Banks will claim that market-linked GICs are the best of both worlds, combining the security of a GIC with the reward of equity investing, but is that true? There certainly are some upsides to market-linked GICs, but there are some downsides you should also consider.
You may have heard of index funds before. These investments will track a certain market, like the S&P 500 or the S&P/TSX 60, and will go up or down when the stock market as a whole goes up or down. You miss out on the benefit of getting amazing performance from a specific company doing well, but also don’t have to worry about any particular company crashing either.
Index funds spread risk around by buying many different stocks and selling you a piece of the fund, rather than the stocks themselves. It’s an easy way to make a diverse portfolio, but it’s still risky. We’re currently in a market downturn, with many people losing a lot of money over the past year. An index fund still hurts when everything is down.
That’s where market-linked GICs come in. Just like an index fund, they’re diversified. Their value will go up and down with the market, but you’ll never lose money, because your principal is guaranteed. Sounds great, right?
The biggest benefit of investing in stocks is that your gains are tied directly to the growth of the company. If they do well, your stock can grow multiple times over in a short amount of time. This comes with risk, as the company could instead go belly-up and erase your investment.
So when a market-linked GIC states it removes the risk of loss but keeps the gains, you might be interested. But how much will you really earn?
Most market-linked GICs put a limit on your gains, which could be as little as 5 or 6% per year. Even in years when the market as a whole gains 10, 20, or even 30%, you won’t make any more.
In years that the stock market does extremely well, a market-linked GIC will outperform a regular GIC but fall far behind an index fund or exchange-traded fund (ETF). In years that the stock market does poorly, a regular GIC will outperform a market-linked GIC – but it gets worse.
Index funds and ETFs are taxed only when you sell the investment – that’s known as capital gains tax. Capital gains are taxed at 50% of your marginal (highest) tax rate, while interest is taxed at 100% of your marginal rate. If you made $1,000 in capital gains you might only pay $148.30 in taxes, but if you made $1,000 in interest you could lose $296.50! The exact amount depends on your income, but you’ll always be taxed double when you compare interest to capital gains.
Market-linked GICs pay out in interest, not capital gains, so you also have to consider how you’re paying twice as much tax when you buy one.
No one likes seeing their investment lose so much value that it’s worth less than what they paid for it. Depending on how much you invested, you can lose thousands of dollars (on paper).
The only upside to losing money on an investment is that you can claim capital losses. You can use capital losses to offset capital gains, and any gains that are offset this way are tax-free. It can feel like a consolation prize for losing money, but really it just means you didn’t make any money.
For example, if you sell investment A at a loss of $1,000 and investment B at a gain of $1,000, you made a total of $0! You can’t get taxed on money you haven’t made.
A market-linked GIC doesn’t lose value, so you don’t get to claim capital losses. You just get your money back at the end of the term.
As time goes on, your money becomes less valuable because of inflation. Some years, deflation occurs instead of inflation, but periods of deflation aren’t nearly as common as inflation.
A typical rate of inflation per year is around 2%, give or take. That’s also the official target of the Bank of Canada. So every year, your money is worth 2% less, on average.
To put a number to that, imagine you have $100. If it’s not invested or in a high-interest savings account, it will still be $100 one year from now.
However, during that time, inflation might increase by 2%. Now that same $100 can only buy $98 worth of stuff. If inflation increases by 2% again next year, your money can now only buy $96.04 worth of stuff.
If you buy a market-linked GIC that doesn’t gain value because the stock market was down, only your principal is guaranteed. That’s the exact number of dollars you put in when you bought the GIC. But if you invested money 5 years ago in a GIC that earned no interest, it’s actually worth less than what you paid for it!
A normal GIC has a similar problem, but only when the national interest rate is lower than the rate of inflation. If your GIC’s rate is equal to or greater than the rate of inflation, you’ll always maintain value, and may get a small real return as well.
GICs can have a part to play in any portfolio because they have no risk of loss. Nonetheless, you don’t want your portfolio to be made entirely of GICs – even market-linked GICs – because you’re giving up a lot of your growth potential.
As you get closer to retirement and can’t risk significant losses, then it makes more sense to transition to GICs. If you’re young, it makes more sense to have less of your money invested in GICs and more of it in the market directly.