Derek Foster, author of Stop Working, launches yet another debate on the merits of a RRSP with this article in Canadian MoneySaver magazine. While low-income Canadians might be better off saving outside a RRSP, the upfront tax deferral and tax-sheltered growth made possible by RRSPs are very valuable for the vast majority of middle- and high-income earners (check out this detailed analysis by Philip, Hager and North of both sides of the debate).
While I agree with some valid points that Mr. Foster makes in his article (like his argument that an accelerated mortgage pay down might be better than a RRSP contribution and a house owned free and clear is a big piece of the retirement puzzle), I think his “alternative strategy” to RRSPs may not work. To recap, Mr. Foster’s strategy is to borrow and invest a sum of money, the interest on which will be equal to a RRSP contribution. For instance, if a person makes a $6,000 contribution to her RRSP, she could instead borrow and invest $100,000 on which she pays an interest of $6,000 per year (assuming an interest rate of 6%). She gets the same tax deduction she would with a RRSP and in theory over the long-term she would come out ahead.
The key problem with Mr. Foster’s strategy is leverage and leverage cuts both ways. Most investors have a herd mentality and sell in panic during a market downturn that almost invariably marks the market bottom. Let’s say our imaginary investor borrowed $100,000 and invested in quality blue-chip stocks. If a market downturn hits and stocks fall 20% (a mild bear market) in the first year, she is looking a $20,000 loss. If she doesn’t sell and stocks fall another 10%, our imaginary investor is $28,000 in the hole (and still paying interest on her loan). How many investors don’t panic when faced with such a loss? How many are going to give up and throw the towel? How many will patiently hold, not knowing how long the bear market is going to last (it may last a decade)? My guess is the vast majority of investors would have discovered their pain threshold and not able to stomach further losses (not to mention the sleepless nights), would throw in the towel.
Compare the above strategy with another investor who saves and invests the same $6,000 in a RRSP (or less outside it). In a year, he has a $1,200 loss but he is investing another $6,000 at lower prices. After the second year, he has lost some more money but he is investing another $6,000 at still lower prices. Even in a bear market that lasts a decade, this strategy has a better chance of succeeding because it is less risky.