While millions of Canadians will make RRSP contributions this year, it is important to understand that there are two investment strategies even better than an RRSP.

Pay off expensive personal debts - those charging over 13%.

Mathematically, most Canadians are better off to pay down personal debts ahead of contributing to their RRSP's when the interest rate on the non-deductible debt is at least 3% higher than their average RRSP return. For example, if you expect your RRSP to average 10% returns, then only debts that charge at least 13% or more, should come ahead of maximizing your RRSP.

This means paying off bank credit cards, and especially department store credit cards where interest rates may still be 32.9% per year. But this generally does not mean mortgages, where rates are less than 13%.

It is almost impossible to beat the guaranteed returns of paying down expensive non-deductible debts. As indicated in a previous MoneySaver article, someone in the middle tax bracket who doesn't pay off their 32.9% charge card is effectively turning down a 57% GIC.

Conservative Leverage

If you believe in doing what rich people do to make yourself richer, then you must be aware of conservative leverage as one of the best wealth-building strategies still available. Done conservatively, with the guidance of a trusted financial advisor, leveraging - borrowing other people's money and investing it - has significant advantages over RRSP's as a long-term investment strategy.

The concept of leverage is not new, and has traditionally been used by more aggressive investors willing to assume increased risk. The reaction to Angelo Vicere's December 1994, MoneySaver article "Are RRSPs Worth It?" indicates the controversial nature of suggesting that leverage is better than RRSP's. Thus, it is important to discover the truth, so every investor - not just the wealthy - can know the most effective investment strategy,

Perhaps it is worth mentioning that my business is purely educational. I do not sell any financial products. I objectively analyze the pros and cons of financial decisions and report what is best for the individual. Thus, my conclusions are totally unbiased and account for both the mathematics and the equally important human factors.

Assumptions: For simplicity, let's assume you have $1,000 a year available to invest for long-term savings. The leveraged investment is invested in several international equity mutual funds, where almost all of the growth is a capital gain. While some will argue that equity funds are 'risky', this is only true for short-term time horizons, of less than, say, seven years. We'll leave it to another article to show how diversified equity funds are the lowest total risk choice for long-term investments. Let's first discuss the pros and cons of putting the $1,000 a year into an RRSP relative to using it to pay the interest on a conservatively leveraged investment loan. Then we'll put it all together and look at the numbers.

Tax deductibility: Initial deduction - Whenever you borrow money to invest outside of an RRSP, the interest expense can be 100% tax deductible. This means that the interest payments produce the same tax deduction as an RRSP contribution.

Growth - Growth inside an RRSP is 100% tax free. Taxable annual distributions from equity funds are typically in the neighbourhood of 5%. Since most of these distributions are capital gains (75% taxable), the taxable amount for someone in the middle 42% tax bracket would be 5% x 75% x 42% = 1.6%. Let's call it 2%. Thus about 98% of the growth compounds tax-free as unrealized capital gains, until you actually sell the investment. Note that the reinvested distributions increase the adjusted cost base, reducing slightly the capital gains payable when the funds are sold. This partially offsets the 2% tax-free advantage of the RRSP investment.

Cashing in - When you withdraw funds from an RRSP, they are 100% taxable. When you sell the equity funds, capital gains are only 75% taxable. This means that $1 of RRSP is equivalent to $1.33 of capital gains (75% of $1.33 = $1). This is a major (33%) benefit in favour of the nonsheltered capital gain investment.

Tax Deduction Limit: In 1995, RRSP contributions are limited to $14,500, or 18% of the previous year's earnings, and possibly further reduced by a pension adjustment. The deductible interest for a leveraged investment loan is only limited by your collateral or additional cash flow. The reverse is also true. Until you have either collateral or cash flow, you can't borrow money, and hence can't leverage.

Magnitude of Initial Investment:

By using your available cash flow to pay only the interest expense every year, you get to have much more money growing and compounding in your name than you normally would be able to. For example, if the interest expense averages 10%, your $1,000 per year could have $10,000 growing in your name from the start, instead of $1,000 after the first year, $2,000 after the second year, etc. This is another major benefit, as illustrated in the example.

Investment Restrictions: Generally speaking, RRSPs are limited to 20% foreign content. Non-sheltered investments have no such restriction, and can be 100% international. For Canadians, getting your money out of the country not only produces more economic, geographical, and political diversification, i.e. reduces risk, but it increases returns at the same time.

For long-term periods often years or more, Canadian equity mutual funds have averaged about 10% per year. International equity funds have averaged about 13% per year, a difference of 3% per year alone. The 3% difference per year over a 30 year time period is in itself enough to double the size of a retirement fund. This is another major benefit of a levemged investment.

Risks: Many people view the strategy of leveraging as risky, but the truth is that some aspects of leverage increase risk, while others actually reduce it. As mentioned, relative to an RRSP, international diversification actually reduces risk while increasing returns.

Perceived risk is more important than actual risk. For those who think they would never be comfortable doing anything as 'risky' as leverage, it is important to point out that anyone with a mortgage is already using leverage, perhaps without realizing it.

A mortgage is a highly leveraged, poorly diversified fluctuating investment with low liquidity and poor future growth expectations for many parts of Canada, where the interest expense isn't even tax deductible! Using leverage for an investment instead of purchasing a house improves each of these factors and should only make the investor more comfortable with the strategy.

The major risk of leverage is a margin call, where your lender requires more collateral to back the investment loan. This risk can be eliminated by borrowing conservatively such that you have much more collateral than required by the lender, or by using collateral other than the investments themselves, perhaps via a second mortgage, or a line of credit secured by the house. A 3rd approach is that some lenders will not issue a margin call if you use a 15 or 20-year amortization period for the investment loan instead of simply paying interest only.

A minor risk with leverage is that you don't want to be forced to sell during a down market. Thus, leverage isn't for someone who doesn't have secure short-term cash flow. You can stop a monthly RRSP investment without any adverse consequences.

Mathematical risk: Mathematically, leverage magnifies returns, and offsets your break-even point. A non-leveraged investment has a break-even point of 0%, (ie. any positive return is profitable), and no magnification of investment returns.

For a leveraged investment, the break-even point depends on the tax benefits for the type of investment (only 75% of capital gains are taxed). If we are evaluating on an after-tax basis, then the individual's tax rate is also a factor, ie. the leveraged investment is not profitable unless the after-tax return exceeds the after-tax cost of borrowing.

The mathematical risk of leverage is the fact that the investment must exceed a certain break-even point before it is profitable. The mathematical benefit of leverage is that the returns are magnified or leveraged. The following table illustrates how leverage offsets the break-even point and magnifies returns. It assumes that the leveraged investment is capital gains, and a 50% tax bracket, and a borrowing cost of 10%.

Nominal Equity Fund Return	Leveraged After-Tax Rate of Return
-10% 0% 8% 10% 12% 16%	-225% -100% 0% 25% 50% 100%

Example calculation for 10% nominal return.

Leveraged after-tax rate of return (*after one year) = After-tax return from equity fund/after-tax cost of borrowing - 1. If your borrowing cost is 10%, $1,000 in interest payments would cover a $10,000 investment.

After-tax cost of borrowing = Before-tax cost of borrowing-tax deduction=$1,000 - 50% x $1,000 = $500.

After-tax equity return = Nominal return - tax due (75% of capital gains x tax rate) = $10,000 x 10% - (75% x $1,000 x 50%) $1,000 - $375 = $625.

Thus, in a one-year time period, on an after-tax basis, you gained $625 at a cost of $500, for a leveraged after-tax return of 25% (625/500-1=25%)

Note that the break-even point is a nominal equity fund return of 8%. Any return of less than 8% is not profitable. The after-tax, breakeven point is slightly different for different tax brackets. Because leverage magnifies losses as well as gains, leveraging poor investments loses money even faster. This break even point of 8% illustrates the importance of having a long-term view where equities have averaged 10% -13%, and getting advice in choosing funds that are expected to outperform the average.

The real risk in any decision is the degree to which you do not understand what you are doing. From this perspective, RRSPs are simpler, familiar, and conventional, and thus have less perceived risk than a leveraged equity investment

Human Considerations: you must understand and be comfortable with a fluctuating investment using other people's money. If you would panic after a 20% drop in the value of the borrowed funds, then leverage isn't for you. If you see a 20% drop in the market as a buying opportunity to start or increase a leveraged investment, then you'll sleep well at night and do very well over the long run.

Let the Numbers Speak.

Let's put it all together the quantify the two strategies. To quantify the difference for the typical RRSP contributor, I have assumed an annual cash flow available of $2,000. This is slightly less than the average RRSP contribution. Actual AnnROI means Actual Annual Return on Investment. The Equivalent Taxable Balance accounts for the fact that capital gains are taxed less than RRSPs. (See chart on page 9.)

Conclusions

Leverage is slightly better than RRSPs even when the equity returns only match the cost of borrowing. When we use the realistic averages for RRSPs and international equity funds, we see that the average RRSP investor could end up with an extra $165,000 after a period of 20 years.

In conclusion, it should be clear that leverage is superior to RRSPs as a long-term, wealth building strategy. Done properly and conservatively with a trusted financial advisor, any Canadian with the collateral to borrow can take advantage of what the wealthy have been using for hundreds of years.

Talbot Stevens,, BSc, Author of Financial Freedom Without Sacrifice, 789 Monsarrat Avenue, London, Ontario NSY 4Y3 (519) 438-6550

Conservative Case: Equity return equals cost of borrowing LEVERAGE VS. RRSP ANALYSIS 10.00% Borrowing Rate 10.00% RRSP Return 10.00% Leverage Return 1.33% Capital Gain Tax Factor (1.33 for pure capital gains) $20,000 Leveraged Principal $2,000 Annual Investment Leverage RRSP Year Total Balance Personal Balance Actual Ann ROI Equiv Taxable Balance Taxable Balance Difference Lev. RRSP 0 1 5 10 15 20 25 30 40 $20,000 $22,000 $32,210 $51,875 $83,545 $134,550 $216,694 $348,988 $905,185 $0 $2,000 $12,210 $31,875 $63,545 $114,550 $196,694 $328,988 $885,185 0.00% 6.70% 8.30% 8.90% 9.20% 9.40% 9.50% 9.70% $2,660 $16,240 $42,394 $84,515 $152,351 $261,603 $437,554 $1,177,296 $2,000 $12,210 $31,875 $63,545 $114,550 $196,694 $328,988 $885,185 $660 $4,029 $10,519 $20,970 $37,801 $64,909 $108,566 $292,111 Average Case: Use actual average return of international equity funds LEVERAGE VS. RRSP ANALYSIS 10.00% Borrowing Rate 10.00% RRSP Return 13.00% Leverage Return 1.33 Capital gain tax factor (1.33 for pure capital gains) $20,000 Leveraged Principal $2,000 Annual Investment Leverage RRSP Year Total Balance Personal Balance Actual Ann ROI Equiv Taxable Balance Taxable Balance Difference Lev. RRSP 0 1 5 10 15 20 25 30 40 $20,000 $22,600 $36,849 $67,891 $125,085 $230,462 $424,611 $782,318 $2,655,631 $0 $2,600 $16,849 $47,891 $105,085 $210,462 $404,611 $762,318 $2,635,631 30.00% 17.90% 15.40% 14.60% 14.10% 13.90% 13.70% 13.50% $3,458 $22,409 $63,695 $139,764 $279,914 $538,132 $1,013,883 $3,505,389 $2,000 $12,210 $31,875 $63,545 $114,550 $196,694 $328,988 $885,185 $1,458 $10,199 $31,821 $76,219 $165,364 $341,438 $684,895 $2,620,204