Many people are used to paying their household bills on a monthly basis. It is a routine that keeps the lights and power on. When it comes to saving and investing, most individuals have a different approach. Often savings and investments take a back-burner approach.
One way to adopt a disciplined approach of setting money aside is to set up a pre-authorized contribution — often referred to as a PAC.
The concept of a PAC is not new. Nearly every financial institution will promote the benefits of contributing early. Building up savings early enables the compounding effect to have a larger impact.
How we set up a PAC today is very different from how we set up PACs years ago. The addition of different regulations, registered accounts, and tax rules makes the investment savings decision more complex. Some of the modern day decisions with respect to a PAC remain the same.
Below, we have outlined the important decisions individuals need to make, along with our recommendations on how to deal with complexity.
How much to contribute?
When it comes to setting up a PAC, we begin by asking clients to look at their monthly cash-flow and create a budget. This process should help you in determining a comfortable amount to set aside.
Setting aside 10 per cent of your monthly income may be a general guideline to get some investors started. Establishing a budget, and letting some time pass with the initial 10 per cent thresholds will likely result in clients adjusting the percentage and finding an optimal longer term savings amount.
How often would you like to contribute?
Most investors who establish a PAC contribute either once or twice a month. We recommend that individuals consider their cash inflows and match the PAC accordingly.
For example, if you get paid twice a month then you could set up your PAC for twice a month. If you are paid once a month then a monthly PAC typically works best. The majority of the PACs we set up are monthly as many clients pay their bills monthly.
What type of PAC investment?
When people are setting up a PAC, they naturally begin thinking about what type of investment they want to contribute periodically to. Some investors may choose to contribute into a mutual fund or money market instrument.
There are a wide variety of investments to choose from. If you do PAC into a mutual fund, it is important to pick a quality investment and to monitor your investment regardless of its initial size. A quality PAC can turn into a significant nest egg over time. Some fund companies have established policies where an initial purchase of a set dollar amount ($500, for example) is required to establish a PAC.
Cash approach to PAC enables us to manage risk
Another option is to simply contribute cash and leave the funds as cash. Nearly all PACs we have set up today are contributed as cash. With cash we can ideally look for the best use of those funds every single month. We can purchase direct holdings to keep the cost of investing to a minimum. We can manage the position size of each investment as cash deposits are made.
In the past, a lot of energy was spent on deciding today what clients would invest in every month going into the future. This is solved by taking a cash approach to PACs.
What type of an account would you like to PAC into?
In years past, we would ask clients what type of accounts they would like to PAC into. For example, you could have a couple that have set up the following monthly PACs: $1,000 into each of their Registered Retirement Saving Plan (RRSP) accounts, $500 into each of their Tax Free Savings Accounts (TFSA), and $200 for each of their two children into a Registered Education Savings Plan (RESP). In this situation there are five PACs set up, each with different forms. We have several concerns with this multi-PAC approach, and we don’t recommend this approach any longer for a variety of reasons. We encourage clients to avoid registered PACs and instead contribute into a non-registered account. This enables us to ensure that we allocate the funds into the correct account after discussions with our clients and obtain the latest financial information.
Ten benefits of setting up a PAC into a non-registered account
In the majority of cases, we will set up a non-registered account and encourage clients to set up the PAC into this one account. For example, the couple that had five PACs set up could save the same amount by setting up one PAC for $3,400 per month into the non-registered account.
The following are 10 benefits of setting up a PAC into a non-registered account:
1) The benefit of this approach is that there is one form and one amount coming from your bank account to your investment account. From a transparency standpoint, it is easy to follow.
2) If the PAC needs to be cancelled or changed at any time, it is significantly easier. A quick phone call and one form is all that is needed.
3) Ensuring that you do not get T1-OVP penalties for contributing too much into a registered plan. When you contribute into a non-registered account, we can choose exactly how much to move over annually to your respective registered accounts, if any.
4) Many of our clients have incomes that are fluctuating every year. Some years, they may want to contribute to their registered accounts a flexible amount based on their changing income.
5) With minimizing the household tax bill we will typically encourage a greater level of contribution from the higher income spouse rather than equal contribution into both RRSP plans. For example, if a couple had only $12,000 to contribute to RRSPs we would not contribute $6,000 into each without first looking at their respective incomes. If one individual is earning $170,000 and the spouse is earning $36,000 then we would typically encourage the higher income spouse to make a $12,000 contribution and the lower income spouse not to contribute.
6) Many clients have group RRSP plans that need to be factored into what they can also contribute to their self-directed RRSP with a financial institution. For example, if a client has $24,000 as a 2020 RRSP Deduction Limit at the beginning of the year, you would first want to know the group RRSP contributions before making additional RRSP contributions. If a PAC goes into a non-registered account, we will have built up sufficient savings that will allow us to contribute the residual, once known, without over-contributing.
7) Periodically, maximum deduction limits get adjusted (i.e. TFSA and RRSP). When you PAC into a non-registered account, the forms do not need to be adjusted. Your portfolio manager can simply confirm with you verbally the dollar amount to contribute each year.
8) With some accounts we would recommend contributing as early as possible in the year rather than spreading the contribution out over 12 months. When funds get built up within a non-registered account, we can fully fund the TFSA in early January each year and the RRSP accounts no later than May each year. The RRSP contributions would be dependent on them having appropriate earned income which can be confirmed verbally prior to the contribution.
9) For many of our clients, saving into a non-registered account is a better strategy than contributing to an RRSP. This is often the case when taxable income is not currently at higher levels. This is also the case when a client may need access to the funds (i.e. purchasing a home, car purchase, home renovations, business purposes, etc.) in the near term.
10) We feel that it is important to automate the savings component of a PAC. We also feel that it is equally important that those funds are allocated in the most efficient manner to ensure you are receiving any grants and maximizing tax deferral opportunities. We encourage our clients to update us if they have any material life events or a significant asset disposition that needs to be factored in. In some cases, we have to wait until later in the year to get all of the available tax and income information to ensure we are making an informed decision on where cash and investment savings should be allocated.
Forced savings is becoming a little more complicated with multiple types of accounts, different deduction limits, and a fast changing political and economic climate. A cash contribution into a non-registered account enables you and your portfolio manager to have the flexibility to make the best decisions each year.
Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director, wealth management, with the Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138. greenardgroup.com