When RRSP Catch Up Loans Make Sense
RRSP Refund Strategy 5: Catch Up
Ted’s wondering if it can make sense to borrow a larger amount to Catch Up on his RRSPs.
Let’s find out, by first understanding what is best mathematically. Then we’ll look at the often overlooked but more important factor: behaviour.
For simplicity, we’ll evaluate a $30,000 Catch Up strategy. If Ted borrows and contributes $30,000 to his RRSP in February, a few weeks later he’ll get a tax refund of a third of $30,000 or $10,000.
To keep the math simple, this assumes that a $30,000 RRSP contribution does not drop Ted into a lower tax bracket, which would reduce the tax refund.
Knowing where tax brackets change is important to MAX your tax deduction when making RRSP contributions, especially large ones. This is one of the reasons why it is valuable to deal with a good financial advisor.
The common approach of assuming that the entire contribution will produce a tax refund at the marginal tax rate often overstates the amount of the tax refund. This leaves the investor disappointed when the refund is less and/or increases the loan balance that must be paid off.
The $10,000 refund is immediately used to reduce the loan balance to $20,000. Assuming a 7% interest expense, the remaining $20,000 can be paid off over 9 years with annual payments of about $3,000 or $250 a month.
Let’s assume that Ted can comfortably commit to investing at least this amount in each of the next 9 years, even during his lowest-income periods. If so, there are 4 different ways that he can use RRSPs to save for retirement. And since each of the 4 RRSP Refund Strategies produces significantly different results, Ted wants to know which is best for him.
He could get $30,000 growing in his RRSP right away, and use $3,000 of after-tax annual cash flow to pay off the $20,000 that would remain on a Catch Up loan.
Alternatively, he could use the same after-tax cash flow and invest it into RRSPs each year, with the refund either Spent, Reinvested, or Grossed Up.
Note that if Ted reinvests his 33% refunds, his annual contributions would be 33% more or $4,000. Better would be to Gross Up his contributions to the full, before-tax value of $4,500.
Since no one knows what Ted’s RRSP returns will be in the future, we should evaluate the strategies for a range of returns. Although the results for other interest rates, tax brackets, returns, and time horizons will vary, the following conclusions generally still apply.
Returns Match the Cost of Borrowing
If Ted’s RRSP returns match the 7% interest cost on his Catch Up loan, the Catch Up strategy produces 50% more than his current approach of spending his refunds.
Returns Higher Than the Cost of Borrowing
As you might expect, when returns exceed the cost of borrowing, you benefit from borrowing to invest. In this situation, the Catch Up strategy always wins.
With 11% returns, the Catch Up strategy produces 72% more than Ted’s normal spend-the-refunds approach. And it is 15% better than the Gross Up strategy.
So we can conclude that when returns match or exceed the cost of borrowing, the Catch Up strategy is at least as good as any of the other refund strategies, even the best Gross Up approach.
Returns Lower Than the Cost of Borrowing
Now consider the possibility that Ted’s RRSP returns end up being lower than the non-deductible interest cost on his Catch Up loan.
Perhaps Ted invests in more conservative, fixed-income investments. Perhaps the equity markets produce below-average returns.
This lower-expectation scenario reveals surprising but significant insights.
When returns average only 3% — less than half of the 7% interest expense on the loan — the Catch Up strategy is still meaningfully better than the typical approach where refunds are spent.
Here, Ted would have 27% more in his RRSP if he made the one-time decision to make a large Catch Up contribution, compared to spending his refunds.
As shown, if Ted was more committed to his retirement goal and reinvested his refunds, his RRSP would be slightly more than with the Catch Up strategy.
But here’s the critical question in determining what RRSP refund strategy is best for you.
How many people would truly invest every penny, of every refund, every year?
Even if they understood how pasta can increase RRSP income 25-100%, how many investors would truly have the discipline to do that?
I think we can agree that when we account for the critical factor of behaviour, the vast majority of investors would end up with a larger RRSP by using the Catch Up strategy, even when returns are less than half of the cost of borrowing.
Note that if one had the awareness and the fortitude to Gross Up contributions every year, in this low-return scenario, you would only be 18% better off than using a Catch Up.
Returns MUCH Lower Than the Cost of Borrowing
Because borrowing to invest, even for RRSPs, is a controversial concept that most investors are appropriately apprehensive about, let’s deepen our understanding of the downside even further. Let’s compare the RRSP Refund Strategies when the non-deductible interest rate on the Catch Up loan is 7% and RRSP returns are 0%.
No investor expects to earn zero growth over a long period like 9 years. But it could happen.
And while 0% returns are undesirable, it does make the math easy!
When returns are 0%, a $30,000 Catch Up strategy is worth the same after 9 years as it is at the start. If instead, Ted used his $3,000 of cashflow for regular contributions where the refunds were spent, his RRSP would increase by a flat $3,000 a year. So after 9 years, Ted would have $27,000.
This means that even with 0% returns, Typical Ted’s RRSP savings strategy, where he invests every year and spends the refunds, produces $3,000 or 10% less than he would have using the Catch Up strategy.
A Behavioural Solution to Lock in Discipline
When returns are less than half of the cost of borrowing, or even 0%, the Catch Up strategy can benefit most investors because it forces a higher level of commitment to retirement savings.
While Ted may intend to reinvest or even Gross Up his refunds every year, the loan locks in his commitment.
Once started, the loan becomes a forced savings plan, like a mortgage, that is not likely to be stopped. As long as Ted can comfortably handle the payments during the lowest-income years, the forced discipline of an investment loan is often more effective than an automatic Pay Yourself First approach that can be easily suspended.
For most, the real benefit of a larger Catch Up loan is behavioural. The Catch Up strategy is a behavioural solution that forces a higher level of discipline and commitment.
Confession and a Deeper Understanding
All of my prior education about the RRSP Refund Strategies over the last 20 years — in a booklet, a book, Leverage Professional software, hundreds of seminars, even this blueprint so far — addressed the behavioural factor of what happens to the RRSP refunds, by definition.
One of the unique features of the Leverage Professional software is that it automatically calculates the minimum return needed for forced savings to be better than an automatic savings approach. It wasn’t until I added this feature to the “MAX your RRSP Strategy” software that I discovered I’ve actually been understating the behavioural benefits of using forced savings for RRSPs.
The behavioural factor that so far has not been included in the analysis of the RRSP Refund Strategies, even by me, is how often the typical ad hoc investor skips contributions altogether.
When there’s no RRSP contribution, there’s no refund to spend, reinvest or Gross Up.
Based on the reasonable parameters used in this Catch Up analysis, including the assumption that refunds are spent and contributions are skipped 20% of the time, the “MAX your RRSP Strategy” software shows that for Typical Ted, the Catch Up strategy is better when returns exceed -6.6%.
You read that correctly. Minus 6.6% returns. Click here for the analysis summary.
This means that if you’re a typical investor like Ted, who spends your RRSP refunds and skips contributions at least 20% of the time, you should be very confident that you’d be better off by borrowing to Catch Up on RRSPs.
Conservative, fixed-income investors can always get positive returns that are guaranteed. And even equity investors can expect to earn more than -6% per year over the worst 9-year period.
The insight that I was slow to recognize and we should all fully appreciate is that using forced savings for RRSPs eliminates the behavioural risks that refunds are spent and that contributions are skipped.
Automatically calculating the minimum return needed for Catch Up loans to benefit investors makes it easy to gain a deeper understanding of the strategy, and quickly assess how confident you should be in using a forced savings approach.
MAXing Mary wisely uses automatic instead of ad hoc savings, so she never skips contributions. In addition, she consistently reinvests 100% of her refunds. Based on these behavioural parameters, and the same 7% loan interest rate, the software shows that the 9-year Catch Up strategy is only better when returns exceed 4.3%.
However, by simply reducing the loan term to 5 years, Mary only needs to get 2.2% returns for the Catch Up strategy to be better than her already-good savings approach. Conservative investors might be able to get guaranteed returns to achieve that. Here’s the analysis summary.
Using forced savings for RRSPs eliminates the behavioural risks that refunds are spent and that contributions are skipped.
Instead of one long-term Catch Up loan, some might prefer a series of shorter loans. Like making ongoing payments for a vehicle, you make ongoing payments for a better retirement.
With three 3-year loans instead of one 9-year loan, you still have the behavioural benefit of forced savings. And the amount borrowed is less which is more comfortable for most investors.
The other potential benefit of this alternative is that if for some reason there was a significant decrease to your investable cash flow, having the forced savings locked in for a shorter period would make it easier to deal with.
Now that we understand the basic Catch Up strategy, let’s look at two variations that help equity investors profit more from stock market opportunities.
MAX Stock Market Opportunities
We’ve seen how a Catch Up strategy can benefit investors even when returns are low, due to the behavioural benefits of forced savings.
But equity investors can also use Catch Up loans to turbocharge their RRSP, and accelerate wealth like the rich do.
Let’s say that you love pasta, pun intended. You either have Italian in your blood or you wish you did. It is your carb of choice most nights.
Pasta sauce, which usually costs $3 a jar, is suddenly on sale for half price. You can’t remember the last time you paid only $1.50. What do you do?
Do you buy a few weeks’ worth of sauce, like you normally do, or a truckload?
When it comes to buying things, most consumers like to pay less. And when the price is low, they often buy more.
But ironically, when it comes to buying investments, we do the opposite. Due to our hard-wired fear response, when stock markets go down, most equity investors interpret the market’s “lower price” as a negative and want to sell.
We rationally know we should “buy low and sell high.” But most of us emotionally find this difficult. Except the wealthy.
The rich recognize that stock markets go up and down, and take advantage of the volatility. And they don’t just “buy low.” The rich “Buy More Low.”
How? By having financing in place ready to borrow, and patiently waiting, to buy more when the market goes “on sale.”
Historically, after the Canadian stock market has lost money over 12 months, the following 1-year total returns have averaged 19%. This is almost double the long-term average return of about 10%.
Most equity investors know the benefits of “dollar cost averaging.” By investing the same amount every month (inflated each year from now on, of course), you automatically buy a few more units of a fund or stock when the price is lower. A “Buy More Low” approach gives the same benefit, at a MUCH bigger scale.
If you’re an equity investor, there are two ways to use this concept to turbocharge your RRSP and accelerate wealth like the rich.
“Buy More Low” Catch Up
With the “Buy More Low” Catch Up strategy, you wait until the market is “on sale,” and borrow to make a large contribution that might take 5-10 years to pay off.
This version of the Catch Up strategy is almost guaranteed to be safer than the normal Catch Up where you don’t wait until the market is down. So there is less financial risk.
But again, the real benefit of a “Buy More Low” Catch Up is not the math. It’s not that you should get higher returns with lower risk than a normal Catch Up. It’s behavioural.
By waiting to start your larger, borrowed investment until the market is down, you’re more likely to have a positive experience, especially at the start. This makes it MUCH easier emotionally, which means you’re much more likely to stick to the plan.
And this early positive experience is especially important for those who are using a Catch Up strategy for the first time — those who might not have the confidence to ride out further market drops, or perhaps borrow to buy even more.
“Buy More Low Lite” Catch Up
The “Buy More Low Lite” Catch Up is the most conservative version of the Catch Up strategies. Again, you wait until the market is “on sale,” but this time, you borrow to make a modest RRSP contribution that is paid off in 2-4 years.
Some investors conceptually like the idea of strategically borrowing when markets are down to magnify returns during the expected recovery. But they are emotionally not comfortable borrowing a large amount over many years, even when it makes the most sense to do so.
By borrowing a smaller amount for only a few years, you’re guaranteed to have less financial risk and less emotional strain experienced over a shorter period of time.
Assuming the markets recover, with the “Buy More Low” Catch Up, you end up with slightly higher returns over a longer period, with a larger amount. With the Lite approach, you should get much higher returns over a shorter period, but with a smaller amount.
To learn more about how to turn the “negative” of stock market drops into an opportunity to accelerate wealth like the rich do, check out this chapter from The Smart Debt Coach entitled “[rrsp_branded_url fileprefix="SmartDebtCoach,BuyMoreLow"]A Commonsense Way to Beat the Stock Market[/rrsp_branded_url].”
Summary of Catch Up Strategies
- Normal Catch Up: Can be used by all investors, any time, independent of stock market levels. The big benefit is behavioural, even when returns are low.
- “Buy More Low” Catch Up: For equity investors. Wait until the market is “on sale.” Then borrow to make a large RRSP contribution that might take 5-10 years to pay off. Less risky than the normal Catch Up.
- “Buy More Low Lite” Catch Up: For more cautious equity investors. Wait until the market is “on sale.” Then borrow to make a modest contribution that is paid off over 2-4 years. Less risky than the “Buy More Low” version.
You now have the core strategies to improve your RRSP savings. It’s time to learn how to combine them in a way that is optimal for you, to “MAX your RRSP Strategy.”