Continuing from Part 1, Part 2 and Part 3 in this series we now actually come to what was named the "Preet Principle". The name actually doesn’t make too much sense, it was more because my colleague wanted to come up with a name to describe this strategy similar to the "Smith Manoeuvre" or the "Singleton Shuffle". There really isn’t any "principle" – except perhaps taking advantage of piggy-backing refunds… which will become clear as you keep reading.
Nothing in the strategy is uniquely mine. I simply took existing strategies and put them all together, created a more formalized step-by-step process, and then ran it all through a probability calculator to quantify the risk-return of the strategy.
The strategy is not for everyone, which I think I’ve made clear in the previous parts to this series. It was originally developed for high tax-bracket investors as a means to both accelerate the growth of their net-worth through leverage and through tax reduction. Further, it is aimed at higher risk tolerant (aggressive to speculative) investors with lots of free cash flow.
I’ll begin by introducing a base case study for the traditional saver, compare that to an alternative leverage strategy, and then introduce the "Preet Principle" – which again, is not actually a principle, but rather a strategy.
Out test investor is currently 40 years old and will be retiring at age 65. He will live until 90 years of age, with full entitlement to CPP and OAS. He lives in Ontario and earns $250,000/year which puts him into the top tax bracket of 46.41%. He has absolutely no retirement savings as of today, but has committed $1,000/month going forward to his retirement plan. He is an experienced investor, but has spent all his non-registered investments on toys and the like.
Any refunds he receives from RRSP contributions or interest deductibility from investment loans is ours to use as we see fit.
His investment portfolio has a long term rate of return of 8% with a standard deviation of 12.5%. For non-registered purposes, he will use corporate class investments and as such his returns are calculated as 0.5% interest, 0.5% dividends, 0.5% realized capital gains distributions and 6.5% deferred growth. Any loans are calculated with an interest rate of 7%.
For calculating the impact of varying return patterns of his investments, we will run 500 different return patterns for his portfolios for each scenario assuming that a trial is successful if he does not have to tap into a line of credit for more than $15,000 in any given year. If he has to do this in any one year of his life – the trial will be considered unsuccessful. We will also randomize the life expectancies so that the computer will simulate living both longer and shorter than 90 years.
Base Plan – The Traditional RRSP Saver
The base plan will serve as a reference point for the two strategies that follow. In this base plan, our test investor will save his $1,000/month to his RRSP account. That adds up to $12,000/year going to his RRSP which will generate a tax refund of $5,569. This $5,569 will then be deposited annually to a non-registered account starting the year following his first RRSP contribution (since the refund won’t be owing until then).
So to sum up the base plan:
1. $1,000/month to his RRSP.
2. RRSP contributions generate a tax refund of $5,569.
3. Tax refund contributed to a non-registered portfolio.
Based on this, our test investor would have a healthy after-tax annual income in retirement of $49,875/year in today’s dollars, and if we run this through a Monte Carlo Sensitivity Analysis, we find that this plan has a probability of success of 72%.
Comparison Strategy – A Straight Interest-Only Leverage
In this case, our test investor will take out an interest-only loan for $171,428.57 to deposit to his non-registered account, since a loan for $171,428.57 would cost $1,000/month in interest payments. He would generate a similar refund as with the RRSP contributions since the interest on the investment loan is tax deductible as well. His refund would also be for $5,569. BUT in this case we are going to put this into his RRSP on an annual basis from this point on, which will generate ANOTHER tax refund. His $5,569 contribution will generate a further tax refund of $2,584 per year. This $2,584 is deposited into his non-registered investment portfolio. (You might want to have two non-registered accounts for this strategy – if you ever need to make a withdrawal, you would take it from the account where you deposited the annual refunds so you don’t affect the tax deductibility of the investment loan.) In order to take advantage of the refunds right away, you would actually set up an annual RRSP loan of $5,569 so that you could get your expected refund in one year earlier from the get go. This will be more clear when we list the steps of this strategy:
1. Take out an investment loan of $171,428.57 – costs you $1,000/month in interest (or $12,000/year).
2. Tax refund on interest payments equals $5,569.
3. Take RRSP loan out for $5,569 before RRSP deadline.
4. RRSP loan will generate another $2,584 tax refund.
5. Total tax refund for first year will equal $8,153.
6. $5,569 will be used to pay off RRSP Loan, the balance of $2,584 will be contributed to your non-registered account.
The beauty of this strategy is that you are using piggy-backing refunds. In this case, with an out of pocket cost of $12,000/year, our test investor is able to generate $8,153 per year in tax refunds. In this case, if our test investor only ever put the refunds into high-interest savings account that averaged 3.5% interest between now and the time he turns 65, he would have $328,672 – more than enough to pay off his interest-only loan, PLUS he would have whatever the original investment of $171,428 grew into over 25 years. So again, to re-iterate, the piggy-backing of the tax refunds help offset the risk of the leverage, and if you assume a long term rate of return higher than 3.5% on the refunds it only gets better. In fact, that is what we have done by assuming an 8% rate of return – let’s look at the new results:
Based on this strategy, our test investor would have an even healthier after-tax annual income in retirement of $62,700/year in today’s dollars, BUT if we run this through a Monte Carlo Sensitivity Analysis we find that this plan has a probability of success of only 65%.
One main point to remember, we have increased his annual income in retirement by a MASSIVE $12,825/year AND his out of pocket cost for each strategy is still only $1,000/month. But the drop in probability of success has been reduced to 65% and that may not be an acceptable trade-off for some. What if we were to calculate the probability of success for this strategy drawing the same income of the base plan of $49,875? It IS slightly higher at 74% (versus 72% of the base plan). That’s more like it!
There is a big caveat however: As we know, we reviewed why most leverages fail in Part 3. To briefly sum it up, leverages usually fail because people tend to do the following:
1. Leverage at the top of the market.
2. Stretch one’s self too thin with the monthly payment.
3. Have a lack of discipline or investment knowledge/experience to keep going in the tough times.
Further, the interest rate risk can be divided into two arguments. If inter
est rates go up, there is more danger of stretching yourself to the point where you cannot support the payments. The other argument is that as interest rates go up, the differential between return rates and the interest rates may not make a leverage feasible – and that is true in most cases, but with the piggy-backing refunds, don’t forget that this risk is slightly mitigated by being able to get more of a refund as well since the amount of your write-offs go up as the cost of borrowing increases.
So with that all in mind, I will now, FINALLY!, present a possible alternative:
The "Preet Principle"
It can be broken down to two parts. One part is the screen for qualifying potential candidates for this strategy and it is:
1. Your TDS Ratio must still fall at or under 40%. TDS = Total Debt Servicing Ratio.
2. You would ideally have been through a full market cycle during which time you were actively investing.
3. You need to wait until a correction of at least 10% before engaging the strategy.
4. You are either an Aggressive or Speculative investor, with respect to your risk tolerance.
5. You are comfortably in the highest tax bracket, have a high net worth, and have other assets.
6. You have a minimum 15 year time frame.
7. You will own between 20-40% of your portfolio in fixed income investments.
8. You expect the market to have another correction of 10-20% in the next 5 years.
I will describe the second part of the strategy before commenting on the screen:
After you have met the screen requirements, you would then engage a hybrid of the straight leverage and the traditional savings strategies, such that instead of $1,000/month going to either strategy, only $500 would go towards supporting the interest-only leverage, and $500 would go to monthly contributions to your RRSP… FOR AROUND THE NEXT 5 YEARS. At 5 years (or a different time as you will gather from below), you would then engage the second half of the original leverage for $1,000/month in total interest costs. (So at no time is your monthly commitment anything but $1,000/month).
I say for the next 5 years, but it was an arbitrary number because really you are going to monitor the strategy for the next few years looking for "something" to happen. By splitting the strategy up you are accomplishing a number of things, most of all: creating flexibility to react to bad events or take advantage of others.
1. Market has a big correction – in which case you would double down and convert the $500/month RRSP contribution to a second interest-only loan bringing you up to the original $1,000/month interest payment. This is in effect taking advantage of the market being "on sale" by making a lump sum purchase at this time. It also is sub-consciously convincing you to hope the market has a downturn so that you can take further advantage of it – which can help you to sleep at night – I know it sounds weird, but I LOVE when markets are going down – the opportunities that present themselves can be quite good.
2. Changes in interest rates – if interest rates go up, then you are not struggling since you can just reduce your monthly contributions to your RRSP to afford the increased interest payments.
3. Emergencies – if you have some sort of cash-crunch, you can just stop your $500/month contributions at anytime without explaining nuthin’ to nobody!
4. Market performs really WELL – then you just collapse your leverage to lock in your gain. You would switch back to $1,000/month going to your RRSP until the market has a correction. At that time you would again engage the 1/2 and 1/2 strategy, waiting for a second correction to trigger the full $1,000/month leverage.
So, let’s put it into perspective by running the numbers. I will assume our test investor uses the 1/2 and 1/2 method for 5 years and then converts to a straight leverage at year 5. (Note that the amount of tax refunds is exactly the same as the total amount of money eligible for deductions is always $1,000/month).
We already know that the annual income amount will lie somewhere between the base plan and the leverage based on what we know about leverage and return magnification… or do we?
Based on this strategy, our test investor would have an after-tax annual income in retirement of $58,450/year in today’s dollars (still a generous $8,575 more than the base plan!), AND if we run this through a Monte Carlo Sensitivity Analysis we find that this plan has a probability of success of 71%. If we further calculate the probability of success for the base plan income level of $49,875/year we get a massive 82%!
Let’s recap all three scenarios:
Base Plan: 72% success rate at $49,875.
Straight Leverage: 65% success rate at $62,700; 74% success rate at $49,875.
Preet Principle: 71% success rate at $58,450; 82% success rate at $49,875.
BUT, I will tell you that the success rates for the Preet Principle would in reality be even higher still. This is because what the computer does not know is that we are waiting for a correction to engage the strategy – this increases our chances of success going forward. It also does not know that we have the flexibility to trigger the second leverage on a further correction, or collapse the initial leverage on a strong bull run whenever we want. Because of this additional information, I would speculate the success rates are quite a bit higher for the Preet Principle than stated above, but I just don’t have the foggiest idea how to model that precisely.
Lastly, while the Preet Principle annual income amount is sacrificing some potential reward in the end (in the computer’s mind) versus the straight leverage, keep in mind that by waiting until a correction before engaging the strategy will serve to not only increase the success rate, but the annual income amount as well. :)
So there you have it, this is my take on leveraging to invest – which, remember, is potentially only suitable, potentially, for certain investors… potentially. :P
If anyone has additional insight or criticisms, by all means fire away and maybe we can make this analysis even more accurate or correct any flaws, etc. So don’t be shy with comments or questions good or bad. The more I have to defend a strategy, the better I learn how to use it! (Or better yet, know if it’s complete crap after all!) :)
Thanks for reading the series everyone. Have a great day and happy investing.
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