Common Financial Planning Mistakes We All Can Make
Fee-for-service financial planner and founder of PlanEasy.ca
When we do our own financial planning we’re often too close to our own situation to have an objective perspective. We may focus on the wrong problems… or take a narrow view of the potential solutions… or miss potential issues entirely.
One of the benefits of working with an advice-only financial planner is that they provide a second set of eyes for your financial plan. Most people are already on the right path, but there are common issues that may end up working against you. A financial planner can help find these common mistakes that may otherwise go unnoticed.
Financial planning isn’t rocket science, it’s something that can be done on your own. The math itself isn’t terribly difficult, and there are tools available online to help, but one of the major downfalls of the DIY approach is that we can be somewhat oblivious to our own personal biases.
Basically, we’re too close to our own financial situation to be entirely unbiased (This goes for financial planners too!) There are certain financial planning mistakes that we all tend to make if we’re not careful.
These mistakes can lead to potential issues over time. These issues can create more risk, or decrease investment return, or increase taxes, or create a higher risk of running out of money in retirement.
These mistakes are quite common and identifying these potential issues is the first step to creating a stronger financial plan.
Having Too Much Cash-On-Hand
Having some cash-on-hand can be an important part of a financial plan. An emergency fund is a best practice that should be part of every financial plan, but holding too much cash can be detrimental to your long-term plan.
Holding cash doesn’t typically provide an investment return above inflation and typically loses value over time. Inflation will slowly eat away at the value of cash-on-hand. Although the dollar amount remains the same the purchasing power goes down. This risk increases during high inflationary periods like we experienced in the 1970’s.
Holding cash is good… but only until we’re able to cover 3-6 months of expenses. After this that extra cash becomes a drag on your financial plan.
Sometimes holding too much cash is a symptom of not having a clear investment plan. Or sometimes this mistake is driven by another common mistake, it’s sometimes driven by a desire to “time the market”. Timing the market is another big mistake to avoid.
Trying To Time The Market
Trying to time the market is another potential mistake that many investors can make. As a general rule, “time in the market” is better than “timing the market”. It’s nearly impossible for an average investor to accurately time the market.
This makes sense given an individual investor doesn’t have the resources, skills, or time to understand all the factors that affect short-term stock prices. Even professionals, with nearly unlimited time and money, have a difficult time predicting stock prices over the short-term.
Trying to time the market is sometimes the symptom of not having a clear investment plan and a good understanding of your personal risk profile.
Holding An Undiversified Portfolio With A Few Large Holdings
The advent of low-cost index investing has made this less of an issue for DIY investors, but it’s still a relatively common issue for investors who invest in individual stocks to have a portfolio that contains a few large holdings, sometimes too large to provide good diversification.
Having a large position in one company can easily happen over-time, especially for a well performing company. Increases in stock price relative to the rest of the market can easily cause one company to increase in value relative to the rest of the portfolio.
But this lack of diversification can lead to increased risk.
The key is to rebalance regularly, at the very least on an annual basis, to avoid having “too many eggs in one basket”. As a rule, I personally don’t like to see an individual company make up more than 3% of an investment portfolio.
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Holding Onto High Fee Investments
Perhaps it’s the fear of the unknown, or perhaps it’s just a lack of visibility/clarity on investment statements, but one common mistake that can be found in many financial plans is when an investor is holding onto high-fee investments. This is especially the case for investments that can be easily replaced with lower-cost alternatives with nearly the same exposure.
The average mutual fund fee in Canada is above 2% and this can drag down the overall investment return of these funds. Index ETFs on the other hand have fees that are well below 0.2% and can often provide the same or very similar exposure to stocks & bonds. Depending on the level of service you receive from your investment advisor these fees may be acceptable but for many investors the value isn’t there.
These fees can drag down investment returns over time and eat away at potential retirement income. On a $500,000 portfolio, not switching can mean $10,000+ in extra fees per year.
Not Equalizing Registered Assets Before Retirement
One big opportunity, especially for those retiring before age 65, is to equalize registered assets before retirement. The main way this can be done through the use of a spousal-RRSP.
For couples, having equal registered assets before retirement allows for more flexibility when income splitting before age 65. This becomes less of a concern after age 65 because we can use income splitting rules to split income on the tax return, but prior to age 65 it helps to have equal registered assets.
Unfortunately, it’s quite common to see a high-income earner with the majority of registered assets in their name prior to retirement. This limits the flexibility we have in early retirement to draw down assets in the most tax efficient way possible.
Using RRSPs Only For The Tax Refund
There are two main tax advantaged accounts in Canada, the RRSP and the TFSA. Picking the right one could save thousands in tax and benefit clawbacks. Both accounts help investors shelter investment gains from taxes over the long-term. This preferential tax treatment helps provide an incentive to save for retirement and helps us build our investment portfolio faster.
But these accounts work differently and using RRSPs solely for the tax refund can potentially be a big mistake.
One group of individuals that gets severely impacted by this decision are soon-to-be retirees on a lower-income.
Approximately a third of seniors in Canada receive GIS benefits. These benefits help create a minimum income level for retirees. These benefits also come with hefty claw backs that range between 50% and 75%. That’s why it’s important to optimize government benefits both now and in retirement.
Unfortunately, RRSP withdrawals will trigger these GIS claw backs. For example, a $1,000 RRSP withdrawal can trigger a reduction in GIS benefits of between $500 and $750. So from that $1,000 RRSP withdrawal the net will be only $500 to $250!
For some soon-to-be retirees, who may expect to receive GIS benefits in retirement, using an RRSP is a big mistake, and can lead to even lower income in retirement.
Using an RRSP just for the tax refund might seem wise when receiving a tax refund the following year, but it may lead to high claw backs on government benefits in retirement.
Not Saving For Infrequent Expenses
Common infrequent expenses include things like vehicle repairs, home repairs, and vehicle upgrades. These are expenses that may only happen once per year or once every few years. Because of the long-term nature of these expense they’re often “forgotten” about when doing month-to-month budgeting.
Failing to plan for these infrequent expenses could mean using emergency funds, or worse, debt like a line of credit or credit cards. This can easily lead to issues if a few of these expenses just happen to occur at the same time.
As a best practice, these expenses should be converted into a simple monthly amount and saved for on a regular basis. These amounts should be sent to a high-interest savings account and then drawn upon as these expenses arise.
We may not be able to plan perfectly, but having an estimate for these infrequent expenses will help avoid potential issues down the road.
Drawing Down RRSPs To Avoid Mandatory RRIF Withdrawals
There is a common fear of mandatory RRIF withdrawals in retirement and one common mistake can be to try and avoid these mandatory withdrawals “at all costs”.
Often this fear results in heavy draws on RRSPs before age 71 (when RRSPs need to be converted to RRIFs). These large RRSP withdrawals trigger equally large income tax payments. Sometimes this can be a good strategy, but many times it can lead to a higher lifetime tax rate.
Often, we would prefer to draw down registered assets in a more systematic way. Taking advantage of basic tax credits, seniors tax credits etc to make withdrawals from registered assets at a lower average tax rate. This draw down of RRSP assets should be part of an overall draw down strategy in retirement.
Creating a draw down strategy with the sole goal of avoiding mandatory RRIF withdrawals can often be a mistake for many retirees.
Starting CPP Or OAS At The Wrong Time
CPP and OAS can make up a significant portion of retirement spending goals. They’re an extremely valuable and important part of every retirement plan. But most individuals start CPP & OAS as early as possible while not fully understanding the pros and cons of this decision.
For some people starting these benefits early will be a smart financial decision, but this isn’t the case for everyone. Making the decision to take CPP or OAS without understanding all the options can be a big mistake.
This is especially the case for OAS benefits which have a lower benefit if delayed but also has a “claw back” if income is above a certain threshold. Starting OAS immediately at age 65 when there might be large RRSP withdrawals, large capital dispositions, or large changes in income in the future could mean that OAS is clawed back entirely during some years. If this is the case it may make sense to delay OAS until after these big events occur.
Understanding the pros and cons of starting CPP and OAS early versus delaying will help avoid starting these benefits at the wrong time.
Financial planner, personal finance geek and founder of PlanEasy.