Thursday, May 3, 2012

Market Secure GICs Not as Good as They Look

A reader directed my attention to Meridian Canadian Market Secure GICs (the web page describing this GIC has disappeared since this article was written). This is a GIC whose interest payment is linked to the performance of the Canadian stocks making up the S&P/TSX 60 index. They claim that the “principal is guaranteed,” that “members participate in 100% of return,” and “the participation rate is currently set at 100%.” This sounds too good to be true.

Before finding the fine print, the marketing claims make it seem like investors can’t lose money, but get 100% of the upside of stock investing. Savvy investors know there must be a catch somewhere because banks (or a credit union in this case) don’t give away free money. It turns out that the catch is in the “method of calculation” that I found after some digging (but has since moved again).

When you buy stocks and hold them for 5 years, what you pay is the stock price at the beginning, and what you get is the stock price at the end of the 5 years. With this GIC, what you get is the average price level over the 5 years. So, if the index goes up 8% per year, instead of making 8% on your GIC, you’ll actually get somewhere close to half of that.

But it gets worse. The S&P/TSX 60 index doesn’t include dividends. So, even if the stocks make a total return of 8% per year, you’ll only get about half of the capital gains and none of the dividend return.

To make this more concrete, let’s assume that the stocks make a total return of 8% each year for 5 years, but that 3% of this is dividends. Then the index will rise only 5% per year. The average month-end closing value of the index over 60 months works out to 12.6% more than the starting value of the index. So, the total GIC return is 12.6% over 5 years or 2.4% per year (compounded). Somehow a 100% participation rate in 8% stock returns turns into only 2.4% on the GIC.

What percentage of people who buy this product do you think understand how low their actual participation rate will be?

18 comments:

  1. My guess is that the percentage of investors who understand these products is very close to zero.

    In any case, if you buy dividend stocks you get the 8% return, plus the 3% dividend, which rises over time. Plus they're not as risky as bonds. :)

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  2. @Dan: Are you sure you only get the dividend twice? :-)

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  3. Man, you guys can turn anything into a dividend bashing post :)

    I looked into market-linked GICs for a Moneyville article and found the upside was limited to about 4% a year at best, and of course 0% at worst. Definitely not worth the risk.

    They're also not appropriate for those looking for a fixed income, as they pay no interest until maturity.

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  4. @Echo: Some market-linked GICs have caps so that it isn't possible to make more than some upper-limit return, such as 4%. Meridian's market-linked GIC doesn't have a cap, and so it is possible to make more than 4% per year if the stock market goes on a very strong bull run. However, you'll always get somewhere close to half the capital gain and no dividends.

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  5. From what I see, investors buy a ton of these products seduced by the "principal guarantee". Add to it minimal disclosures, financial institutions are happy to feed the quacking ducks.

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  6. I realize this comment may be coming from left field…

    In an earlier post you talked about Preferred Shares – the particular one discussed was BNS.PR.J. I have a question regarding this… I believe it “may” be called in October 2013 – I assume this depends on the bank. However, since it pays around 5% it will most likely be called. (thoughts?).

    Note, it’s a perpetual preferred – does that mean that if the bank does not call it in that it will keep paying this dividend?

    My other question is this – this stock has run up as well because of the dividend. I assume that when it gets closer to the call date, it will go back to its original value?

    Also, I assume the interest rate will also play into this? i.e if the BoC decides to increase interest rates the stock will go down – but, will it go down to less than the value of the call?

    Looking for advice… 

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  7. @CC: I think you're right that the principal guarantee draws in many people. The illusion of 100% participation in the upside of stocks likely helps as well.

    @Anonymous: BNS.PR.J can be called in October 2013 for $25 per share. Whether BNS does this is anyone's guess, but presumably it will depend on whether they think they can borrow money on better terms. Whether or not the share price starts to return to $25 will depend on whether the market thinks BNS will buy them back. My understanding is that if they don't buy them back, then they would continue to pay the dividend (as long as their business performance permits paying the dividend). Here is a link to more information:

    http://www.scotiabank.com/ca/en/0,,3085,00.html

    You're right that interest rates affect the value of these shares. If the market treats these shares as though they are likely to be redeemed, then the share value premium is a function of the number of remaining dividend payments and the difference between the dividend yield and current interest rates.

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  8. Good post. These products are brutal. The advertising is misleading and the transparency is awful.

    We've been writing about them for a while at Steadyhand. Here's a Globe column you might enjoy:
    http://www.steadyhand.com/globe_articles/2006/08/03/principal_protected/

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  9. For anyone who is interested, my column in this month's MoneySense (June issue) explains how you can build your own "guaranteed principal" investment by using a strip bond and an index ETF.

    At the end of 5 or 10 years, you are guaranteed to have at least as much money as you started with, plus the full return on your equity investment. No magic.

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  10. @Dan: You've got me trying to figure out how your scheme will work. All I've got is if you start with some principal amount, invest enough of it in the strip bond so that it pays an amount at maturity equal to your original principal, and invest the difference in the index ETF.

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  11. MIke, guess you'll have to buy the magazine. :)

    It's actually pretty simple. Say you start with $10K and want that guaranteed for 10 years. You get the current rate on 10-year strips and then figure out the present value that would get you to $10K in 10 years. (At 3.5% it's about $7,090.) You buy a strip bond with that amount.

    Then you take the remianing $2,910 and buy XIU or HXT, or whatever equity ETF you please.

    Now in 10 years, even if the equities go to zero, you will have at least $10,000 (unless the bond defaults). And if equities deliver 6% to 8% annually, you do pretty well: somewhere between 4.25% and 5% overall.

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  12. @Dan: So, I guessed right. These results look better than the market-linked GIC I reviewed. An added benefit is that the DIY approach is overwhemingly likely to give a positive return, but the market-linked GIC could easily give a zero return if equities have a bad decade.

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  13. Glad I could help provide a blog topic. While this product seems bad, it's the only bank i've seen that offers 100% participation. Most other banks offering this type of instrument at around 50% and therefore your return would be only a 1/4 of the markets return.

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  14. @Chris B: I'm not sure that all market-linked GICs use the averaging trick. So, maybe some pay a very low participation rate because there is no implicit divide by 2.

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  15. My mother got sucked into one of these from Meridian back in March 2009. She timed the bottom almost perfectly, and entirely by mistake! I looked at the literature and explained it to her afterward, and she was rather annoyed. She is so tired of finance industry types lying to her. She was burned by what I call a 'smash-and-grab' financial 'advisor' (MF salesperson). The smash and grab was churning her RRSP into 7% DSC funds and then essentially disappearing. This experience has taught her that she can't blindly trust people to act in her interests when it comes to investment products.

    PPNs or their strip bond+XIU counterparts are still a bit of a mental fiction to trick people into buying a 70-30 bond-equity allocation when they are otherwise deathly afraid of losing money in the stock market.

    Even if you get your original investment back in 10 years (in nominal terms), you will have lost substantial purchasing power (18% loss in real value).

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  16. @Andrew: That sounds like an expensive lesson for your mother. I agree with your other points -- especially the limited value of principal protection that doesn't take into accout inflation.

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