No safe place for money

I spent two mornings recently doing radio interviews about my new book with CBC morning shows across Canada. By the time the marathon was over, I had talked to 19 stations from St. John’s to Whitehorse and just about everywhere in between.

One of the questions I was repeatedly asked related to a chapter in the book titled: “There is no safe place for your money”. The hosts wanted to know exactly what I meant by that.

The short answer is that it means just what it says. There is almost nowhere that you can put your money today with complete confidence that you will get the entire principal back and earn a high enough investment return to make a profit after taxes and inflation are taken into account.

Some people are under the illusion that just protecting their capital is safety enough. It’s not. Even with inflation running at a relative modest annualized rate of 2.3 per cent (December figure), every $1,000 in cash that you tuck into a safety deposit box will only buy $893 worth of goods and services at the end of five years. After 10 years, your purchasing power is down to $797. There’s nothing safe about that.

In years past, you could sock your money away in a five-year GIC which might pay you anywhere from 4 per cent to 8 per cent and on occasion even more. We have not seen anything close to 8 per cent in the past decade but major banks were paying more than 4 per cent for five-year terms in the spring of 2002 and about 3.5 per cent in the summer of 2007. Now the best you can get from the giants of Bay Street is 1.85 per cent. Smaller financial institutions, notably some Manitoba-based credit unions, are offering five-year rates in the 3 per cent to 3.5 per cent range but they only have a tiny share of the GIC market and very few people even know about them.

Let me reiterate a point I have made many times before: risk-free investments do not exist. There are many securities that are low risk but if you’re looking for zero risk, forget it.

That hasn’t stopped financial engineers from devising products that appear to be risk-free while holding out the potential of above-average returns. Since they usually offer high commissions, retailers from banks to brokers have welcomed them. These are not fly-by-night con artists. Even some of our largest financial institutions have found that peddling the illusion of safety works, especially in the wake of two stock market crashes already in this young century.

I look at these securities as “dream-busters”. They are designed to create the illusion that investors can earn high profits without putting anything at risk.

Market-linked guaranteed investment certificates (GICs) were the original dream-busters. Like regular GICs, your principal is guaranteed at maturity. But there is no fixed rate of interest and thus no certainty of return. Your profit depends on how a benchmark index performs over the term of the GIC. If it does well, you make money — although perhaps not as much as you might think because in many cases the maximum profit is capped (this is called the “participation factor”). If the index drops, you get your principal back but nothing more. So it is possible that you could commit your capital for up to five years with zero profit at the end — and less purchasing power because of the effects of inflation.

That’s the situation facing people who invested in these securities at the start of last year. According to a GIC calculator on the RBC website, any money invested in one of their Canadian or global market-linked GICs at the start of 2011 has a zero return to this point.

This is not to suggest that market-linked GICs never make money. They do, but a lot depends on timing. For example, $10,000 invested in a three-year RBC global market-linked GIC at the start of 2009, just when the stock market crash was near bottom, would have paid $11,033.28 when it matured earlier this month. That’s a total return of 10.33 per cent. That may look okay at first glance but it translates into an average annual compound rate of return of only 3.33 per cent over that time. You could have done much better in hundreds of mutual funds, ETFs, and stocks.

Principal-protected notes (PPNs), which I have written about before, are a more sophisticated version of the market-linked GICs. The idea is the same — your money is “safe” while your return potential is theoretically high. More dream-busters!

Like market-linked GICs, a simple PPN will track the performance of a recognized stock index, such as the S&P/TSX Composite. As with market-linked GICs, you tie up your money for three or five years, at the end of which time you receive a return based on the performance of the index over that period.

But PPNs come with a lot of extra costs attached. In fact, the only sure winners are the underwriters of the issue and the broker or dealer who sells it to you. They get their fees and commissions right off the top — typically 3 per cent to 5 per cent. If the commission is 5 per cent, only $95 out of every $100 you invest actually goes to work for you. Of that amount, a significant percentage, perhaps as much as 70 per cent of the total, goes to purchasing a strip bond or a forward contract that provides the “guarantee” that your capital will be returned to you at maturity.

As well, most PPNs have annual fees and expenses attached. I have seen management expense ratios (MERs) as high as 2.65 per cent. Some of that money is paid as a trailer fee to financial advisors, thus providing another incentive to sell the product.

There are literally hundreds of these notes out there. If you click on the Miscellaneous (Other) category on Globefund, you’ll find almost 1,100 entries, most of which are PPNs. Bank of Montreal and CIBC are by far the major issuers among the banks.

If you scan through the performance numbers, you’ll find that many of these PPNs show a negative return since inception. If that continues, investors will only receive their principal at maturity, nothing more.

I won’t go into more detail here (there’s a section in the book if you want to read more) except to note that the average annual compound rate of return for the entire category over the five years to Dec. 31 was -0.5 per cent. Over three years, it was in positive territory at 4.04 per cent. But the S&P/TSX Total Return Index showed a 13.18 per cent annual return to that point.

The bottom line is that it’s not a good idea to seek safety in gimmicks. The returns are generally poor, they are often expensive, and they offer no protection against inflation.

Focus instead on keeping risk to an acceptable level by choosing low-cost, high-quality securities. Your portfolio will thank you.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts.

Photo © Konstantin Inozemtsev

Purchase Gordon Pape’s best-selling new book, Retirement’s Harsh New Realities at 50 per cent off the suggested retail price.