Guaranteed investments may not provide the returns you need

Ongoing market volatility has many Canadian investors beating a path from equity investments to low-risk vehicles like Guaranteed Investment Certificates (GICs) and money market mutual funds. In fact, according to data compiled by the Investment Funds Institute of Canada, net redemptions of equity mutual funds in 2016 totalled $ 6.04 billion.¹

The downside of safety

But “safe” investments have risks of their own. With interest rates remaining near record lows, returns are likely to be negligible. In May 2017, for example, the best available rate on a three-year GIC was less than 2% at most institutions.²

And then there’s the issue of taxation. Outside of Tax-Free Savings Accounts, Registered Retirement Savings Plans, and other registered plans, interest income is fully taxed. So if your combined (federal and provincial) marginal tax rate is 40%, 40 cents of every interest dollar you earn is taxed away.

What does that look like in dollars and cents? Here’s an example: Suppose you put $5,000 in a non-registered GIC earning 1.8% annually. At the end of the year, you’d have interest earnings of $90. At a marginal tax rate of 45%, you’d be left with net earnings of $49.50, or 0.99% on your original investment.

 

Don’t forget about inflation

Still, earning 0.99% is better than losing money, right? Unfortunately, there’s still inflation to take into account. As of December 2016, inflation (as measured by changes in the Consumer Price Index) was running at 1.5% annually.³

In other words, once you factor in low interest rates, income taxes, and inflation, those “guaranteed” returns could actually be costing you money. That’s why equity-based mutual funds are worth considering.

Over the longer term, equities have historically outpaced inflation by a greater margin than assets that generate interest income. In addition, equities have the potential to generate dividend income and capital gains, both of which are taxed more favourably than interest income when earned outside a registered account.

What about volatility? It’s true that equities may fluctuate in value over the short term. However, building a well-diversified portfolio with a mix of equities, fixed income and other asset classes will help in smoothing out market volatility.

 

A question of balance

Secure investments like GICs will always have a role in most portfolios. The key is to use them strategically, not as a refuge from short-term volatility.

¹ IFIC Industry Overview, January 2017.

² ratehub.ca.

³ Statistics Canada, Consumer Price Index, December 2016.