Sometimes it makes sense to borrow for RRSPs

> Short-Term “Top-Up”
Loans . Short-term RRSP loans that are repaid within a year are almost universally accepted as a good idea. In addition to the benefit of increased tax savings, the short-term “top-up” loan strategy reinforces the habit of investing every year — ideally, the maximum amount that can be sheltered. As a bonus, if markets are down, a temporary RRSP loan allows clients to “buy more low,” decreasing the average cost of fund units already owned and/or profiting more when markets eventually recover.

Short-term RRSP loans might not be best when clients know that they will be in a higher tax bracket the next year, or when markets are very high and a better buying opportunity is expected soon.

> Long-Term “Catch-Up” Loans .The more controversial question, which offers significant opportunity for both clients and their advisors, is: when do larger, longer-term “catch-up” loans make sense?

Most accountants and conservative experts suggest that borrowing over periods of 10 years or more to catch up on unused RRSP room only benefits the lender. While such brief rules of thumb are simple and efficient in today’s world of 30-second sound bites, we should all be careful when giving and receiving such general conclusions.

From a purely mathematical perspective, it is obvious that long-term borrowing to invest in RRSPs will benefit investors if returns are high enough relative to the cost of borrowing.

Clients with unused RRSP room can use their investible cash flow to borrow a large amount and invest it to catch up on RRSP room now, with the loan paid off over, say, 10 years.

As long as the large catch-up RRSP contribution does not drop clients into a lower tax bracket, the rule of thumb is that, mathematically, long-term catch-up loans only benefit clients when the average annual RRSP return is higher than the interest rate on the loan.

In our example, with an 8% RRSP loan rate, we would need returns of 8% or higher for a long-term RRSP loan to make sense.

Of course, clients can always use the same after-taxes cash flow to invest monthly.

> Behaviour Trumps Math. To be objective and provide the best advice to clients, we need to account for all key parameters when analysing financial strategies. The critical parameter that is generally overlooked is a client’s behaviour and discipline level.

There are two behavioural aspects that are important. The first is that 90%-95% of clients spend their RRSP tax refunds, unknowingly contributing less than the after-taxes amounts with which they started and could have invested toward retirement.

Assuming a 50% tax bracket for simplicity, if a client has $1,000 after taxes to invest and spends the 50% RRSP refund, the net investment is only $500. Advisors need to educate their clients about the fact that, in this scenario, they have contributed only $500 after taxes toward their future, not $1,000.

Reinvesting the $500 refund for an initial contribution of $1,500 is better — and benefits both clients and advisors by 50%. But we need to recognize that in a 50% tax bracket, $1,000 after taxes equates to $2,000 before taxes in an RRSP ⎯ referred to as the equivalent “grossed-up” amount. (A $2,000 RRSP deposit less a 50% refund equals $1,000 net after taxes.)

The second behavioural issue is the effectiveness of the three fundamental savings strategies.

The “ad hoc” savings strategy is the most common and least effective, in which clients invest only when they have cash available and they are “in the mood” to invest.

The “automatic” savings strategy, when clients “pay themselves first” and invest monthly, is much more effective.

For many, a “forced” savings strategy, in which a small investment loan is paid off over time, is the most effective because it locks in a higher level of discipline. Once started, the loan payments cannot be stopped.

When these behavioural factors are combined, we discover that most clients who have the discipline to reinvest 100% of their RRSP refunds would be slightly better off using a catch-up loan strategy, even if returns are only half of the non-deductible interest rate. If the RRSP loan rate averages 8%, even conservative clients — who average annual returns of 4% or higher — would produce a larger RRSP by committing to the catch-up strategy. The reality is that the majority of investors don’t come close to reinvesting every penny of every refund, and thus would be even further ahead.

@page_break@Recognizing that a large RRSP contribution could drop clients into a lower tax bracket, advisors who want to give greater value to clients would be better to answer the question: “What is the optimal amount to borrow and contribute to an RRSP this year, if any, as part of a disciplined long-term contribution strategy, accounting for different tax brackets and behavioural factors?”

Borrowing to invest in RRSPs is a form of leveraging, which — like any tool — can help or hurt clients, depending on how the tool is used. As long as clients borrow such a small amount that there is negligible financial or emotional strain, this is “good debt” that should increase their long-term wealth. IE

Talbot Stevens is an industry con-sultant, developer of RRSP Contribution Optimizer software, and author of Dispelling the Myths of Borrowing to Invest. E-mail him at talbot@talbotstevens.com.