Safe, secure GICs have downsides

Guaranteed Investment Certificates, or GICs as they are commonly known, are extremely popular savings vehicles.  They are the classic safe investment vehicle that provide a low-risk and low-return combination. Furthermore, many investors prefer GICs as they are a simple guaranteed investment that returns capital plus income.

The Canadian Deposit Insurance Corporation raised this guarantee from $60,000 to $100,000 in the 2005 federal budget.  CDIC provides valuable protection for investors primarily concerned with capital preservation.  When investors place money in eligible deposits they are automatically insured to a maximum basic coverage limit of $100,000, including principal and interest.  For information, visit www.cdic.ca

For all the simplicity and safety of GICs, investors sometimes pay little attention to the risk that their low interest earning investments may not preserve purchasing power over time. Interest rates on GICs are currently at low levels and when one considers the impact of taxes and inflation on their investments, the real rates of returns (return after accounting for inflation) can be negligible or potentially negative.

Let’s look at an example:  William has $300,000 in a non-registered annual pay GIC yielding 4 per cent, and has a marginal tax rate of approximately 43 per cent.  We will assume inflation is at 2.3 per cent.

GIC Income $300,000 x 4 Per Cent = $12,000

Taxes at 43 Per Cent                        =  ($5,160)

Net Return                                       =  $ 6,840

A net return of $6,840 is approximately 2.3 per cent.  With inflation at 2.3 per cent or higher the “real return” will be negative.  Investors with long-term objectives need to understand that the safety of GICs can actually erode the real purchasing power of their investments. In many cases, investors requiring income to provide for their day-to-day expenditures will be forced to encroach on capital as the real returns will be insufficient to meet their needs.

Clients dependent on GICs as their sole investment vehicles need to consider diversifying a component of their investments into alternative types of securities to provide inflation protection, generate tax-effective income, and to build long-term wealth.

Some tips for GIC investors:

Tip 1

We encourage investors to place no more than $100,000 per individual issuer.  Solution:  deal with a firm that is able to issue multiple issuers of GIC’s (as CDIC covers up to $100,000 held per issuing company).

Tip 2

GICs generate interest income which is fully taxed if held in a non-registered account.  Solution:  we encourage investors to look at the structure of their investments and consider putting GICs in their RRSP, as is the normal recommendation for most income generating products.

Tip 3

Occasionally we see GICs purchased near the end of the year in non-registered accounts.  Rather than purchasing a GIC at the end of the year it may make sense to put these funds into a high interest savings account until early January.  This would allow you to defer the annual interest one year.  A $100,000 one year GIC at 4.5 per cent purchased on December 6, 2006 would have $4,500 in taxable income for 2007.  Solution:  waiting until after December 31, 2007 to purchase a GIC would defer this taxable income one full year.

Tip 4

Many financial institutions will ask you if you would like to set up an automatic renewal of your GIC investments.  It only takes a few minutes to discuss rates and reinvestment options with your advisor when investments mature.  During these discussions you may want to consider different options and terms.  Most importantly you should make sure you are receiving a competitive rate.  Solution:  cancel all automatic renewals and ask your advisor to give you a call when your GICs mature.

Tip 5

Many structured products are attaching the “GIC” name in their advertisements.  One of the benefits of a GIC is its simplicity, transparency, and security.   Why does a GIC need to have some type of complicating feature to it?  Do those extra features benefit you or do they provide the issuer with more benefits?  Solution:  speak with your financial advisor for more information and avoid structured products that you do not understand.

Tip 6

Before purchasing a GIC you should determine if it can be transferred or sold.  Some GICs can be transferred to other institutions and some cannot.  In addition, most GICs cannot be sold prior to maturity.  Solution:  speak with your financial advisor for more information and attempt to purchase GICs that are transferable.