Month at the End of the Paycheque
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Increasingly we read media stories about workers who struggle paycheque to paycheque and the ancillary story line that they worry about being unable to afford retirement. I sometimes wonder just how prevalent this struggle is when I see long lineups at the drive-through coffee shop and new cars flying off the dealer lots.
With that said, there is a real possibility that many among us are living well beyond necessity and at a level of luxury that cannot be afforded. The illusion might be masked by substantial debt and a razor thin monthly budget with little room for error. What we do know for sure is that at least some among us are in the situation of being on the edge even if they are living the most modest existence because we know that a minimum wage income does not go far today with rents, gas and groceries as high as they are.
When I was just starting out, the Canadian Institute of Actuaries published a standard of practice for calculating annual rates of interest. It seemed surprising to me that a standard of practice was needed since these calculations were fundamental to almost all our work and was part of our training in school and the actuarial exams. It was impossible to be an actuary and not know how to do these calculations in your sleep.
A deeper inquiry by me uncovered three truths. First, it turns out that because ‘annual rate of interest’ was not absolutely defined, some actuaries were quoting rates assuming interest was paid at the end of the year, some at the beginning of the year, and some assuming interest was paid ‘continuously’. This last method was a clever road to showing a lower rate of interest than the traditional rule of ‘interest in arrears’. The second truth was that there was legislation – the Criminal Code – to limit the rate of interest a lender could charge a borrower and the courts sought the opinion of actuaries on the matter. So, the profession needed a clear set of rules on the calculation so that actuaries were consistent in their response. Third, the limit on interest was a rate of 60% per annum! Yep, in a high-interest world of the late 1980s, where rates were sometimes in the double digits, lenders could actually charge up to 60% each year on loans – I was shocked and couldn’t believe the limit was that high.
As I have grown in experience, I better understand the motivation of lenders and the factors that they consider when deciding how much to lend and at what rate of interest. Embedded in the whole business of lending is the risk that you might not get repaid. We consider loans to our federal government through the purchase of their bonds as ‘risk free’ since in theory Canada is never going out of business and if the government is short on cash they can just print some more (and lately they have been doing so in large quantities). The provinces aren’t likely to go out of business, but they can’t just print their own money, so even a provincial bond comes with a ‘risk premium’.
Turning to regular folks and private businesses there is a much lower level of guarantee that the money will be repaid. Lenders must underwrite the level of risk involved and lend accordingly in both the amount loaned and the interest rate to be charged. Incredibly, I have seen business contracts charging billions in interest and I have been called in to demonstrate that at a limit of 60% per annum the interest being charged should only be in the hundreds of millions. Welcome to high finance.
Where business is generally occupied by sophisticated borrowers and sophisticated lenders – individuals are at the peril of grossly overpaying on the rate of interest they are charged out of ignorance around the effects of compound interest. When you need $200 to pay the utility bill so the heat won’t get cut off, time at the library studying what Albert Einstein calls the 8th wonder of the world is unlikely to be how you use your time.
I was shocked when almost 20 years ago I was first asked to calculate the annual rate of interest a local individual here in Windsor was paying their payday lender – it was well over 300% per annum. How could this be when the legal limit is 60%? The short answer is a lack of agreement what ‘fees’ can be charged to a borrower over and above the ‘interest’. After several class action lawsuits demonstrating that the conduct of payday lenders was predatory, the federal government did what you would expect. They made it a problem for the provinces to solve and removed payday lenders from the limits of the criminal code. The folks most likely to need the protection due to a lack of understanding were the ones sacrificed at the altar of ‘freedom of choice’.
Elected officials loathe the stories of predatory lending and have tried over the years to clamp down on the lending industry – but these politicians also loathe the stories of where a worker would have to turn to get money and the measures used to enforce repayment if the legitimate lenders didn’t exist.
When is Payday?
What got me thinking about all this was a new report a few weeks ago about a payroll company that was introducing ‘daily payroll’ to businesses that wanted to pay their workers more frequently than once every week or two. Why? Is this a service that we need? Just because advances in technology means we can do this – should we?
It turns out that a survey by the very company that is selling this service reports that 34% of Canadians run out of money between pay periods. They are selling this service to be the solution to the problem of having an unexpected expense at a time where you have spent your last paycheque and are waiting for the next. They are also telling employers that similar to the growing demand from workers for a permanent ‘work from home’ entitlement – this will be a way for ‘good’ employers to attract the ‘best’ workers.
I am completely unconvinced that paying workers daily will help them budget more effectively. Frankly, I think there is an increased chance that when the rent or mortgage payment is due these workers will be short because they overspent a little each day. At a minimum, the financially challenged need to line up payday with rent and mortgage payments so that these expenses come out of pay first leaving them a smaller problem to manage for the rest of the month. If someone can’t look at a month of income and expenses and figure out how to make it balance – it seems implausible that dividing that problem into 30 smaller pieces will make the job easier unless landlords are moving to daily rent.
The Truth about Money
The real solution is financial literacy which I remain stunned is getting little traction over the past 30 years when all evidence has shown it is critical to helping people make better choices. I taught Junior Achievement for a few years and saw firsthand the varying degree of understanding of money between kids in grade 7 and 8. I also wrote about financial literacy last year and my main message was that if we can’t save the adults we need to at least make a renewed effort to save the kids who will one day be the next generation of adults.
There is a lot of attention in the media lately about income inequality and I even spoke out against the outsized paycheques some CEOs get for seemingly riding the stock market ups and downs rather than driving true value in business. But with that said, it is increasingly clear to me that the income we each earn is only one part of the story. Underneath the income story is the story of accumulated wealth. The truth is there are families with millions in accumulated wealth and that wealth continues to grow – compounding at rates much higher than the rates that income grow.
I don’t think we should vilify those around us that have sacrificed and saved and are now the winners in the compound interest game. What we should do is make sure that everyone understands how money and interest works and make sure that everyone sees a road to be the lender earning interest and not the borrower paying it.