5 year plan: From the Kremlin to your kitchen table

If you lived through the cold war you probably remember TV images of lavish military parades in the Soviet Union and China to help usher in the latest five-year economic plan.

Communists loved five-year plans. It gave the centralized governments the opportunity to appease the masses with lofty economic goals, impose them at the point of a gun, and achieve them even if they weren't really achieved (if you catch my drift).

Communism failed for the super powers but the five-year plan still has its merits in personal finance. Whether it's the Kremlin or the kitchen table a five-year plan is short enough to set realistic goals based on current circumstances and long enough to level out short-term uncertainties along the way.

On a broader level economists gravitate toward the five-year time span because historically economic cycles tend to average about five years - recessions and boom times run their course, sectors come in and out of favour, stocks trend up or down.

On a personal level your financial life should be a series of five-year plans, each ending at a benchmark measured by your net worth. Each plan is as different as the individual but here's a basic layout you can follow or revise to meet your circumstances.

Determine Your Net Worth

At the top of a spread sheet list your total assets: registered retirement savings plans, tax free savings account, defined contribution company pensions, non registered investments, appraised home value or anything that can be independently appraised and store value. A car, for example, does not store value. A good rule is: when in doubt leave it out. It's better to under estimate your net worth and be pleasantly surprised in the end.

Then subtract everything you owe: mortgage, student loans, line of credit or credit cards.

This is your net worth entering year one of your five-year plan.

Equity Plan

Enter years one through five down the left hand row of your spread sheet. In the first column along the top enter "equities". In the year-one row add up the current market value of any stocks or equity funds you own in any of the plans mentioned above.

Determine a realistic annual rate of return. A well diversified, conservative equity portfolio could be expected to return five per cent annually. A riskier portfolio could be expected to return eight per cent.

Next determine how much you plan to contribute each year to the equity portion of your portfolio. This is where discipline plays a role.

From there it's just basic math — add the market return plus your contribution each year to year five.

Fixed Income Plan

In the second column enter "fixed income". Add up all your bonds, GICs or other investments that generate interest. You can also include bond and balanced funds.

In this low interest rate environment it would be realistic to expect a return of three per cent on government-backed debt, although you may get more if you hold corporate debt.

Also keep in mind interest rates have nowhere to go but up so add a per cent or two to compensate for the five-year average.

Like equities, add the expected return and the amount you plan to contribute to your fixed income portfolio each year to year five.

Property Ownership

In the third column enter "property ownership". Like equity and fixed income, property requires a best guess. In the case of a home the Canada Mortgage and Housing Corporation estimates the average Canadian home has appreciated in value by just over five per cent annually for the past forty years, and they expect that rate of growth to continue in any forty year span. It's a good starting point for estimating your home's appreciation depending on where you live.

Estimating price appreciation is even trickier with other property like jewellery or coin collections but do your best and be realistic. A safe rate of appreciation would be inflation, which currently runs at about two per cent.

Calculate return growth for each of the five years.

Debt Reduction Plan

In the fourth column enter "debt". This is the one column where the numbers are expected to get smaller as time goes on.

It's important to understand that you can not have a five year plan unless you have a debt reduction plan (see last week's blog on consolidating debt).

If your only debt is a mortgage find out how much of the principal is being paid down each year. Most lenders provide a breakdown in your on-line profile. If your mortgage is due for renewal compensate for a slightly higher average mortgage rate over the next five years.

Add any debt outside a mortgage, along with annual principle reduction targets for each year, and subtract the total debt from total assets each year. By year five you have established your net worth goal.

Repeat every five years.

Have a parade if you wish.