With interest rates nearing historic lows, many investors are looking for alternatives to government bonds and savings accounts, both of which are struggling to provide attractive returns. A guaranteed investment contract, or GIC, is one such option. This is popular with some investors who want a safe alternative with higher interest rates.
A guaranteed investment contract is a savings instrument that functions as a loan to a financial institution. Although you earn a specific interest rate, your money is often tied into the account for a set period. This can range from 30 days to 30 years. The higher the interest rate is, the longer the period of the GIC will be.
Depending on the contract terms, interest might be paid monthly, quarterly, yearly, or once the contract term has ended. You are repaid your principal plus any interest at the end of the period. You may have to pay the penalty if you take your money out too soon, so you’ll want to avoid using a GIC for any money you need to access quickly.
A GIC usually involves a pension fund or an employer-sponsored retirement plan like a 401(k). GICs are frequently one of the investment options available to employees who enroll in a 401(k) or similar plan.
How do Guaranteed Investment Contracts work?
Guaranteed investment contracts are classified into two types: participating guaranteed investment contracts as well as non-participating guaranteed investment contracts. Participating GICs have a variable rate of return, which allows investors to profit from changing interest rates over time.
For example, Employers provide GICS for employees to invest their pension or 401(k) contributions. Companies often offer three other investing options: standard stock options, equity, and money market mutual funds.
A GIC acts most like a regular bond with variable maturities, and companies may offer maturities ranging from a year to 10 years. At the end of a contract, the investor is paid out their primary investment and any accumulated interest. On rare occasions, some GICs provide monthly distributions of the accrued interest during the contract’s life.
When contemplating the possibilities and terms of a GIC, an investor should consider current and predicted market rates. If the analysis shows soaring interest rates in the following years, the buyer may want to choose a participating GIC. In general, however, investors who buy GICs are looking for something other than significant returns, and GICs are a safe bet with short or long maturity periods and consistent earnings.
What are synthetic Guaranteed Investment Contracts?
A synthetic guaranteed investment contract refers to a group annuity contract that establishes an insurer’s obligations to a segregated portfolio of assets. The agreement serves as an accounting record for an accumulation fund.
The set rate of return credited to the fund reflects the segregated portfolio’s market gains and losses over the crediting formula’s stated time. This is subject to any minimum interest rate guarantee.
This contract is a diversified portfolio of fixed-income securities protected from interest rate volatility by bank and insurance company contracts. With a conventional GIC, the insurance company owns the underlying assets as part of its general account.
That said, the plan owns a modified guaranteed investment contract rather than the insurance company, as with the GIC.
This ownership right is of particular importance if there is a concern about the long-term financial soundness of an insurance company. The synthetic plan segregates the plan’s assets from the insurance company’s assets.
What are the benefits of investing in GICs?
GICs are incredibly safe investments (which is why they are so popular). Your principle (and often the interest) is usually insured. However, the insurer can vary based on who you deposit with and where you live.
Depending on where you live, amounts up to $100,000 to $250,000 are insured. Your money would be protected even if your financial institution went bankrupt.
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Top Five Advantages of GICs insurance:
- Your principle is usually guaranteed up to the insured limitations, so you won’t lose it (and interest is generally guaranteed as well).
- Being unable to access your money without incurring a penalty can help keep you from raiding your funds.
- There are numerous GIC rates and terms to select from.
- They can be stored in registered accounts.
- Interest rates might be significantly greater than in traditional savings accounts.
In short, GICs present less risk in exchange for a larger return. Consider working with a financial professional to design and revise your long-term investing strategy.
Guaranteed Investment Contract examples
Let’s pretend Company A purchases GICs insurance from an insurance provider called Insurance B for the employees in its pension plan. In return, Insurance B guarantees Company A a return on the investment.
In addition to repaying the original amount Company A purchased the contract for, Insurance B also pays interest. This may be at a fixed or variable rate until the end of the contract.
This GIC will probably be a general account, so Insurance B pools money from different GIC accounts and manages the funds accordingly. Company A potentially loses its principal and returns if it does so poorly or files for bankruptcy. Alternatively, the GIC might be categorized into different accounts and managed separately.
GICs target a specific group of people. In particular, insurers market GICs to individuals that qualify for favorable tax status. That includes nonprofit organizations and churches, making them exempt from taxes. Usually, the insurer manages a retirement plan or pension and offers GICs as a low-risk investment.
What are the risks associated with GIC investments?
While GICs are less risky than many alternative investment options, they are not risk-free. Investors who invest in a GIC risk losing money, just like any other investment.
The period and size of the investment determine the return on a GIC. As a result, the higher the return on a general GIC account, the larger the investment. A general account GIC with a fixed interest rate, on the other hand, is sensitive to inflation.
Take the following scenario as an example: an investor buys a 20-year general account GIC with a fixed interest rate. Inflation may rise during the holding period, which is the period in which the owner owns the investment.
Because GICs typically pay modest interest rates, inflation may overtake the investment’s interest rate. This means that the investor loses money and misses out on larger profits.
GICs were once a popular investment for 401(k) retirement plans. However, their popularity fell once the market crashed in the early 1900s.
The failures of two insurance companies resulted in a dramatic loss in investor confidence. However, the latest versions of the GIC have additional safeguards against potential issuer default.
Here are some other risks to bear in mind when considering a GIC:
- The best GIC rates require you to lock in your money for several years.
- You will face a penalty if you remove your money too soon.
- Closing your cash for an extended length of time at a low rate during a period of stable inflation may result in your money losing value.
Who should invest in GICs and why?
GICs are ideal for anyone on a fixed income. Your money will be locked away for the duration you specify, and you will always be assured of getting it back with the stated interest attached. GICs and high-interest savings accounts share many similarities.
GICs are also ideal for cautious investors, retirees who need to protect their liquid assets, and investors who need to fulfil a long-term financial goal.
In other words, if you’re searching for a ‘safe’ investment that will protect your principal while earning more interest than a savings account, a GIC could be a good option.
GICs often appeal to risk-averse investors who want to balance out portfolios by putting some of their money in a low-risk account in retirement plans. GICs are given to retirement plan participants as part of a stable value fund or another conservative investment choice with a similar name.
How can you get started investing in GICs today?
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Before investing in GICs, here are three questions you should ask yourself:
1. Can you afford to lock up your money?
Consider how soon you might need your money if there’s a risk you’ll need it. If you are considering a significant purchase soon, six months may be plenty, but you might also wait one, two, or up to five years.
Choose a period that meets your investment objectives while not leaving you in debt.
2. Would you like a fixed or variable interest rate?
Most GICs offer a fixed interest rate, so you’ll know exactly how much interest you’ll receive at the end of the period. Variable interest rate GICs do not provide a guaranteed interest rate after the term because they are subject to market volatility. You could earn more, but you could also make nothing.
3. Which technique will best suit your needs?
You can purchase a GIC with monthly interest payments. Inquire about a GIC that pays interest automatically each month rather than at the end of your term.
Stack your GICs by purchasing GICs with various maturities. For instance, if you have $10,000 to invest, put $2,000 in a one-year GIC, $2,000 in a two-year GIC, and so on. That would provide you with $2,000 in principal yearly for the next five years. You can reinvest it in another GIC with a different term if you don’t need the money.
Final thoughts
Finding the right investment for you requires a lot of research. To profit from diversity and protect your assets, you should have a solid variety of investments in your portfolio. That said, it’s worthwhile to investigate assets with varying risk levels and return rates before committing to an investment.
A guaranteed investment contract carries little to no risk and offers good interest rates. If it aligns with your investment approach, consider investing in a GIC.