Are GICs Risk-Free?

If you’re a sports fan, you’ve probably heard a player or team guarantee a victory. Sometimes, these dramatic promises come true: Mark Messier famously “guaranteed” that his New York Rangers would win Game 6 of the Eastern Conference final in 1994. They did and ended up winning the Stanley Cup.

But for every Messier there’s a B.C. Lions, who guaranteed they would beat the Saskatchewan Roughriders on August 24, 2014 or their fans would get a free ticket to another game. Oops! B.C. Lost and that meant issuing nearly 34,000 tickets at no charge.

The difference, of course, was that if Messier’s guarantee didn’t work out, fans got nothing. It was just pure bravado. At least with the Lions, the guarantee had some backing.

But enough about sports guarantees. Just how guaranteed are GICs?

To answer this question, let’s take a look who provides the guarantee. The first line of defense, so to speak, is the financial institution that issues the guaranteed investment certificate. For them, your principal plus accrued interest is a legal liability. So long as they are solvent, paying you back is not an option but a responsibility. You are, in effect, a creditor of the bank.

Now you may be wondering, but what if the bank can’t pay? In this admittedly unlikely event, there’s a second line of defense: the Canada Deposit Insurance Corporation (CDIC) or a credit union equivalent. CDIC insurance covers up to $100,000 per insured account at member institutions. Deposit insurance exists to promote confidence in the banking system. People are far less likely to pull their money from banks if they know the government guarantees deposits.

If you’ve been reading carefully so far, you’ll know that the CDIC guarantee is not unlimited. If you have over $100,000 in one account, for example, not all of it will be covered by the government.

Inflation is the Big Risk

Even if GICs are “guaranteed” and you stay within the CDIC limits, that doesn’t necessarily mean they are risk-free. Indeed, the big risk you take when you buy a GIC is that inflation could unexpectedly pick up and eat into your purchasing power.

Let’s take a look at how this happens. Say you buy a $10,000 non-redeemable 3-year GIC that pays 2.00% interest per year. Here’s how much interest you would earn during that 3-year investment.

Unfortunately (in this example), soon after you invest your money, inflation jumped to 3% per year and stays there for the term of the GIC. How much would you need to earn to keep pace with inflation? Well, you would need to receive 3.00% (the inflation rate) interest or more.

As you can see, just to maintain your initial $10,000 purchasing power, your investment would need to keep up with inflation, so you could walk away with $10,927.27 at the end of the 3-year term. If you were stuck earning just 2.00%, you’d miss out on $315.19 ($10,612.08 – $10,927.27) of interest and potential earning power, which means you’d technically be losing money in “real” i.e. inflation-adjusted terms.

Opportunity Costs Are Risks, Too

Economists have a phrase called “opportunity costs”. What this means in plain English is the lost benefit of doing one thing instead of another. So for example, the opportunity cost of going to the movies on Saturday is not being able to go that concert you were thinking of attending.

What are the opportunity costs of investing in GICs? GICs, while considered very safe investments, are not high-yielding. During the term of your GIC, there are bound to be other asset classes that perform better. Maybe it’s stocks, maybe it’s bonds, or maybe it’s gold.

The problem is that unless you have a crystal ball or are an amazing stock picker, you won’t know what the best investment will be until after the fact. Otherwise everyone would just buy it and enjoy the ride!

What should you take away from this discussion of GICs and risks? Two things: much like the sports guarantees we talked about, GICs are not 100% safe in the truest sense. They may be very safe, but there’s always the risk that inflation could run rampant and eat into your purchasing power. This doesn’t mean you should buy a GIC, just that it’s always good to know the risks before making an investment.

Flickr: Nicolas Baltenneck