Editor’s note: the piece below was written a few weeks before the market chaos of last Friday and this Monday, which only makes it that much more relevant now. Even more prescient was a B&E guest post on August 13th entitled What you can do about the upcoming stock market crash.
By Marie Engen, Boomer & Echo
Special to the Financial Independence Hub
The stock markets have shown some volatility this summer and this has concerned some investors who have been riding the latest “full steam ahead” bull market and think a market correction is imminent.
These concerns have increased interest in investment products that have a principal guarantee. But are they worth it? These guarantees come with a steep cost.
Market-linked GICs, also called equity-linked GICs, are hybrid products that proclaim to capitalize on the growth potential of the stock market without risking your original investment. The return is derived from gains in the equity markets over the term of the GIC – usually 3 or 5 years.
The portion of the return derived from the equity markets depends on various components:
- The benchmark used to calculate the return e.g. S&P/TSX Bank Index or Capped Utility Index, Nikkei 225 Index
- Pre-set maximum return e.g. 6% for a 3-year term
- Dividends are not included in the calculations
Interest income is paid on maturity. If the equity portion produces no return, you receive no interest at all. Pay particular attention to how the equity portion of the return is calculated.
Like conventional GICs they are guaranteed by the Canada Deposit Insurance Corporation to the maximum allowable limits and are available for purchase in registered and non-registered vehicles.
A segregated fund is essentially an insurance product based on an underlying mutual fund that is offered by insurance companies. Under the insurance contract – usually for 10 years – part, or all, of the original principal amount may be guaranteed. In some cases there is the ability to reset the guarantee at a higher amount in future years.
Besides principal protection, there may also be other benefits such as:
- Death benefits
- Creditor protection
- Probate protection
Because of the insurance premium that’s included in the cost of the funds, MERs can be considerably higher than the equivalent regular mutual fund. Also be aware of costly fees if the funds are withdrawn before the term expires.
Guaranteed investments are quite popular with risk averse investors who are seeking stability in their portfolios and would still like to capture the upside of equity markets with no downside because the principal amount is secure.
Don’t get caught up in a compelling sales pitch, however. You need to determine if the price of a guarantee is worth the extra cost.
Look at the opportunity cost of locking in your funds for a lengthy period of time with no particular guarantee of any investment return.
Get a clear picture of what you’re receiving, and what you’re giving up, and evaluate them in light of alternative investments.
Marie Engen is the “Boomer” half of Boomer & Echo. In addition to being co-author of the website, Marie is a fee-only financial planner based in Kelowna, B.C. This article originally ran on the site on August 4th and is republished here with permission.