Leveraging strategy

This section applies to personal insurance representatives, financial planners, and group savings representatives.

The leveraging strategy is a strategy that involves borrowing money to invest it. The borrower is then able to use more funds than if he had drawn only from his savings. Using this proactive strategy is based on an investor’s hope to increase his net worth with money that belongs to the lender, and thereby reach his goals more quickly than originally anticipated.

The most common form of leveraging is bank loans: the investor makes an initial deposit, to which he adds money from a bank loan, to purchase mutual funds or to contribute to a registered retirement savings plan (RRSP), for example. A person who chooses a personal property mortgage to then invest the capital in a mutual fund or segregated fund is also using a leveraging strategy.

Because leveraging lets the investor have a larger sum of money than what he has in savings, it increases the earnings potential on an investment by using a lender’s money. If the strategy is properly executed and there is no lack of returns, the investor could reach his financial goals more quickly or with less savings effort. The strategy can also help him take advantage of certain tax benefits in the event that interest paid on the loan is deductible from his taxable income. For leveraging to be worthwhile, the profits from the investment must be higher than the cost of borrowing.

Leveraging is a strategy that involves risks. While is increases the earnings potential, is also increases the loss potential.

When returns on borrowed money are less than the cost of borrowing, the investor loses money that he doesn’t have, but will need to pay back to the lender regardless. His losses will be even higher and he will reach his financial goals later, or will need to save more. Therefore, this strategy is not suitable for all types of investors.

Financial losses can be caused by several factors. For example, if interest rates increase, they can increase the investor’s cost of borrowing. At the same time, they risk decreasing the value of their securities in mutual funds and slowing the growth of their investment value. However, a leveraged loan cannot be profitable unless the growth of the investment outweighs the cost of borrowing.

When a client experiences losses, he may question his representative’s advice. It is very important, therefore, that the representative fully adhered to his legal and ethical obligations. This is even more true when certain clients claim that the representative put his own interests before theirs, because by recommending a leveraged loan, he receives a higher commission than he would on the amount invested in the loan.

A leveraging strategy may be suitable for…

  • A client with long-term financial objectives
  • A client with a healthy financial situation and the necessary cash.
    He must be able to pay back the loan he is taking out without needing investment income to do so. The representative must therefore know the value of the client’s cash assets, his monthly expenses, and any other information that impacts his financial flow. Generally, a loan for purchasing an investment should not exceed 30% of the client’s net worth, and 50% of his liquid net worth. Additionally, the client’s total debt should not exceed 35% of his total income, regardless of investment income.

Warning! Even if a financial institution agrees to lend an amount of money to a client, this does not mean that a leveraging strategy is suitable for him.

  • A client whose tax rate is high enough to take advantage of possible tax deductions from interest paid on the loan – if his tax rate is not high enough, he will have little or no tax due, which will make these deductions ineffective for him

Warning! The representative must be aware not only of the client’s taxable income, but also of all the other deductions for which he is eligible that impact his overall tax rate. The tax impacts of a leveraging strategy must be considered before making a recommendation in this regard.

  • A client who has a high enough risk tolerance – he must be comfortable with all risks involved with the strategy
  • A client who has the knowledge required to understand the risks he is taking on by using this strategy and to realize that if he relies solely on his investment income, he could be unable to repay the loan – normally, a client who uses leveraging already understands the financial markets and has been investing in them for some time. 

When a representative recommends the leveraging strategy, he must adhere to certain requirements, in particular those mentioned below.

Know your client 

The only way of knowing whether or not a strategy suits a client is to know the facts determining his situation, both personal and financial. This obligation remains even after a loan has been contracted. The representative must ensure that the strategy still suits the client. The section Know your client provides more details about this obligation. 

Fulfil your duty to inform 

The client must know what to expect. He must know and understand all the risks associated with a leveraging strategy and have access to all available updated information. If the client is unable to understand the details and risks of this approach, the strategy’s suitability for his situation may be reconsidered. The representative must therefore ensure he fully understands the product so he can explain it to his client. He must also inform the client of administrative fees, management fees, and redemption fees for the product purchased.

Provide the information document to the client

This is a document called “Using leveraging when purchasing collective investment fund securities,” if mutual funds are purchased through a loan. This document educates the client on the risks of abusing leveraging. The representative must take the time to review the document with the client and explain the most important passages to him.

Although such a form is not required for insurance, the representative’s duty to inform obliges him to divulge this information to his client.

Prioritize the client’s interests 

The representative must make sure that using leveraging is in the client’s best interests based on his personal and financial situation, his investment objectives, his risk tolerance, and his understanding of financial markets. He must also put his client’s interests before his own personal interests and warn him if he requests a transaction that goes against his interests.

Document the client’s file

The representative must add all information regarding the loan to the client’s file, whether or not he was involved in the loan request, before proceeding with purchasing mutual funds or segregated funds. He must also include all pertinent explanations as well as all of his recommendations in the file. The representative must make a habit of clearly documenting each of his communications with his client in the file in addition to major changes that arise in the client’s life (e.g., marriage, birth, promotion).

In the event of a difficult situation, the notes will be extremely helpful to the representative to demonstrate that he conducted his work in a professional manner.

Conduct regular follow-up

Once the leveraging strategy is established, the representative must conduct more frequent follow-up with his client, especially in the following cases:

Change in the client’s situation

The client’s personal or financial situation may change, and the strategy may no longer be appropriate. The representative must stay abreast of changes in his client’s situation so he can revise the strategy as needed, thereby avoiding unwelcome consequences.

Non-compliance with the strategy

If the client doesn’t follow the planned strategy, for example by making withdrawals in a bear market, the representative must speak with him to understand the reason and, if applicable, encourage him to be more disciplined or to change strategies.

Bear markets

In the event of a bear market, the representative should communicate with his client immediately to verify whether he is still confident and whether the strategy is still appropriate. The client’s perception of his strategy may be shaken when reality hits. A theoretical understanding of risk from the comfort of an office while markets are up is one thing; it’s another when markets are down and losses occur. Furthermore, it is sometimes more reasonable to end the strategy to limit the damage.