Guaranteed income certificates (GICs) or other similar investments are used in many capital accumulation plans (CAPs). They are included because CAP members are often uncomfortable making investment decisions and believe a GIC is a simple and “safe” (risk free) investment (i.e., interest rate and capital are guaranteed). In some cases GICs are included as a place to temporarily investment during volatile markets or economic situations. In either situation GICs are not as straight forward as they appear from either a sponsor or member perspective. In fact GICs can be risky and result in losses in certain situations.
How GICs work
GICs issued by an insurance company (record keeper) should, and usually do, pay an interest rate plus a premium (0.10%-0.50%) in excess of current bank GIC rates. Interest is based on a base rate (based on current bank GIC rates) determined by the record keeper plus the premium. Theoretically, with a competitive base rate plus a premium, the CAP GIC rate should be better than a comparable bank a GIC rate (the benchmark). As part of their fiduciary responsibilities administrators should verify that the base rate is competitive and the premium is included in the rate. Needless to say, record keepers like offering GICs and don’t discourage their use. Why? Because CAP money is “sticky :“ once in a GIC members are likely to stay in it. At the same time, GICs provide a reliable cash inflow and they provide a steady source of low cost revenue for the record keeper.
Members can invest in GICs via a transfer from another of their investment options or via monthly or bi-monthly contributions. If the investment comes via a transfer, the maturity and interest rate are set at that time. If the GIC is acquired through contributions, the member acquires a separate (rate and terms) GIC with each purchase and ends up with a series of GICs with different maturities and interest rates e.g. investing in a five-year GIC results in 120 GICs each with a different maturity date and rate of interest. However, the member does not know what the return is since record keepers do not disclose the average interest rate paid on a series of GICs. GICs are reported at book value on member statements vs. market value which is also confusing since the other investments are valued at market. A fee is also buried in the spread on the GIC interest rate paid but is not disclosed by the record keeper.
In a nutshell, the member acquires a series of GICs where the overall returns, benchmarks, durations, fees and market values are not known. As GICs mature members usually choose to reinvest in the same GIC doubling up their contribution at the prevailing interest rate and potentially compounding their risk.
Fiduciaries should as whether this is a prudent investment in line with the CAP guidelines. Is a member being provided with sufficient information to make investment decisions? Is there sufficient information to understand the risks? And are members being informed of the cost of the GICs?
The “Guarantee”
CAP members appear to place a high value on the GIC “guarantee.” Assuris, a non-profit organization, guarantees the GICs issued by member record keepers to a maximum of $100,000 in total per member (this includes contributions and interest earned).
The guarantee kicks in the unusual event of a record keeper defaulting. The guarantee is in the form of a transfer (at market value) to another insurance company so the possibility of a loss due to duration exists. A member will suffer a loss if the amount invested in GICs exceeds the guarantee maximum.
The interest rate is only guaranteed to the extent the interest has been earned so there is no rate guaranteed into the future. From a fiduciary perspective the key issues are whether members are aware of the guarantee limitations, potential losses and of the opportunity cost relative to other non-guaranteed fixed income investments. The sponsor is responsible for ensuring that the record keeper is an Assuris member.
Are GICs risk free?
Some CAP members assume GICs are risk free: to the extent of the guarantee they are but that is only part of the story. Often overlooked is the fact that the guarantee for GICs is limited and that there are other types of potential losses.
One of the more important GIC risks is that the interest rates are generally lower than those of other reasonably safe fixed income investments. Low GIC rates can result in negative real rates of return so the member is losing in relation to inflation, making it difficult to generate retirement income. In either case members often do not see this as a risk and are unaware or ignore the impact on their savings.
If a member terminates a GIC before maturity, a cash value is determined based on current interest rates: the member will not receive the book value shown on their statements. If the GICs were acquired in a period of low interest rates and terminated when interest rates are higher, the cash value would be less than book value so the member would suffer a loss. If a series of say five-year (120) GICs is terminated the market value for each GIC is determined manually by the record keeper making it very difficult for the member to verify or estimate the final cash value. If the sponsor decides to change record keepers the members’ GICs are also effectively terminated. If members realize a loss as a result of such a change the sponsor should consider reimbursing the losses to avoid problems. If the GIC is mapped into the new record keeper’s GIC it would be in the form of a lump sum GIC investment with a single maturity at the prevailing interest rate which also may not be ideal.
A win-some-lose-some approach regarding the duration risk in GICs is simply not appropriate from a fiduciary perspective: members need to be made aware of potential loses.
Summary
The bottom line is that the GICs are not as simple an investment as they appear: the guarantee
has limitations and the risk of loss exists in certain situations. The returns are also not sufficient in most cases to create a reasonable retirement income.
Unsophisticated members are more likely to invest in GICs and to have a low awareness and tolerance for risk. Sponsors are therefore often concerned about the impact on retirement savings and potential fiduciary risks if there is extensive use of GICs. As members near retirement or start withdrawing cash from the plan, risk and duration issues become more critical. Ensuring these members are aware of the nuances of investing in GICs is therefore important.
To mitigate the risk of loss and in keeping with a short term investment philosophy for GICs, sponsors should consider offering only a one-year GIC as an investment option. This will minimize duration risk and potential losses while emphasizing the short term nature of the investment.