping 50 cents of interest for every THOUSAND dollars in the account. And on their web site the bank uses phrases like "Maximize your savings", "best savings offer", "High interest", and says this is the perfect account to "grow your savings" for a big purchase like a vacation, a new car, or your degree.
Luckily, Eugene sees through this smoke-and-mirror show and doesn't open up a savings account at his bank to grow his money for the long term. Eugene is fortunate that he paid attention in his elementary school math class when they talked about percentages, and Eugene is also wary of corporate advertising. Not all Canadians are so lucky. There is a large portion of the Canadian population who either don't understand math very well, or simply follow their bank's advice about what to do with their money.
For decades, banks have been putting out TV advertisements showing happy working people going into their banks, giving something to a smiling bank employee, and then later on sipping champagne from fluted glasses while watching the sunset from the beach, a boat, or a cottage. Bank advertisements use phrases like "we can help", and "you're richer than you think", in a bid to make you think of them as the ones who can help you to reach your financial goals. And MOST PEOPLE BELIEVE IT. In fact, when Eugene went shopping for a rate on Ratehub, he was of the minority. Most people wouldn't take this extra research step. They would go to their bank, ask where to put their money, and be directed to a bank product such as the savings account.
The lesson here is, don't blindly trust your bank. Banks and investment houses aren't in business to make you money. They're in business to increase their profits, and to give their shareholders fat dividend checks. In fact, when they say things like "you're richer than you think", they know exactly how rich you are, and they want to slowly move some of your money onto their own profit line. Be smarter.
Don't get me wrong, I think there is a time and a place for using certain bank products. In full disclosure, we have some bank products ourselves for certain purposes (no-fee checking accounts and low-cost borrowing accounts/mortgages). But at this time, bank savings accounts in Canada are NOT good places to put your money to grow. Nor are GICs (Guaranteed Investment Certificates) which max at 2.4% (Ratehub) for a 10 year term. Note that this is also below inflation. In other words you are "guaranteed" not to grow your purchasing power if you buy a GIC.
So far it's clear we can't trust our big banks to always provide advice and products that are in our best interest. And Eugene still hasn't found a place to put his growing surplus of cash where it can grow. Because Eugene is new to investing, he doesn't really know where to turn. But he asks the right question: "If not the bank, where can I find financial advice that is in my best interest?"
At this stage I should pause and remind you that I am still not selling anything. None of the links or resources I mention are affiliated with me in any way. The exception is that even though I just finished bashing the big banks, I do hold (directly and indirectly) shares in Canadian banks. I have used Ratehub in the past, but I get no affiliate rewards or preferential treatment by mentioning them in this blog post. Also, I am not a certified financial advisor so I can't give you any advice for your particular situation. That said, I CAN discuss some things worth considering and some things that have worked for us in the hopes that it guides you further along your own successful personal financial path.
So where can Eugene go for advice? If the answer to this big sticky question was easy, this article would be done by now. But the road to good advice is fraught with bandits, potholes, and dead ends. Even if we just told Eugene where to go, he would still have to walk the road to get there, and be set upon by all the hazards. So let's learn to spot the next bandit on the road: investment banks. By investment banks I'm referring to traditional "Full-Service Brokerage Firms", "Wealth Managers", and other companies that primarily earn their money from selling mutual funds and insurance products.
Often when someone talks to us about investments, they say "I have a guy who handles it for me". Digging further, we usually find that they have deposited their money with a so-called "Financial Advisor" investment bank, like Investors Group or Edward Jones for example. Typically the investment bank takes the investor's money and principally invests it in mutual funds. And while they're at it, gets the investor to buy a "Whole Life (WL)" or "Universal Life (UL)" insurance policy. There's a lot here to unpack, so let's send Eugene in to see what Edward Jones has to offer, for example.
Eugene walks into an Edward Jones office and sits down with fictional financial advisor Mary. The first thing Mary does is get Eugene to fill out a "know your client" (KYC) form that spits out a risk profile for Eugene. While doing this, Eugene explains that he is in the accumulation phase of his life. In other words, he is trying to accumulate enough invested capital to get to retirement. The KYC form asks about his time horizon for the money, and is his tolerance to loss, and how much value of liabilities and assets does he have.
Using the information from the KYC form, Mary suggests Eugene put his money into a (probably overly conservative) portfolio of mutual funds in registered accounts (TFSA and RRSP) and any extra money that exceeds contribution room into mutual funds in a non-registered account. She also suggests a "Whole Life (WL)" insurance policy because rates get more expensive the older you get, so if you buy it now you can have a lower monthly payment!
Let's look at these recommendations a little further.
Investment bank recommendation #1. Open registered accounts like a Tax Free Savings Account (TFSA) and/or an Registered Retirement Savings Plan (RRSP). This will help to reduce the taxable impact of Eugene's investing and so allow him to grow his wealth faster. Yes, generally speaking you should maximize one or both of these if you can before buying securities (stocks, bonds, mutual funds, Exchange Traded Funds (ETFs) etc) outside of these accounts. So this part is actually good advice! This post will not go into whether Eugene should first contribute to a TFSA or an RRSP….because it depends. And also because a lot of other articles abound that discuss this and I don't want to add another! But yes, if he doesn't have one of these, then he should definitely invest in at least one of them before investing outside of one.
Investment bank recommendation #2. Buy some mutual funds. A mutual fund is a security that an investor may buy that is (usually) comprised of underlying stocks and bonds. The idea is that small investors pool their money, and the mutual fund manager uses that money to buy a diverse group of assets, of which each investor gets a piece in direct proportion to the amount in the fund and their buy-in amount. For hands-off investors who don't want to do much themselves and would rather let their bank do their investing for them, they will most likely have their assets placed into mutual funds. Spoiler alert….generally speaking, this very sub-optimal for Eugene. And for you! Here's why: FEES!
In this example, let's say Eugene has been a diligent saver and has managed to save $50,000 for his investments, and he has enough contribution room to put all this into a Tax Free Savings Account (TFSA) to protect it from taxation. After his $50,000 TFSA contribution he still has enough TFSA room left over to allow $1000 of extra contributions monthly (Eugene's monthly savings amount). This is because Eugene turned 18 before 2009 when TFSAs were introduced, and hasn't contributed to a TFSA before, and so has a total contribution room of $75,500. Let's look at what the fees look like at Edward Jones for one year of doing this.
Here's where Eugene will lose his money with Edward Jones6.
- Having an account. The annual administration fee for a TFSA is $50, plus tax.
- Buying mutual funds.
- Dollar Cost Averaging. This is another way of saying you are buying investments periodically, instead of all at once. In the accumulation phase, most people are well advised to set up automatic investment contributions monthly. At Edward Jones, they take a 2% cut right off the bat (or $5 if greater than 2%) for any investment money set up to buy monthly. So if Eugene was to add $1,000 per month to his account, Edward Jones would take $20 right off the bat from each monthly contribution and only $980 per month would actually be invested. Over the period of a year of investing, the fee amount from this would be $20 x 12 months = $240.
- Loads. These are extra fees levied by mutual funds to buy and sell mutual funds. Usually they take the form of "Deferred Sales Charges (DSC)" that are charged upon selling shares of the funds. DSCs were recently outlawed (within the last couple of months) but can still be charged until June 1 2022. https://financialpost.com/fp-finance/ontario-securities-commission-to-ban-deferred-sales-charges-on-mutual-funds In my opinion they are a predatory fee grab that can impose hefty costs if you decide to move out of your chosen funds for any reason. The amount of fee could be as much as 7% of the withdrawal. For this example I will assume that any funds Eugene buys will be held in the account long term, and will not incur DSCs from selling or withdrawing.
- Management Expense Ratio (MER). Mutual fund offering prospectus from Edward Jones are very hard (almost impossible) to find online to get this information. That said, I know 2% to 2.7% are fairly typical MERs at these institutions, and I used to pay them myself at Investors Group. An MER is charged against the whole invested balance in the mutual fund. So, if you have $50,000 in mutual funds at the start of the year, and your account grows to $62,000 by the end of the year due to your contributions, the amount of money you lose to the fund expenses (MER) is approximately $1120 in the first year.
- Reinvesting distributions. A "transaction fee" of 2% will be charged against any distributions that are reinvested. So for Eugene's hypothetical $50-62K portfolio, if he was to get 3% dividends from the portfolio annually ($1,680), then 2% of that ($33.60) would be taken away and he would only have $1646 reinvested.
So here's what we have for fees for his mutual fund TFSA:
|Account fee including tax
|Dollar Cost Averaging
|Loads. Avoiding these by assuming it's late 2022…
|Management Expense Ratio (reduces account value: not charged as a separate fee)
|Fee for dividend reinvestment
You may be like, hey that's not so bad….Eugene's rich! Look! He has $62,000 invested! What's a measly $1,446 for someone who's "ballin" like him?
Well to put it in perspective, ignoring the potential growth or decline (if any) of the mutual fund due to market fluctuations, Eugene's investments with their 3% dividend (comparatively high these days) only produces income of $1,680. Of that, he's lost $1,446 to fees and expenses, leaving him with only…. $234 reinvested dividend in his account. That's equivalent to only 0.2% of what should have been reinvested, if it weren't for fees. Compare this to what his dividend return would have been if, instead of giving his money over to a company like this, he directly held the underlying assets of the mutual funds. In that case, his dividend return should have been the whole 3% (simplified to avoid going into the details of how mutual funds distributions are calculated by fund managers) or $1,680, bringing his account balance up to $63,680 with no drag from an MER or other fees. In other words, Edward Jones and the investments they put him in would take an equivalent of 86% of Eugene's distributions and pocket it for themselves and for the fund managers.
Note that I did not account for changes in account balance due to growth or decline of the stock / share price of the assets held, because the movements of these prices up or down in a given year would be purely speculation. Also, if the mutual funds are invested in securities on the public markets, then any comparable product holding the same securities should track similarly, aside from the drag from any fees imposed. The dividend based example is used to help illustrate the impact of the fees charged by these investment banks.
Imagine if Eugene then also had to pay some extra fees to make a withdrawal or transfer, or maybe some deferred sales charges…. It's scary how much this halts growth…even after only one year, ignoring the compounding effect. But wait…isn't compounding a really powerful force for growing your wealth? Yes!!! It is critical! And this fee structure essentially eliminates any significant compounding ability on these types of accounts.
The compounding effect of fees
To demonstrate the power of compounding and the significant impact of fees and Management Expense Ratios, let's use Eugene's example above, with a starting account value of $50,000 and an addition of $12,000 invested every year for 25 years ($1000/month). I will run this example based on getting an average return close to the S&P / TSX index total return over the last 8 years (8.3%), minus about 0.3% as would be achieved with an ETF - so 8% as our baseline. If Eugene does this, at the end of the 25 years his account would be valued at $1,289,876. Note the power of compounding, as the cumulative sum of his invested capital is only $350,000, including his annual contributions.
Now let's redo this math, using the same distribution of assets (shadowing the Canadian stock market), but instead of Eugene investing in a low-cost ETF, he invested in Canadian actively managed equity MUTUAL FUNDS through one of these investment houses, and therefore the effect of MER and fees reduced his performance by about 2.5% (MER plus account fees), so his return averages 5.5%/year. Also, the dollar cost averaging fee of 2% effectively reduces his $12,000 annual contributions to only $11,760 /year. What does his account look like after 25 years? He will have $825309. This is a difference of $464,567 as compared to the DIY option. Where does the difference go? To the investment bank.
If you take away the principle amount invested of $350,000 you can better see how stark the difference is. In the low-cost DIY example, the compounding effect earned Eugene $939,876. In the managed mutual fund example, the compounding effect earned Eugene $481,309. In other words, over 25 years Eugene would have MADE almost TWICE as much money by choosing a lower-cost account and saying good-bye to Edward Jones (or their equivalent). Fees matter.
Some objections I sometimes hear are:
"But I get these great reports!" Great! But is your report worth thousands of dollars a year? Or more importantly, hundreds of thousands of dollars over decades? Would you choose to go to the store to buy a fancy thousand dollar binder every year and then pay another thousand dollars to print out your investment info to put it in your binder? Especially considering people don't (usually) display these things in their homes for their friends to admire like a work of art, if you are paying all these fees for your reports, and then sticking it on top of a pile of other binders under your desk, you may be a sucker. There are cheaper ways to get reports and graphs if you're not a spreadsheet person. More to follow on this in a subsequent post.
"But my investments have been doing really well lately!" The answer to this is, 'All ships rise with the tide'. For the last decade, the Canadian and US stock markets (where the bulk of most Canadian's investments are housed) have climbed by an astronomical amount. For example if you were invested in an index-tracking low-fee ETF that tracks the S&P/TSX (an indicator of the performance of public companies listed on the Canadian stock market), then over the last 10 years your portfolio would have grown by 8.36% annually5, minus whatever nominal MER and or trading fees you had. Let's say if you were in ETFs your total growth during this period would have been 8% annually to be conservative, as in the above example. Shortening our scope to only the last 5 years, the return was even better…with a total return equivalent to 10.04% annually5. Since one year ago, the TSX total return has been 27.98%5. Have your actively managed mutual fund accounts done as well as that?
Investment bank recommendation #3. Buy a whole life (WL) or Universal Life (UL) insurance policy. This article is getting long enough already, so I won't get in to a lot of detail on this, except to say that for most people this is bad advice. WL and UL policies are fancy insurance policies that are tied to some sort of optional investment option. So when you die, your beneficiary gets your insurance payout, plus whatever the balance of the investment account at the time of your death. While this sounds good, the problem here is that these policies are fee-heavy with premiums that are a lot more expensive than a comparable "term" insurance policy. And there are so many more better options for investing your money than to over-contribute to your life insurance policy. "Financial advisors" [read salespeople] who sell these products often get HUGE commissions for selling policies like these, so they are incentivized to sell them to you whether they are the right fit for you or not. Before I learned more, I had been paying for a small one of these policies for almost 10 years. Just another wasted thousands of dollars! Don't be like me! Don't get WL or UL insurance policies. And if you already have one, consider cancelling it! If you need insurance….get term insurance.
So you can't trust the big banks. And you can't trust the investment banks. What's left?
"But I know nothing about money" Eugene says.
Great! Everyone begins with no knowledge. But you have help. And that help is called the Financial Independence community, also known as the FIRE community.
If you're reading this post, and are not Eugene, you're already somewhat tapped in to the financial independence community. You're reading a little bit about finances, and you just need to be directed to the key content to fit your current situation. The FIRE community has been growing quickly and there are many resources out there that can be valuable to you; social media groups, FI / FIRE podcasts, books, and local FIRE groups. For example, on Vancouver Island there is a Facebook group called "Van Isle Mustachians". A Mustachian is a person who is a reader of the Mr Money Mustache FIRE blog. This group posts online content and discussions, and even has face-to-face and online meetups. There are also popular national groups like "Choose FI Canada", and "Canadian Mustachians" and there is probably a local group near you.
It doesn't take long to learn what you need to get started investing and sorting out the rest of your financial house. With just a little bit of effort learning to do a few things yourself, you'll save yourself lots of money and set your future up to be much more wealthy.
If you’ve gotten this far and decided you are totally uninterested in all of this and still just want to hand over your money to someone to manage for you….there are robo-advisors where you can invest your money for relatively low cost. In Canada the most common robo-advisor is Wealthsimple. A robo-advisor invests your money in a portfolio of low-cost index ETFs and add on a small management fee of about 0.5%. This is the price to pay for handing your money over to someone else. That said, 0.5% is not bad by comparison to the investment bank's 2.5% overall.
There you have it. Eugene decided to skip the bank savings accounts and GICs, and to run fast and far from traditional full-service investment banks. He will not buy an expensive and complicated life insurance policy (UL or WL policy) that doesn't suit his needs. He's going to connect with his local FIRE group on social media and learn the basics of investing. Within a month he will be ready to put his accumulated savings to work growing his wealth.
As a final note, I will mention that there exists another trustworthy style of financial planner, known commonly as a fee-only or fee-for-service financial planner. This means that you hire this person, pay up front for their analysis and advice, and then they often help you put a plan into action. A fee-only advisor's compensation is not tied to the investments that you purchase, and they are more likely to provide advice that is "in your best interest" and not just "suitable". "Suitable" is a low bar, which basically means anything that is not obviously bad for you. For many people who are willing to put a few hundred to a few thousand dollars up front, a fee-only planner is a good choice, and can fast-track their plan. This is especially suitable if you have a reasonably large nest egg and the relative impact of the initial fee is palatable.
Although Eugene and Mary in this story are fictional characters, the rates, figures, products and institutions listed are NOT fictional. Be like Eugene. Avoid the bandits and potholes on the road. Seek out good advice from people who are not looking to make money off of you. Connect with the financial independence community, and do some of your own research. And of course, keep on following here at onfilandtime.com!
1 CIBC - Ratehub.ca, August 3, 2021
2 ratehub.ca, August 3, 2021
3 www150.statcan.gc.ca, August 3, 2021
4 CIBC.com, CIBC eAdvantage Savings Account, August 3, 2021
5 https://ycharts.com/indices/%5ETSX, September 22, 2021
6 https://www.edwardjones.ca/ca-en/disclosures/account-fees, October 17, 2021