Why GICs are NOT what they're made out to be: The Effect of Taxes and Inflation

A couple of things that are commonly overlooked when dealing with investments is the effects of taxes and inflation your overall purchasing power. Living in Canada, especially, we are taxed a fair bit (some would argue, more then fair!), but that is not the only point to consider when investing. Inflation also adds to the reduction in your purchasing power (i.e. $1 today will not necessarily be able to buy the same things a year from now, as it would today).

As I mentioned in one of my earlier posts, the cost of living has gradually been increasing over time. 10 years ago the gas prices were about 60 cents/litre, groceries were a lot cheaper, houses were a lot cheaper etc... One would assume that the income levels would be increasing at the same rate as cost of living, but that's not the case, which is why we must pay close attention to the effects of inflation and taxes on your investments.

One investment that many people like to get is a GIC. What is a GIC? It is what's called a "Guaranteed Investment Certificate". In English: the company you invest with will guarantee you a certain interest rate for a certain period of time (that is usually locked in). Why do people invest in GICs?

Pros

- principal guaranteed
- rate of return guaranteed
- liquid asset (can be easily converted into cash in case of emergency)
- people see it as a "safe" investment

Why should people be weary of GICs?

Cons

- interest is taxed fully at your marginal tax rate (MTR)
- very little flexibility
- long term returns are minimum
- inflation erodes purchasing power
- if you break the term of a locked-in GIC, you lose all the interest accumulated and just receive your principal back
- the money you invest is the same money the bank is lending back to you for credit cards and mortgages etc... (credit cards usually charging in the 18%/19% range)

People think GICs are "safe", but are they really? Let's take a look at an investor who has $100 to invest and gets 2 rates of return on his GIC.

Example 1:

Client getting 3% interest rate on a 1 year GIC; 31% MTR (Marginal Tax Rate)
*Note: I'm using Inflation at 3.5%. Most people would say inflation over a 15+ year time period should be calculated between 2.5% and 3.5%. I use the higher end of the scale as an example because, based on all the things that are going on in the world today, we might actually be looking at rates at this level or even higher.

Saving: $100.00
At 3% Interest: + 3.00
Pay Tax at 31%: - 0.93
___________
Net After Tax: $102.07

Inflation at 3.5%: - 3.50
Actual Return: $ 98.57

As you can see, you actually end up LOSING money with this rate. Remember, at this point in time, you'd be pretty lucky to get 3.00% from a bank on your GIC.

Example 2:

Client getting 5.25% interest rate on a GIC; 31% MTR (Marginal Tax Rate)

Saving: $100.00
At 5.25% Interest: + 5.25
Pay Tax at 31%: - 1.63
___________
Net After Tax: $103.62

Inflation at 3.5%: - 3.50
Actual Return: $100.12

As you can see, you BARELY break even even at this rate. You must get about 5.25% or more in interest on your GIC to beat taxes and inflation. Also remember, the higher your rate of return, the more you will pay in taxes. At this point in time it is pretty much impossible to get 5.25% interest rate on your GIC. (To view current rates of GICs in all provinces in Canada, you can do a quick search in your browser and find a few different links that will provide you with the rates)

Now, you can answer the question: Is it REALLY a "safe" investment? To me, the only thing 'guaranteed' is that, unless you're getting at least 5.25% in interest, you're going to LOSE MONEY!

Now lets just say 6 months into your term, an emergency comes up, and you need to take out money from you GIC. You call your bank, and let them know something has happened and you need the funds. What do they do? If they funds are in a locked-in GIC, they tell you that any interest you have accumulated up to that point will be lost, and you only get your original amount invested back. Does that seem like something you want to sign up for? Probably not.

Some would say "well, why go into a locked-in term to begin with?". The answer is quite simple; you will not get the best rate unless you lock the money in. Cashable (redeemable i.e. not locked in) GICs give very little return so they're not even worth it most of the time.

I hope this has helped you to understand how the Real rate of return is calculated, and how it affects you. I have sat down with many people and shown them this easy calculation, and they are completely baffled, because they have never been taught such a simple concept like this.

I have tried to hold an un-biased view on this topic, but it's hard to see many positives from this sort of strategy. I hope you've learned something! Please feel free to contact me for more information or any questions you might have!