Plan to make your dreams a reality - It's easier than you think

"So what can I do for you today?" Jay asked as he sat down at Ivy and Brent's dining room table.

Ivy and Brent had been clients of Jay's for about 10 years. During that time, he'd helped them manage a number of financial transitions, including a job change for Brent and the unexpected death of Ivy's mother. In fact, at their previous meeting, he was pleased to learn that their eldest daughter would be starting university in the fall, financed in part by the Registered Education Savings Plan (RESP) he had helped them set up soon after he had become their financial advisor. Jay was curious, however, about why they had asked for this meeting today. It had only been three months since their last meeting and Brent had given no clue as to the reason for the meeting when he had called last week.

"Well, as you know, Emma will be starting university in a few weeks," started Brent. "And in another couple of years Chad will probably join her."

"Brent and I were talking last week and we realized that retirement doesn't really seem that far off anymore," added Ivy. "Based on what you've shown us, we're both pretty comfortable that we'll have enough retirement savings to manage our day-to-day expenses. But, the more we talked about it, the more we realized that we both want to be able to travel once we retire. We'd love to see other parts of the world, but I don't think we've planned for that... financially, I mean."

In anticipation of this meeting, Jay had reviewed their file and had a fairly good idea of where they stood. "Well, the bad news is that you're right," said Jay. "Based on our current projections for your retirement savings, becoming world travellers in retirement would put quite a strain on your budget. However, there's also good news. Even though retirement suddenly seems a lot closer, you've still got a good 15 years remaining to save, which is more than enough time to make that dream a reality."

"That's good news," said Ivy. "And we're actually one step ahead of you here. After Brent and I talked last week, we looked at our expenses. Since the cost of university for the kids will be mostly looked after by the RESP, our expenses will be going down over the next couple of years."

"And, since we're not making any new contributions to the RESP, we've got some extra money to put towards a travel fund," added Brent. "We figured out that, with those savings, we should each be able to save about $200 per month. So, I guess the reason we asked for this meeting is, how can we make sure we have enough to travel once we retire?"

Jay smiled. "I wish all of my clients were like you. Not only do you know what your goals are but you've already found the money to make it happen. I'm glad you asked for this meeting. I've reviewed your file and it looks like you're both already maximizing your RRSP contributions so you'll need to save with a non-registered savings plan."

"What's the difference?" asked Brent.

"The main difference is that, with a non-registered plan, you don't get to deduct your contributions at tax time," answered Jay. "The other difference is that, with a registered plan, you don't pay taxes until you take the money out of the plan. With a non-registered plan, you pay taxes each year on the income the plan generates, such as interest and dividends or capital gains resulting from the sale of an investment."

"So, if we each put $200 per month into a non-registered investment plan, how much would we have in 15 years?" asked Ivy.

"Before we get to that, Ivy, I'd like to take a step back and ask you both to look at a couple of different strategies for achieving your goal," answered Jay. "The first strategy is straightforward investing. You could use the $200 each month to make contributions to an investment fund, just as you do with your current RRSP contributions. The second strategy is called investment leverage and it has the potential to help your money grow more quickly than the first strategy."

"I understand the first strategy," said Brent. "But how does leverage work?"

"With leveraged investing, instead of using the $200 each month to purchase an investment fund, you would take out a loan from a bank and use the loan to make a single, much larger contribution to an investment fund," answered Jay. "Then, you would use the $200 each month to make interest payments on the loan."

"You mean we would spend our money on interest payments instead of putting it into an investment?" asked Ivy. "That doesn't make any sense."

"It might seem strange to pay interest on a loan rather than make a contribution to your plan each month but leverage has two things going for it," replied Jay. "First, remember you are making an investment, only it's all at once with the money you borrowed. And, because you're using your loan to buy an investment, you can generally deduct your interest payments from your taxable income1. This reduces the amount the loan is actually costing you.

"Second, with leverage, you're investing a large lump sum on day one. This means that a much larger amount will have the full 15 years to grow. On the other hand, if you simply invest $200 per month, only the $200 you invest today can grow for the full 15 years. The $200 you invest at this time next year only has 14 years to grow and so on. Perhaps it will make more sense if I show you an example."

Jay turned his computer monitor so Brent and Ivy could see it. "I'll run an illustration based on one of you but since your tax rates are the same, it should be applicable to both of you," said Jay. "Now, let's start with how much you have to invest over the next 15 years. Two hundred dollars per month times 12 months is $2,400; times 15 years is $36,000. So, if you set aside $200 each month for the next 15 years and assume there is no growth in your investment during that period, you'd have $36,000. Not bad but I'm pretty sure you can do better.

"Now, you have $36,000 to invest over the next 15 years but, as I mentioned, you'll need to pay some taxes on the growth along the way. If we compare this to the opportunity of leveraging, we'll need to ensure that the $200 covers both the interest payments and the taxes. For the purpose of this illustration, I'm going to assume that you'll be paying seven per cent interest on the loan."

"Isn't that pretty high?" asked Brent. "I keep hearing that interest rates are near an all-time low right now."

"Rates are low right now but they may not stay that way for the 15-year period you are looking at investing," said Jay. "With an investment loan, you borrow at a floating rate so your interest cost will change over time. Even though you could get a loan at about six per cent right now, rates may go up and I'd like to build in a buffer for you so you're not caught short if that happens. I'm also going to be relatively conservative with the investment return and assume a long-term return of eight per cent. Based on these assumptions and a couple of others2, I'm going to estimate that you could each manage an investment loan of $45,000. Here's what that would look like." Jay finished making the entries and the Investment Leverage Illustration (below) appeared on the screen.

NVESTMENT LEVERAGE ILLUSTRATION *

Results	Non-Leverage Strategy	Leverage Strategy
Cost of investing	A	B
Initial client deposit	--	--
Total cash contributions during the investment period	$33,675	--
Income tax paid on fund income during the investment period*	$2,006	$7,331
Total after tax loan interest paid during the investment period	--	$28,350
Total cost of investing	$35,681	$35,681
Investment Results	C	D
Investment value at the end of the investment period	60,427	$142,748
Less repayment of loan	--	$45,000
Less capital-gain tax on sale of investment	$4,013	$14,662
Client equity at end of the investment period	$56,414	$83,085

* For illustration purposes only. Actual rates may vary.

"Remember how I mentioned that each of you has $36,000 available over the next 15 years?" started Jay. "This table shows you the potential results of the two different investing strategies we discussed. Section A shows your costs if you simply contribute $200 per month to an investment plan. I wanted to keep you under the $36,000 over 15 years so this illustration actually assumes contributions of about $187 per month, with a few dollars set aside each month for taxes. As you can see, over 15 years, you'll contribute $33,675, and pay $2,006 in taxes for a grand total of $35,681.

"Now, let's look at your costs under the leverage strategy shown in section B. With a seven per cent interest rate, you'll actually be paying about $260 per month in interest. But remember, you'll be deducting those interest payments, so your actual interest cost after you get your tax refund works out to just under $160 per month. Over 15 years, you'll be paying $28,350 in after-tax interest and another $7,331 in taxes, leaving you with a total cost of $35,681 – the same cost as with the non-leverage strategy. Are you with me so far?"

"So, with a leverage strategy, we pay interest each month and then claim it as a tax deduction at the end of the year, right?" asked Ivy.

"Right," said Jay.

"How come we're paying so much more tax with the leverage strategy?" asked Brent.

"Good question," responded Jay. "You're paying more taxes because your initial investment is much larger and it's earning much more income. This is a good thing. Let's move onto the results and you'll see why. Section C shows you the results of the nonleverage strategy. After 15 years, your investment will be worth $60,427. Let's assume you decide to sell the investment at that time. You'll end up paying $4,013 in taxes on the gains, which will leave you with $56,414. Not bad, but let's look at what a leverage strategy might do for you.

"Section D shows the results of the leverage strategy," continued Jay. "At the end of 15 years, your $45,000 initial investment has grown to $142,748. We'll again assume you want to sell the investment at that time. Once you sell the investment, the first thing you would need to do is repay the loan so that takes $45,000 off the top. Next, you'd have to pay taxes on any gains that you haven't yet paid tax on. This would come to $14,662 in this scenario."

"Almost $15,000 in taxes?" gasped Brent.

"But look at how much more the investment is worth," said Ivy. "More growth equals more taxes."

"Exactly," encouraged Jay. "Now, looking at the screen, can you tell me how much a leverage strategy would leave you with after you've repaid your loan and taxes?"

Ivy leaned in to look at the screen. "$83,085?"

"If our assumptions are correct, yes," said Jay. "The leverage strategy would outperform the traditional investing strategy by more than $26,000 after 15 years."

Ivy turned to Brent. "Did you hear that, honey? We could have more than $83,000 to travel with when we retire!"

"I think you're forgetting one thing," Jay interjected. "The $83,000 is just the result for one of you. If you both use a leverage strategy with your $200 per month, you're actually looking at $166,000. That should be enough for a few great vacations."

Brent and Ivy stared at each other with grins on their faces. "So how do we get started?" asked Ivy.

Jay laughed. "I'm glad you're excited," he said. "But before we jump into this, I'd like to point out a few things about investment leverage to make sure you understand how this strategy works. First, you should know that leverage magnifies the performance of an investment – up when the markets are good and down when the markets are bad3."

"I've seen people try leverage without being committed to the strategy. Often they cash out before the strategy has had a chance to work. These clients typically end up worse off because once they pay the early-surrender charge on the funds that they have invested in, there's not enough left over to repay the loan and they need to make up the difference out of their own pocket. Moreover, if there was any investment growth before the surrender charge was taken off, they've had to pay the tax on that too. Leverage can work but you need to give it time. I need to know that you're committed to this strategy and can ride out the bumps along the way."

"That's no problem for me," said Brent. "I've been keeping track of my RRSP fairly closely over the years and I know there can be a lot of ups and downs."

"I'll just keep thinking about the trips we'll be able to take in 15 years," said Ivy, smiling.

"Good," said Jay. "The second important point I want to make is that there are no guarantees. I've used conservative estimates but I can't promise you that you'll have $166,000 in 15 years. It could be more or it could be less. What I'm saying is leverage is riskier than traditional investing. Given that you're saving for a luxury rather than a necessity, I'm more comfortable recommending this strategy to you but you need to evaluate the risk for yourselves and decide if you're comfortable with the risk. To give you an idea of the risk, let me show you one more thing."

Jay clicked his mouse and another graphic came up on the screen. "This table shows you what return your investment needs to earn to make you better off with a leverage strategy than with a non-leverage strategy," said Jay. "If our other assumptions are correct, your investment will need to earn an average annual return of 5.16 per cent for you to be better off with leverage than with traditional investing. It also says that if your investment earns less than 4.05 per cent per year, you'll end up with less money than you put into the strategy."

"So what are the odds of that happening?" asked Brent.

"Historically, the Canadian stock market has had an average annual return of around 10 per cent4. But that varies quite a bit from year to year – I'm just talking about long-term averages. That's certainly well above the return you need," replied Jay. "However, as I said, there are no guarantees. I'd say it's unlikely your long-term return would be below the level you need but it could happen. And regardless of how the investment performs, you're still responsible for paying the taxes and interest and eventually repaying the loan."

"Those sound like pretty good odds to me," said Ivy. "I'm comfortable with the risk."

"And you, Brent?" asked Jay.

"I think the chances are fairly small that the investment would earn less than 5 per cent per year over 15 years. I think we should give leverage a try," replied Brent.

"Excellent," said Jay. "Let's get started."

Brent, Jay and Ivy spent the next half hour discussing the strategy and ensuring they understood how it worked. Brent and Ivy each applied for a $45,000 investment loan to invest in a pair of diversified, high-quality investment funds. When they were finished, Jay got up to leave.

"Thanks for all your help Jay," said Brent, shaking his hand. "I feel like we just took a huge step towards our dream of seeing the world when we retire."

"You have taken a big step," said Jay. "Now, you just need to stick with the program for the next 15 years and let the investment do the work for you."

"There's no problem there," grinned Ivy. "I'll let the investment do the work while I'm busy planning our trips."

1 Not all investments are tax deductible. Consult your tax professional for more information.
2  Assumptions: $45,000 investment loan, 15-year investment period, 8% return, 25% taxable portion of return, 30% tax rate on investment income, 7% loan interest rate, 100% interest tax deductibility, 40% marginal tax rate. Assumptions are for illustration purposes only.
3 Borrowing to invest is suitable only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be magnified. The value of your investment will vary and is not guaranteed, however you must meet your loan and income tax obligations and repay your loan in full. Please read the terms of your loan agreement and the investment details for important information, and discuss with your financial advisor before deciding to borrow to invest.
4  Based on rolling 10-year periods between January 1966 and December 2004, the average annualized 10-year return of the S&P/TSX Total Return Index was 10.14%. During this period the lowest 10-year annualized return was 3.34% and the highest 10-year annualized return was 19.51%. Past returns are not indicative of future returns.