Leverage can be powerful tool for boosting retirement savingsBy Andrew Rickard | February 18 2008 02:40PM
While the term "leverage" is usually associated with borrowing to purchase investments in non-registered accounts, Talbot Stevens believes it can also be used effectively in registered retirement accounts.
In a presentation at the 2007 Investment and Investments Convention in Montreal last fall, Mr. Stevens said,"With almost 80% of tax payers having average unused RRSP room of over $20,000 now, I think a really good place for advisors to start is to ask and perhaps answer, ‘What is the best use of that RRSP room?’"
Mr. Stevens is the president of Financial Success Strategies Inc., a financial education firm that specializes in teaching people how to benefit financially without sacrificing their standard of living.In his book,
Dispelling the Myths of Borrowing to Invest, he gives the example of a client in a 40% marginal tax bracket with $20,000 of unused contribution room available:
• He takes out an RRSP catch up loan for the full $20,000.
• He will get a refund of $8,000 which can be applied to reduce the balance to $12,000.
• Assuming an 8% rate of interest on the loan, if he pays $1656 annually, the debt will be paid off in 10 years.
Even if this leveraged client only earns a 4% return he will still be better off than someone who, rather than take a catch up loan, simply invests $1656 annually, earned an impressive 8% rate of return, but spent his tax refund cheques on a holiday every year.
The RRSP catch up loan, once started, becomes a kind of forced savings plan. It is a behavioural tactic that heightens the commitment of the client. Those who are not leveraging may have every intention of reinvesting the tax refunds they receive for making an RRSP contribution, but once the cheque is in their hands, it isn’t always easy for the advisor to bring the funds back into the client’s portfolio.
Handle with care
Mr. Stevens says borrowing to invest is a bit like operating a power tool. "Depending on how it is used, it can either help or hurt you," he says. "Most of us use power tools to speed up or magnify our efforts, often without thought about our safety."
He suggested advisors should consider how a conservative amount of leverage could help their clients accumulate more money. Ultimately the decision will depend on the individual’s risk tolerance.
If, after having investigated the matter, advisors feel the concept is inappropriate, he still thinks they should educate their clients about how leverage works in order to insulate them. Other competitors will introduce the subject if you do not, he says, and they may not do as good a job.
Mr. Stevens says there are several myths commonly associated with leverage investing.
Not just for the wealthy
First of all, he says that leveraged investing is not simply for the wealthy. The gains may be smaller, but lower and middle income Canadians can still realize benefits. Nor is all debt "bad debt," he adds. Consumer obligations like credit cards should certainly be avoided, but when loans are taken out in order to purchase something that will increase in value, that’s "good debt."
It may also be a mistake to categorize all forms of leverage as "too risky."
In his book, Mr. Stevens asks readers to consider the nature of their mortgages, which may have been purchased with a down payment of as little as five per cent. "This highly leveraged equity investment generally has poor liquidity, no diversification, expectations for low returns, and the interest expense isn’t tax deductible," he writes. But people accept that kind of debt as a fact of life despite the fact it reduces net worth. In fact, says Mr. Stevens, a loan made to purchase a diversified portfolio of investments may be a less risky form of debt than a mortgage.
Making it work
Finally, Mr. Stevens tackled the belief that returns must exceed the cost of servicing the loan in order to make leveraging worth while. In fact, the marginal tax rate of the investor and the type of returns earned will determine the target rate. Since capital gains and dividends receive favourable tax treatment, someone at a 45% marginal tax rate who takes out a loan at 9% interest may only have to earn about 6.3% in equity returns in order to benefit from leveraging.
Investors do, however, need to be aware of the risks involved with leverage. And not just the financial risks such as potential drops in household cash flow or increases in interest rates, but also the emotional risks. They may fall prey to fears that will motivate them to pull out of the markets and lose money, or to a greed for profit that will propel them into taking on more debt than they can safely carry.
Mr. Stevens is also quick to agree that those who leverage to the absolute limits of their cash flow are in very dangerous waters. "What I’m suggesting is that there are a lot of possibilities between none and lots," he says. "I suggest the sweet spot is somewhere between 0 and 50% [of available cash flow], maybe around 25%."
"If we stay in the shallow end of the pool, where even if we can’t swim, we can feel safe, we get back up if we fall down, then we should be able to get in the water," he says. "But even if we are good swimmers, if we get in the deep end of the pool, we might not be able to deal with all the waves that the markets provide for us."