Thinking of putting your RRSP contribution into GICs? Stop and read this first
So you just put some money into your RRSP ahead of the March 1 deadline for claiming a tax refund on your contribution. Now the question: What should you do with those funds?
You may have heard a lot about guaranteed investment certificates (GICs) lately, as banks ramp up ads after RRSP season. Several financial institutions are offering premium interest rates on GICs for a limited time only.
It’s a bit like retailers coming up with aggressive discounting after Christmas, says Jason Heath of Objective Financial Partners. Now that you’ve poured some funds into your RRSP, the banks want to keep you coming back.
But are GICs really the best place to park your savings?
A GIC is an investment that guarantees 100 per cent of the money you originally put in. Generally, you agree to park your funds at a financial institution for a set number of months or years in exchange for interest that’s paid out at regular intervals or at maturity. GICs are one of the safest investment options out there, which is why many Canadian gravitate toward them.
But for years now, the trouble with GICs has been that, with interest rates at historic lows, returns have barely kept up with inflation.
If you were to buy a fixed-rate, one-year GIC at any of the big banks right now you’d get a return of between 0.8 per cent and 1.4 per cent. Inflation was 2.1 per cent in January, according to Statistics Canada.
GICs make sense for people who don’t want to invest in the market and wouldn’t be able to sleep at night knowing that some of their investments might lose money, Ted Rechtshaffen of Tridelta Financial told Global News.
Still, there is also risk in picking investments that don’t even keep up with the cost of living, said Heath, of Objective Financial Partners.
“There is a risk of losing money and a risk of not having enough money to fund your retirement,” he told Global News.
Before you decide whether GICs are for you, here are some things to consider:
If you buy GICs, at least make sure to shop around
If you’re set on buying GICs, you should at least shop around for the highest available interest rates, Heath said. Many smaller financial institutions such as online banks, credit unions and trust companies offer significantly higher returns on GICs than the big banks, he noted.
Ontario credit union Luminus Financial, for example, currently offers a rate of 2.1 per cent on those one-year, fixed-rate GICs.
The risks of buying GICs from small-shop financial institutions are very low, as the federal government guarantees both principal and accrued interest on GICs up to $100,000, Heath noted. GICs held at credit unions are generally guaranteed by provincial governments, he added.
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GICs are still better than bond mutual funds right now
If the only type of investment you’ll consider is something that pays out fixed amounts on a fixed schedule, GICs, for all their shortcomings, might still a better option than bonds or mutual funds, said Heath.
That’s because such funds, especially when they are low risk, might yield an even worse return than GICs once you factor in mutual fund fees.
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GICs do have fees — you just can’t see them
Speaking of fees, one of the things Canadians generally love about GICs is that the rate you see advertised is generally the return you’ll get. There are no hidden fees.
But you’re still paying for the bank’s cost of managing GICs, noted Rechtshaffen, of Tridelta Financial. Instead of charging a fee, the bank will reduce your return, which, in essence, works out to “an invisible fee,” he noted.
That’s why online banks and credit unions, which have lower overhead costs, are generally able to offer better returns, he added.
Perhaps you’ve heard that interest rates are going to go up. Does this change anything?
Long-term interest rates in the U.S. and Canada have already started going up, in part as a result of interest rate hikes by the U.S. Federal Reserve. In addition, several Canadian economists believe the Bank of Canada (BoC) might raise it own key interest rate, which affects short-term interest rates, sometime next year or even late this year. Many analysts believe the year of rock-bottom interest rates may coming to an end.
Like fixed-rate mortgages, fixed-rate GICs tend to track long-term interest rates. GICs that have a variable interest rate, which are less common, are generally affected by short-term interest rates and would generally rise if the BoC were to raise rates.
So what should GIC investors keep in mind?
It would take an interest rate of at least 3.5 per cent for Rechtshaffen to call GIC returns somewhat attractive. Getting there might take some time, given the gradual pace at which interest rates are rising.
Heath noted that investors who believe interest rates will rise soon should probably avoid putting all their money into GICs with terms of five years or more.
Also, if you were to invest your money through a GIC ladder, a shorter term ladder might make more sense.
Say, for example, that you were planning to invest $100,000 in GICs, split evenly among a combination of GICs with maturity dates ranging from one to five years. Each year, one of the GICs matures and you use the money to buy a new five-year GIC to keep the ladder going.
Each year you’d get a chance to benefit from higher returns, if interest rates rise. But if you think interest rates are set to rise soon, you’d benefit even more by having a three-year, rather than a five-year, laddering strategy, Heath said.
When to consider market-linked GICs
In addition to regular GICs, many financial institutions offer market-linked GICs, which track the performance of a stock market index. If stocks go up, you generally enjoy a percentage of those returns. If the market tumbles, you don’t make money but your principal is intact.
Market-linked GICs sound like every investor’s dream of stock-like returns with very little risk. The reality, however, is quite different.
First, if stocks fall, you get a return of precisely 0 per cent, which is worse than any plain-vanilla GIC.
Another things to consider is that it’s rare for the stock market to produce negative returns over a span of several years. So, especially for longer-term GICs, the guarantee on your principal might not really be worth giving up on being able to enjoy 100 per cent of the returns in the stock market, noted Heath.
“The bottom line is that financial institutions are very good at math, and they’ve made sure the math is tilted in their favour,” Heath said.
If you can stomach a bit of exposure to stocks, you’re probably better off with a conservative portfolio that has a small percentage of holdings directly in equities, he added.
Still, Rechtshaffen, who calls market-linked GICs “the stock market on training wheels,” argued that they might make a sensible option for Canadians working toward a near-term savings goal.
If, for example, you’re squirrelling away some money to buy a new car in two or three years, a market-linked GIC might yield better returns than a regular GIC and you wouldn’t risk losing any of the principal.
If stocks fall, the worst case scenario is that you might have to hold on to your clunker for a bit longer.