There's a single solution to our twin problems of too much spending and too little saving.
Start a pre-authorized contribution (PAC) plan. Every excuse or dodge that people have for not managing their money effectively is defeated by the PAC.
With a PAC, sometimes called a pre-authorized purchase plan, you automatically invest a set amount every quarter, every month or every pay period. Essentially, you'll take money you might have spent and invest it instead.
The recent carnage on the stock markets makes this the perfect time to adopt a PAC plan. You know how you're supposed to buy low, but you never actually do because you're too nervous? With a PAC plan, you're on auto pilot.
On a regular basis, whether markets are up or down, you'll invest the same amount. You're guaranteed to get some money into the market at its lowest point, and you'll be tiptoeing around markets that have already risen a lot. They call this approach dollar cost averaging and it's the ideal way for nervous investors to approach today's unpredictable stock markets.
Here's another benefit of the PAC plan: It eliminates the tedious annual ritual of finding money to contribute to a registered retirement savings plan. It's always RRSP season when you have a PAC plan.
PAC plans also deliver the benefit of long-term compounding. If you start with $100 and make monthly contributions of the same amount for 25 years, you end up with almost $45,000 assuming a modest 3-per-cent rate of return.
The beauty of a PAC is that it makes saving or investing non-discretionary. Lots of people intend to spend less and save more, but it never ends up happening because of a phenomenon that rules the finances of many people. If money is available, it will be spent.
If money is saved or invested as soon as you get paid, it can't be spent. This is where the PAC plan comes in. It's the means by which you follow the widely advocated strategy of paying yourself first.
The first step in setting up a PAC is to decide how much to save or invest. In an interview I did recently with David Chilton, author of the new book The Wealthy Barber Returns, he suggested saving 10 to 15 per cent of your gross income (read the interview here.)
If you can't afford that, some mutual funds companies will accept PAC plan instalments as small as $25. Start there and ramp up as you get your spending and debts under control.
You can base a PAC plan on an RRSP, a tax-free savings account, a registered education savings plan or a non-registered account. For lots of people, a mix of these vehicles, say RRSP plus RESP, would make good sense.
Next, pick an investing product for your PAC. Mutual funds used to be the best choice for the most people, but exchange-traded funds have just started elbowing their way into this line of business.
The appeal of mutual funds for a PAC plan is that you can often invest with no sales commissions. Many advisers will let you do this – so will the banks and no-load mutual fund companies that deal directly with the public ( here's a column I wrote on them not too long ago.
The classic ETF is an index-tracking fund that trades like a stock, which means you have to pay brokerage commissions of $5 to $29 to sell through an online broker. Just recently, though, the online broker Scotia iTrade introduced commission-free trading for 46 different ETFs.
Don't bet the PAC on a single fund or ETF unless it's a balanced fund with decent diversification. You can easily have your regular PAC payments spread across a Canadian equity fund, a bond fund and a global fund.
A PAC application can often be downloaded online. Fill it out and send it to your investment firm with a void cheque from the bank account where your pay is deposited. While a PAC plan is automatic, it's not maintenance-free. If you get a raise, increase the amount of money you're savings or investing by the same percentage. If your PAC contributions are putting too big a strain on your day-to-day cash flow, try dialling back the amount a bit.
A PAC plan is bound to be a challenge if you've never saved regularly before. Just live with it. Before you know it, you'll be investing more, spending less and doing your part to keep the global economy on track. If only they'd tried this in Greece.
How to PAC
- Set up a pre-authorized contribution (PAC) where money is withdrawn from your chequing account just after you get paid; that way, you’ll never miss the money.
- If you’ve been remiss in your saving and investing, push things a bit when deciding how much to contribute on a regular basis through a PAC.
- Using your own bank’s mutual funds or online brokerage will expedite things, but you can electronically transfer money to a wide variety of firms.
- Pick the best mutual funds or ETFs available – if you’re not happy later on, you can always change things.
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Rob Carrick