Guarantees are expensive, insurance is limited
As stock markets gyrate alarmingly in this season of market volatility, novice investors often start to have second thoughts about their investment strategy, especially those novices who don’t have a financial plan, an investment strategy policy, or a clue about their real tolerance for risk. That’s when financial advisors start to get questions about “guaranteed” investments and deposit insurance and segregated funds, and other types of vehicles that seem to offer safe haven or some protection against loss. Let’s take a look at some of these, and see what’s really involved.
Canada Deposit Insurance
There’s quite a bit of misunderstanding about this program. The Canadian Deposit Insurance Corporation (CDIC) is a federal Crown corporation that protects deposits held at its member financial institutions. In case a CDIC member institution fails (it hasn’t happened for a long time, but it has happened), Canadian depositors are protected by insurance that covers eligible deposits up to $100,000 (principal and interest combined) per depositor. You don’t need to apply – your deposits are automatically covered.
The insurance covers loss of cash held in savings and chequing accounts and term deposits (e.g., GICs) of up to five years’ maturity and not exceeding $100,000, as a result of the failure of the financial institution holding the deposit.
It’s very important to stress that CDIC insurance coverage does not extend to any other assets that may be held at the insured financial institution. So that means accounts (including discretionary investment accounts at affiliated brokerages) holding securities and assets like stocks, options, ETFs, mutual funds, U.S. and foreign currency deposits, corporate and government bonds, notes and debentures, commodities, Treasury bills, Banker’s Acceptances, certain index-linked and traded principal protected notes, and mortgages, and so on, are not covered by CDIC insurance. That includes assets held in an RRSP or TFSA or any other registered plan or account.
The only potential investment guarantees for assets held within an RRSP or TFSA are those that have some type of internal insurance or guarantee specific to that product. For example, segregated funds and Principal Protected Notes may offer certain types of principal guarantees. But these are offered by the issuer of the security have nothing to do with the RRSP or with any government agency like the CDIC.
Guaranteed Investment Certificates
Guaranteed Investment Certificates (GICs) are really a type of locked-in deposit. The principal amount (but not the interest) of a GIC investment is covered by the Canada Deposit Insurance Corp. or in the case of credit union GICs, by a provincial equivalent, to a maximum of $100,000 per institution. Check the terms of your prospective GIC to determine your specific coverage.
Because the financial institution gets the use of your money for the specified term, it will offer a slightly higher rate than you’d get with a totally liquid deposit such as a savings account, a money market fund, or a short-term Treasury bill.
GICs are offered with many term lengths, depending on the financial institution. Terms range from six months up to as long as 10 years. Most popular are five-year terms. The annual interest rate offered remains static for the term of the GIC, and interest may be paid monthly, quarterly, semi-annually, or annually, depending on the financial institution and the conditions of the GIC. Your money is locked in until maturity, and you’ll pay a penalty if you decide to cash out early.
Some financial institutions will offer redeemable (that is, cashable with no penalty) GICs. However, these GICs offer a (usually much) lower annual rate than the non-redeemable version for the same term.
Another variation is the market-linked GIC, whose rate of return is variable and linked to a market index of some type, for example, the S&P/TSX 60 Index or the S&P 500 Composite Index. Interest will typically be paid at maturity, a crucially important point to remember if you’re considering this type of GIC. That’s because it’s impossible to predict how the linked market index will do over the term of the GIC.
While the principal amount of your investment in the GIC is protected, at maturity, you may also receive a lump sum if the market has performed well, or you may receive a pittance – or even worse, nothing at all – if the market has underperformed or tanked. The end return is usually calculated by the financial institution based on a complicated formula that typically looks like an equation from an astrophysics textbook. So this type of GIC has lots of drawbacks and is in effect a high-risk bet on a market-linked return sometime in the future. Most advisors stay away from these kinds of products, looking at them as neither fish nor fowl, but some awful combination of the worst characteristics of both.
Segregated funds are basically mutual funds with a principal guarantee. Because of this “insurance” characteristic, they are offered by insurance companies as a type of insurance policy. Although a segregated fund might hold a portfolio identical to its non-segregated mutual fund counterpart, its fees are typically much higher to cover the costs of the insurance premium, while returns tend to be lower.
Segregated funds are regulated by provincial life insurance legislation. Your premiums (net of fees) are invested in the segregated funds of an insurer, which, in turn, invests the money in such securities as stocks, bonds, and money market investments. Insurance companies often team up with mutual fund companies to provide a “branded” seg fund whose investments are identical to an existing mutual fund.
The twist is that the seg fund version provides a principal guarantee, typically between 75% and 100% of your principal at the end of a specific period, usually 10 years or at death. Seg funds also provide protection from creditors and avoid probate (because of their characteristics as an insurance policy), while mutual funds do not. Average MER for seg funds is much higher than for mutual funds, ranging between 2.5% and 6%, in order to pay for that insurance coverage.
Industry protection funds
Various financial industry organizations also offer a measure of “insurance” to investors, but typically only in the event that the institution the investor is dealing with becomes insolvent.
Canadian Investor Protection Fund (CIPF). This fund covers the loss of property (e.g., stocks, cash) up to $1 million by eligible clients of an insolvent member firm. Note the distinction here: It does not guarantee the “value” of your initial investment – only the recovery of your property, whatever its value, as of the date of the firm’s insolvency.
MFDA Investor Protection Corporation. This is the equivalent of the CIPF for mutual funds, offered by the Mutual Fund Dealers Association of Canada (MFDA) and provides protection of up to $1 million to eligible customers who incur losses as a result of the insolvency of an MFDA member firm. Losses may take the form of shortfalls in the amount and type of assets that are held by the member firm at the time of insolvency. But losses that result from the changing market value of securities, unsuitable investments, or the default of an issuer of securities, are not covered.
Looking for investment guarantees or insurance is a mistake many novice investors make. They either don’t exist or are too expensive. It makes much more sense to develop a coherent financial plan that includes a diversified investment portfolio tailored to your financial objectives and tolerance for risk – one that can smooth out the inevitable bouts of volatility that infect markets and that steadily builds wealth over the longer term.