Tuesday, November 29, 2011

Past GIC Returns Not as Good as They Appeared

Many GIC investors long for the days double-digit returns 30 years ago. In a post warning of misconceptions about guaranteed income funds, Jim Yih at the Retire Happy Blog observed that today's low GIC rates are “not very appealing to a lot of people.” He’s right that people feel this way, but the truth is that today’s GIC rates aren’t too far out of line with past rates when you properly take into account inflation and taxes.

Most investors understand the idea of spending interest and leaving their principal alone. The problem with this approach over the long term is that inflation erodes principal. A better approach is to avoid spending part of the interest to account for inflation. This way the principal maintains its purchasing power over time. GIC investors should be focusing on real returns, which is the GIC return minus inflation. For example, if a GIC pays 3% interest and inflation is 2% per year, then the real return is only about 1%.

Using inflation data from Statistics Canada and 5-year GIC return data from the Bank of Canada, I found that from 1969 to 2009, the average GIC return was 2.35% per year above inflation. This is better than today’s GIC rates, but not by as much as most people think.

Historical GIC rates look worse for investors whose interest is taxable. The average real GIC return from 1969 to 2009 at a 25% tax rate is only 0.71%, and at a 40% tax rate it drops to -0.28%! So, for GIC investors who pay taxes, current GIC returns aren’t much different from what they have averaged over the past 40 years. Inflation is the silent killer of wealth.

2 comments:

  1. This is why I prefer dividend stocks over GICs. :)

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  2. @Kanwal: I know you meant this as a joke, but I worry about people who see dividend investing as a higher return replacement for GICs. Dividend investing has similar levels of volatility to investing in stock indexes. The risk of big swings in investment value (that could be later reflected in the dividend stream) is always present. I'm a fan of investing in stocks, but no investor should see it as being as safe as GICs.

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