FOO - A wealth building framework
Ever wondered what you should be doing with your sweet hard earned cash? I have one word for you...FOO
Ever wondered what you should be doing with your sweet hard earned cash? I have one word for you...FOO given our last post on the retirement crisis and a portion of that problem being attributed to lack of financial literacy, we wanted to write an article on FOO - Financial Order of Operations for the Canadian market. In this article you'll find the basic concepts of personal finance capital allocation and the options available to grow personal wealth for Canadians While individual circumstances my vary, this framework is a helpful starting point on what to think about when weighing up wealth building decisions.
In the spirit of simplifying financial planning process, we think it's really important to start by having a structured approach to wealth and personal finance, so we'll start with laying out an intuitive and logical framework. The Money Guy provides an amazing yet simple framework that they call the "Financial Order of Operations" (FOO) for structuring wealth building decisions [1]. While they focus on the US demographic, their framework can be generalized and applied more broadly to other regions (i.e., Canadians). The goal here is to make sure the essential financial requirements are covered before being able to use cash inflows for "pick your own path" preferences (e.g., risk averse individuals may prefer to pay down mortgage before investing for hyper accumulation). We've outlined how the FOO steps apply to Canadians below:
--- Essentials Covered ---
1. Deductibles Covered: Start by having enough set aside for covering your minimum deductibles on insurance policies, such as home and car insurance. This will help protect from unexpected financial hits and the negative impacts those may have on personal premiums in the future.
2. Employer Match: If an employer offers a matching contribution to a retirement plan, such as a Group Registered Retirement Savings Plan (RRSP) or Defined Contribution Pension Plan (DC RPP), contribute enough to take advantage of the full match. It's free money for contributing to your retirement and could be a 100% return on your contributions for virtually no effort (depending on matching policies)!
3. Emergency Fund: Build up an emergency fund that covers 3 to 6 months of living expenses (these are the minimum expenses needed to live - e.g., rent, food, bills, etc.). This fund can help you weather any unexpected financial shocks like loosing a job.
4. High Interest Debt: Next, focus on paying off high-interest debt, such as credit card debt, personal loans etc. High-interest debt can be a significant burden on your finances and hinder your ability to save as interest payments can snowball if not controlled / paid down.
--- Pick Your Own Path ---
5A. Invest (TFSA / RRSP): Once you've covered the essentials, it's time to start thinking about saving for your future. Contributing to a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) can be a great option. Both accounts offer significant tax advantages and can help you build wealth over time. The TFSA is as the name suggests - tax free, so any capital gains made within the account won't be taxed by the government so is a great for holding more risky assets that may provide a higher ROI. Meanwhile the RRSP is a tax deferred account meaning that you won't pay capital gains on your assets until it's withdrawn from the account at retirement. There are many other investment accounts for Canadians (e.g., RESP, FHSA) that can be leveraged depending on individual circumstances. However, individuals should keep in mind the yearly contribution limits for these account types.
5B. Invest (Hyper-Accumulation): For some, it may make sense to save aggressively beyond what's available in their tax advantage accounts. Consider taking advantage of investments like stocks, bonds, or ETFs through non-registered accounts such as an individual margin investment account. How you invest will be dependent on your goals, time horizon, and risk tolerance.
6. Prepaid Future Expenses: For long-term planning, consider pre-paying future expenses like life insurance, a will or a prepaid tuition plan for children. These will reduce the financial burden in the future given all the prior steps have been completed. This is more of an optional step if risk adverse.
7. Low Interest Debt Pre-Payment: Finally, consider paying off any remaining low-interest debt, such as student loans or a mortgage. This is typically the last step given paying off low interest debt will provide a lower benefit than using money to gain higher returns in registered or non-registered accounts. This is based on the opportunity cost of the $ used to pay off the debt vs leveraging those $ to yield higher returns by investing in assets. The caveat here is it will depend on the expected rate of return of using $ elsewhere and the current interest rate in the market at the time.
Keeping these steps in mind when it comes to personal finance can make a world of difference in optimizing an individuals financial situation. Do you follow your own mental model when thinking about your wealth goals, if so, would be interested to know how your model may differ - so please let me know!
[1] https://knowledge.moneyguy.com/knowledge/what-is-the-financial-order-of-operations-foo
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