Paying a premium for market-linked GICs and segregated funds
Q: With stock markets showing more volatility this summer, I’m a little concerned that there may be a correction ahead. But I’m reluctant to get out of stocks completely, because the return on conventional fixed-income vehicles like GICs is so low. I’ve heard that there are such things as GICs with an equity component, so that while your principal is guaranteed, you can still participate in stock market gains if and when they occur. And a friend also told me about segregated mutual funds, which have some kind of a guarantee as well. How are these vehicles different, and do you recommend investing in them? ~ Asked by F.T., London, Ontario
Products that offer various kinds of capital guarantees while offering participation in equity markets have been around for quite a few years now. And some of these are quite popular with highly risk-averse investors who still like capturing the upside of equity markets. As you’d expect, however, these guarantees come with a rather steep cost.
Like regular guaranteed investment certificates, these GICs, commonly referred to as market-linked or equity-linked GICs, offer a guarantee of principal for the term of the certificate. But the twist is that the return includes some form of return derived from gains in equity markets over the term of the GIC. These types of GICs are sometimes also referred to as “structured notes” or “principal protected notes.” Like conventional GICs, they are guaranteed by the Canada Deposit Insurance Corp. for terms of five years or less to the maximum allowable limits.
But if it were just that simple, the decision would be easier. However, as with most financial products these days, there’s an embarrassment of riches. Market-linked GICs come with a bewildering variety of options. And the portion of the rate of return derived from the equity market is not quite as straightforward as it’s sometimes made out to be. Much depends on the benchmark that the GIC uses to calculate the equity return. It’s not always the “S&P/TSX 60 Index,” or the “S&P 500 Composite Index,” for example. The benchmark used by the issuer of a market-linked GIC could be a basket of stocks chosen by the issuer or a hybrid of indices of some sort.
There are usually numerous conditions and restrictions on the equity return, including pre-set maximums. And dividends are typically not included in return calculation. Of most concern is that interest on market-linked GICs is not paid until maturity. If the equity portion of the GIC produces no return over the period, you may receive no interest at all. Again, it makes sense to speak with your financial advisor before investing in these types of investment products.
Segregated funds differ from market-linked GICs in that they are an insurance product based on an underlying mutual fund. They are essentially a mutual fund offered as an insurance contract by life insurance companies. Under the insurance contract, part or all of the original principal amount of the investment may be guaranteed, and there may be death benefits, creditor protection, and in some cases the ability to reset the guarantee at a higher amount in future years. The funds may be the insurance company’s own funds or they may be a mirror version of another company’s fund but with the insurance contract features overlayed to create a segregated fund.
The high cost of insurance
Management expense ratios of segregated funds are considerably higher than an equivalent conventional mutual fund, because of the insurance premium that is included in the cost of the fund. As a typical example, the CI Harbour Fund has an MER of 2.43, while the CI Harbour GIF (Foresters Life Insurance Co. provides the annuity contract) has an MER of 5.07. That’s an additional hurdle in cost to overcome in performance, so you really should discuss with your advisor whether the price of the guarantee is worth the extra cost.
The cost of guaranteed equity participation investments like market-linked GICs and segregated funds is high in terms of MER. There’s also an additional cost that’s hidden – the opportunity cost of locking in your funds for a lengthy period with no particular guarantee of investment return, so you’ll want to get a clear picture of what you may be giving up for a “guarantee.”
© 2015 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.