You may have recently seen an ad for equity-linked GICs. Whether a billboard or an online banner, most banks are heavily promoting these products. As we explain in our education centre, these are set up like hybrid investment vehicles: part fixed income investment, part stock market participation.
The banks have what seems to be a pretty compelling sales pitch for buying equity-linked GICs. It amounts to, “You can’t lose, but you can gain X, where X is listed as an attractive amount”. Put another way, your principal is guaranteed, but if the stock market rises, you will earn far more than if you simply bought a regular GIC with predictable interest payments.
The problem is: while this sales pitch is not technically untrue, there are things consumers need to know before buying these products. The more you look under the hood, to use a car analogy, the less alluring equity-linked GICs become.
So what are the issues associated with these type of GICs?
The first issue, which is not something the banks exactly trumpet, is that you may not make any money whatsoever. You can buy a 3- or 5-year equity-linked GIC, and if the stock market goes down over that period, you will only get your principal returned to you. (That said, some banks will offer a “minimum return”. For example, the RBC U.S. Market Smart GIC promises to pay at least 1% over 3 years. Of course, even this is paltry: it works out to roughly 0.33% per year.)
This hurts you in two respects: on the one hand, there’s a large opportunity cost because if had you owned something, such as a garden-variety GIC that paid interest, you would have received income over the term of the product. And that aside, as long as inflation is positive (i.e. prices are rising), the return of your principal means that, adjusted for inflation, you will in effect lose money.
Here’s why: Say you put $10,000 into a 5-year equity-linked GIC and then the underlying market, such as the TSX, fell during the term of the product. So the bank gives you back your $10,000. Ok, but $10,000 at the start of the term will not have the same purchasing power as $10,000 when the 5 years are up, because prices have increased.
Another problem with equity-linked GICs is that your potential return is capped. The banks offering the products may only pay you a maximum percentage return every year. Alternatively, your return may be subject to a specified “participation rate”, which is a proportion of the return. For example, the contract may say that your return will max out at 60% of the index’s gains. In both cases, you are not fully realizing the benefits from a rising equity market.
A third issue with these products is that dividends are not factored into your return. If you owned actual equity products instead of GICs that mirror equity, dividends could form a substantial part of your gain from the stock market. By excluding dividends, the bank is once again limiting how much you can make.
And finally, the promotional materials for equity-linked GICs may not technically be “false advertising”, but a good case can be made that they are overly optimistic. When, as with this RBC example, a bank prominently touts the possibility of 9% returns over 3 years, many investors may not be aware that the product could also return $0 over that time period. A robust disclaimer might say something along the lines of, “You may not receive any return at all”, or, “This GIC will not return anything if the stock market declines”.
Interestingly, one financial institution, ATB Financial in Alberta, has actually stopped selling equity-linked GICs completely. ATB cited three reasons: the complexity of the products, the absence of transparency and the lack of control they have over the return the consumer receives.
What’s the solution, then, for the investor who wants exposure to the stock market?
The answer is to have a meaningfully balanced portfolio that includes both fixed income and equity investments. If you want to participate in the stock market, that’s exactly what you should do. Nowadays, it’s very easy to invest in the overall market through low-cost products, such as index funds or exchange traded funds (ETFs). Index funds are mutual funds that track the performance of a specific market, such as the Toronto Stock Exchange. ETFs also track a given market, but they can be purchased as a stock.
One approach for investors to consider is what’s known as the “principal plus strategy”. Let’s say a couple has $100,000 to invest for five years. They can take the vast majority of this amount, say $88,000, and invest it in long-term GICs. By the end of the term, the $88,0000 should roughly be $100,000 at today’s interest rates. The couple can invest the remaining $12,000 in more growth-oriented vehicles like an equity fund. Even if the equity fund doesn’t perform well, they can rest easy knowing that the GIC portion of their portfolio will grow over the 5-year period. In essence, it’s a conservative way to participate in the stock market.
There’s another good reason to invest in equities directly: in addition to actually receiving dividend income, any capital gains you make will not be subjected to the tax treatment of equity-linked GICs. Income from equity-linked GICs is reported as interest to the CRA, all of which is taxed at your marginal rate. By contrast, investing in equities is much more tax-friendly. If you buy an ETF and sell it for a profit, capital gains taxes apply. What this means is that you must pay tax on only 50% of the gain at your marginal rate. The other 50% of the profit is not taxable.
If you buy and hold ETFs that own equities, the tax treatment is also more favourable than equity-linked GICs. Many ETFs will distribute money to unit holders every year, but the bulk of the money they give you is often from dividends earned by the fund. Dividends from Canadian companies get preferential tax treatment compared to interest income from something like a GIC.
All of this is to say that there are more reasons NOT to buy equity-linked GICs than they are reasons to do so. If you want to invest in equities, consider some of the other options we’ve listed above.
Flickr: Paolo Ferrarini