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rob carrick

The stock market made you do it, right?

Ignore your registered retirement savings plan, that is. Several days back, I asked members of my Facebook personal finance community (subscribe here) what their biggest challenges were to making contributions to RRSPs and tax-free savings accounts. Several people commented that poor investing results had persuaded them to ignore their RRSPs and put their money into mortgage repayment.

Disappointing returns are a sign you need to rethink your investments, not that you should ignore saving and investing for retirement. But that said, there are times when it makes sense to pay down debt at the expense of retirement.

RRSPs versus debt repayment is one of the longest-running debates in personal finance, and the reason is that few experts are willing to take a firm stand on what the right approach is. Too often, you hear that the right approach is to make an RRSP contribution and then use the tax savings to pay down your mortgage. But aren't there situations where one approach is simply better than the other?

Thanks to some work by Talbot Stevens, a financial speaker, author, and industry consultant, we now have a real-life guide for deciding on retirement saving versus debt repayment.

Mr. Stevens has listed four factors to consider, the first being your savings discipline. Ask yourself: If you pay your debts down, what will you do with the cash flow you free up?

Imagine you spend $20,000 a year on mortgage payments. Once your debt is cleared, you need to add that money to your savings/investing routine, not spend it. "Only the most disciplined, who will truly invest every penny of their mortgage payments after they're debt free, will be better off paying down their mortgage first," Mr. Stevens writes in an outline of his views on RRSPs versus debt paydown.

Next, consider the emotional angle. Do you find yourself worrying a lot about your debts or lack of a solid retirement fund? If so, Mr. Stevens' suggestion is to "do what is emotionally best for you first. Then you'll be better able to do what is financially best later on."

The third factor is math-based. If the interest rate on your debt is three percentage points higher than the average annual return you expect from your retirement investments, then ignore the RRSP and pay off debt. To further simplify, paying off a big unpaid credit card balance accruing interest at a rate of 29 per cent or thereabouts is your top priority.

After that, you have to consider a few variables, such as the expected rate of return on your retirement investments. For a balanced portfolio, 5 per cent after fees sounds reasonable. This sets a fairly high hurdle for debt to take precedence over retirement savings. In today's low interest rate world, credit lines and loans don't often cost 8 per cent or more.

The qualification on this rule is that it applies to people who invest two-thirds of the cash flow they free up by paying off debt. The ideal is 100 per cent reinvestment of your former debt payments, but Mr. Stevens is mindful of human frailty. "I'm trying to pick a middle-of-the-road behaviour," he said.

The threshold for choosing debts over RRSPs isn't quite so high for a disciplined saver who plans to put 100 per cent of his or her former loan payments into retirement savings. Analysis by Mr. Stevens suggests that someone in this position needs returns that are roughly equal to his or her borrowing cost.

Mr. Stevens' final point will appeal to investors who are dead set against adding to their investments right now because of stock market volatility. In an analysis of TSX total returns since 1956 (dividends plus share price gains), he found that an especially opportune time to invest is after a down year for the markets.

Returns in the 12 months after a down year averaged 19 per cent, double the 11.1 per cent average for other time periods. The data doesn't suggest that your long-term results will be better if you invest after a down year, but you'll at least have the benefit of knowing that a very good year often follows a bad year. This in turn will help you stay focused on investing and resist the temptation to sell. "This is psychologically important," Mr. Stevens said. "You're less likely to get off the roller coaster and say, 'never again.'"

My own advice: RRSPs beat a mortgage paydown in today's low-rate world, but credit cards and high-rate loans and lines of credit beat RRSPs. Get rid of that high-rate debt. Kill it dead.

RRSPs vs. debt

Make the decision in four easy steps:

  1. If you pay down your debts, will you redirect the freed up cash flow into your saving?

    If yes, continue; if no, choose the RRSP.

  2. Are your debts making your life miserable?

    If yes, choose debt repayment; if no, think RRSPs.

  3. Is the rate on your debt more than 3 percentage points higher than the return you expect in your RRSP?

    If yes, then pay down debt; if no, continue.

  4. Was the stock market down last year?

    If yes, historical market behaviour suggests your RRSP contributions to stocks and equity funds could have a good year; if no, consider a debt pay down if you are squeamish about falling stock markets.

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