Buying GICs for an RRSP

In times of stock market turbulence, guaranteed investment certificates (GICs) are an alternative. There are lots of GICs out there. Some are worth your consideration and some aren’t. Here’s a run-down or some options you’re likely to find:

Redeemable GICs:
Also called cashable GICs, they’re the financial community’s equivalent of Canada Savings Bonds. They can be cashed anytime, although you won’t receive interest if you redeem within the first 60 or 90 days, depending on the issuer. You’ll receive full interest up to the day you redeem (CSBs only pay up to the last day of the previous month).

They’re covered by deposit insurance. Plus, the interest rate may be slightly higher than that offered on CSBs, depending on where you buy them.

Almost all financial institutions, including the big banks, offer some type of redeemable GIC at certain times during the year. But be careful. In most cases, the sale period is limited. This means you won’t be able to roll over your redeemable GICs if rates rise in a few months.

A few trust companies and credit unions offer them year-round, however. Compare rates before you buy-they can vary nsiderably. Recommended for a combination of good return and maximum flexibility.

Extendible GICs:
Here you lose some flexibility because you’re locked in for a year. However, you have the option of extending the GIC for a second year at the same rate of return.

Remember that the extra year will only be of value if interest rates fall a year from now. If rates were higher, you wouldn’t renew. If you think lower rates are unlikely, this type of product won’t be a good alternative.

Escalating GICs:
This product is designed for long-term investors who are unhappy with present GIC rates. The idea is seductively simple:

• Your interest rises each year (or sometimes after the first two years) over a five-year term. By the time you get to the fifth year, your GIC is paying a rate that looks impressive by today’s standards.

It seems great, but if you analyze it carefully, it actually isn’t. What really counts is the blended rate you’ll receive over the full term.

You’ll probably find that figure isn’t much more than you’d receive from a regular five-year GIC. To obtain that, you’ll have to accept two disadvantages.

1. You’re locked in for five years. It’s never a good idea to tie up your money when interest rates are low. The probability is that they will rise during that time.

2. If the certificate is held outside an RRSP or RRIF, you’ll be taxed on the blended interest rate over the five-year term. That means you’ll pay disproportionately higher taxes in the early years. Since it usually works to your advantage to defer tax as long as possible, that’s not exactly a great idea.

For these reasons, only choose this product within an RRSP or a RRIF-and then only if you get a clear interest rate advantage over a standard five-year GIC and there is a high probability that interest rates are set to decline.

Staggered maturity GICs:
Financial advisors are always telling people that the best way to beat volatile interest rates is to stagger the maturity dates of their GICs. By having 20 percent of your GIC assets roll over each year, instead of the whole amount coming up for renewal every five years, you smooth out interest rate variations and ensure you won’t see your investment income suddenly nose-dive.

Some financial institutions now put that advice into practice by offering GICs that can be divided into separate components, each with a different maturity date. For example:

• You could invest $10,000 in a five-year GIC but have $2,000 come due on the anniversary date of each year.

If you’re a conservative investor who wants to be sure your RRSP continues to grow at a relatively constant rate, this type of GIC is worth looking at. But keep in mind that, by using it, you won’t get the full benefit when interest rates are high.

Stock market index GICsSome financial institutions experimented with these in the 1980s, with little success. Now they’ve resurfaced and they have been hot sellers during recent RRSP seasons.The attraction for investors seems to be the idea that they can play the stock market without risk. If stocks do poorly, your capital is protected, even though you may get no return on your money. At maturity, your principal will be completely refunded.

But the risk-free aspect is an illusion. While your capital may be guaranteed, your return is totally at risk, depending on the vagaries of the market.

Some of these GICs guarantee a small base interest rate, plus a premium if the underlying index rises. But they’re the exception rather than the rule. In most cases, the interest you receive is tied directly to the market index on which the GIC is based.

Canadian indexes
There are many variations on this theme. Most stock-linked GICs are tied to one of the two major Canadian stock indexes:

• The TSE 300 (a broad-based index)
• The TSE 35 (a blue-chip index).

But you can also buy stock-linked GICs that are tied to the Standard & Poor’s 500 Index in the U.S. or to various international indexes.

As well, with the growing acceptance of a new market benchmark, the TSE/S&P 60, in recent months, we can expect to see some adapted GIC products.

Essentially, index-linked GICs are instruments designed for people who are afraid to invest in the stock market directly but still want some of the action. They come in such a variety of shapes, sizes, and colours, it’s difficult to select the good ones.

Some important variables to bear in mind include:

• Method of Calculation: Some GICs base their return strictly on the movement of the underlying index between the time of the investment and the maturity date.

So, for example, if the index of choice was the TSE 300 and it rose 25 percent over the term, that’s the return you’d receive.

However, other GICs use a monthly average in determining the rate of return. This can work out to be much less advantageous to the investor if the markets move up considerably.

Cap on Returns:
Some of these GICs place a limit on how much you can earn over the term of the security. If the cap is, say, 20 per cent and the market rises 40 per cent, you’re still stuck with the 20 per cent. Stay away from any stock-linked GICs that limit the potential return.

• Locking In: A few stock-linked GICs allow you to lock in your profits along the way. That can be a very useful feature, so ask about it.

Consider market state
We don’t recommend this type of GIC for retirement plans at times when stock markets are high. If there is a major correction, you could find your money tied up for several years with zero return. That runs completely contrary to the principle of using the tax-sheltering advantages of an RRSP to maximize the effect of compounding.

If you must use this type of GIC, the time to buy is during a recession, when stock market values are down. Unfortunately, you probably won’t find these GICs being offered (and certainly not heavily promoted) during such periods because no one wants to hear about stocks in a pessimistic climate. An alternative approach:

• If you think stocks are going to rise, a well-managed equity fund will give you a far better payoff.