eternallyephemeral

Wow, you're a psychologist, so I guess I shouldn't be surprised that you're referencing pseudoscience! It has everything to do with the character of the interviewers and interviewees. People of strong character won't care what you're wearing--like me. I have transcended such things, I hope one day you, too, will achieve such a level as I have . One of the quickest ways to spot a lying sadistic psychopath is to look for people that are overdressed.

Have you ever heard of heuristics or unconscious bias?  Those of us who are worried about what to wear are attempting to maximize the favorability of the "snap judgement" that a person makes in the first ten or so seconds of meeting another human.  This has nothing to do with the character of the interviewers or the interviewees.  
It may be true that this initial impression is largely outside of either parties control, but there are some things that can be done to sway the probabilities.  Including dressing appropriately for the occasion.  Because many of us are entering social situation that we haven't encountered before, it is useful to seek the advise of other, more experienced, members of the community.  

I heard a few years back that the reason Waterloo doesn't have Masters as an option for their application is to dissuade people who would only go there and leave afterwards (particularly an issue for I/O psychology, since people can get a well paying job after).
As for funding--is the Masters degree only not funded by the school of graduate studies? I'm currently in a master's program, and on the graduate school level, there's no guaranteed funding, but at the departmental level, funding is almost equal to PhD's. Perhaps this is the same case in Waterloo? They may just be putting you at the Master's level to extend your "fundable period" within the department. There's also the added benefit that there's an extra year you'd be eligible to apply for the Doctoral-level SSHRC, along with another year's worth of experience. Definitely talk to your PI regarding the funding structure.

Congrats on your interview and invitation to Western's open house! 
I'm not sure, only they know the answer, but it sounds to me like a nice way of saying you maybe weren't the first pick for the PhD, but that they still want you to go there, so they are hinting that you could apply to the MASc... Hopefully that's not the case! Good luck!