As the saying goes, it’s better to be safe than sorry. And for investors seeking safety, guaranteed investment certificates (GICs) can be a useful part of your overall financial plan, as they preserve your principal while returning a predictable amount of interest. Here’s what you need to know to use GICs effectively in your own plan.
What is a GIC?
Similar to a savings account deposit, a GIC is a short-term loan you make to a financial institution, in exchange for an agreed-upon rate of return. As an investment option, they’re considered safer because GIC buyers are guaranteed their initial funds plus interest.
Purchasing a GIC may feel identical to putting money in a bank account and earning interest on it. The potential advantage is that GICs usually earn higher interest payments than your money can earn in a bank account. The downside is you are agreeing not to use the money in your GIC until the agreed-upon term is over. You can access your funds if you need to, but be aware that you will pay steep penalties for doing so.
The minimum you can invest in a GIC is typically $500, but it can be higher, depending on which financial institution you’re dealing with.
How does a GIC work?
Why are GICs considered to be safe? It’s because they have two protective measures:
Financial institutions that issue GICs are legally obliged to repay investors’ principal and interest.
If a GIC issuer goes bankrupt, your bank account and registered accounts at separate banks and credit unions, which may contain GICs, are eligible for coverage of up to $100,000 each by the Canadian Deposit Insurance Corporation (CDIC). GICs that you own are insured as long as they are issued in Canadian dollars, the term is five years or less and the company that sold it to you is a member of CDIC, a credential that all major Canadian banks hold. Credit unions are members of the deposit insurance corporation of the province where they operate and may have a smaller insurance repayment policy, so check before you open an account or purchase a GIC with a credit union.
These government-mandated standards ensure you are compensated if a CDIC-insured GIC issuer goes bankrupt.
Terms and maturity
The shortest GIC terms are 30 days, but they can be as long as 10 years. In general, the issuer will pay you a higher interest rate for a longer term until maturity.
Like most fixed-income securities, there is a usually costly penalty for withdrawing your money early (i.e., before the maturity date).
Investors who may need access to their funds before their maturity dates should purchase cashable or redeemable GICs—meaning that you can cash your investment at any time with no extra cost. Keep in mind that cashable GICs usually pay significantly less interest.
Types of GICs
There are a few different types of GICs—and understanding what each offers will help you decide which fits your investment needs best. The terms (amount of time you must agree to deposit your money) and interest rates can differ quite a bit. In all cases, though, your initial deposit is protected.
Fixed-rate GICs pay a predetermined interest premium each term. For example, $1,000 invested in a one-year fixed GIC at 2% interest will return $20 of interest plus the original $1,000. This type of GIC is the most commonly issued type. However, it offers no protection against inflation. In this scenario, if the inflation rate is 3%, the purchasing power of your GIC deposit plus interest will be $990 in real dollars, which is even less than the $1,000 you initially deposited.
Some GICs link interest payments to a fluctuating benchmark, usually the institution’s prime rate. These types of investments are called variable-rate GICs and will prevent you from missing out on potential interest-generated gains because your nominal returns grow as interest rates do.
Other GICs link interest payments to an underlying stock market index and are called equity-linked GICs. The interest rates on these are not determined until maturity. If the market underperforms, you may see no return except for your original principal, which is guaranteed.
Escalating-rate GICs increase the interest rate that you are paid over time. Let’s say you buy one that matures in three years. It might pay you 1.05% interest in year one, 1.20% in year two, and 1.65% in year three. These GICs give you a bigger incentive to not take your money out early, as it generates the best return in the last year of its term. Like fixed-rate GICs, this type does not protect against inflation.
GICs also differ based on how often interest payments are made. Issuers let you decide if you want to receive these payments monthly, semi-annually or annually—or they can be automatically reinvested until the maturity date.
Registered and non-registered GICs
GICs can be held in non-registered and registered accounts.
Non-registered accounts are assets that deposit-taking institutions keep secure, such as a bank account.
Registered accounts are Tax-Free Savings Accounts (TFSAs), Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs), which allow your investments to grow tax-free. The government encourages Canadians to save more of their income through the incentives included with these accounts.
TFSAs and RRSPs both have contribution limits that are calculated in different ways.
If you have never contributed to your TFSA and you are over 28 years old, you have a TFSA contribution limit of $69,500 as of 2020. (Your contribution room started accumulating after you turned 18.)
Your RRSP contribution limit is calculated based on 18% of earned income that you reported on your tax return in the previous year, for a maximum limit that changes each year. For instance, the maximum is $27,230 for income earned in 2020, $26,500 for 2019, and $26,230 for 2018. Company pension plan contributions reduce your limit; this is the government’s way of ensuring that Canadians with workplace pension plan don’t have an unfair advantage in saving for retirement over those who don’t.
The biggest difference between using these two savings vehicles is that you have to pay tax when withdrawing assets, including GICs, from an RRSP, but not when taking them out of a TFSA. Withdrawals from a TFSA are completely tax-free, and when you make a withdrawal, you regain that same amount of contribution room the following year.
GIC laddering is when you buy GICs that mature at different times, allowing you to collect a steady stream of income that includes both interest and principal repayments. An example of this is buying a one-year GIC, a two-year GIC and a three-year GIC all on the same day.
The benefits of laddering are twofold:
Laddering gives you greater access to your funds without any penalties, as you have the option to do so every time that one of them matures. Or you can simply choose to reinvest the funds.
When you are invested in GICs with a range of maturity dates, your interest-rate risk is reduced because you have more opportunities to renegotiate.
Are GICs worth it?
You may want to consider purchasing GICs if you are a fixed-income investor who has a short time horizon. GICs produce a secure income stream, although the returns are usually much lower than from a long-term stock portfolio. Income-oriented investors who value security over potential returns will benefit from this investment. Just be wary of allocating too much of your portfolio to GICs, even if you are a retired investor, as you may still have many decades ahead.
In the end, the line between safe and sorry varies from person to person, so you have to find what works best for you.