March 1998

The ABCs of
Indexed-Linked GICs

© Talbot Stevens

What do you get when you combine the potential returns of hot stock markets with a guarantee that you won't lose money? Answer: an innovative new product that sells like hotcakes.

Index-linked GICs offer the sex appeal of stock markets, which have produced double-digit returns in the last few years, and the guaranteed safety and security of a GIC.

While a regular GIC is one of the simplest investments that exist, index-linked GICs are anything but.

Since you generally don't get something for nothing, investors need to understand that you don't get the total returns of a stock market index and a guarantee that you won't lose money. Something has to give.

Returns are limited. These special GICs are linked to the returns of a stock index. None of the indexed-linked GICs offers the full returns of stock indices. To get the safety of a GIC, you give up some of the total market returns, in several ways.

They are linked to the price index, not the total return index which includes dividends. Reinvested dividends can account for 20-30% of the total return and make a big difference, especially over five years.

The return is based on the index's average monthly value over the final year. This helps if the markets drop in the final year, but hurts if they rise, which is the long-term trend.

Finally, returns are further limited by either a “participation factor” where you get, say, 80% of the increase in the price index, or your maximum return per year is capped.

Outside of an RRSP, indexed-linked GIC returns are fully taxable as regular interest. Stocks produce capital gains which are only 75% taxable and tax deferred until you sell.

Other benefits. If tied to an international index, these GICs allow you to increase your global diversification, which further reduces risk, while participating in the historically higher returns of international markets.

Also, international index-linked GICs are considered Canadian content, allowing you to increase your foreign content beyond the 20 percent limit of RRSPs.

For short-term investments, or for those not yet comfortable with the fluctuations of stock markets, index-linked GICs are a clever innovation that will become even more popular if interest rates stay low.

Sometimes referred to as “mutual funds on training wheels”, they may also increase the mutual fund market by attracting GIC investors who would never ride stock markets without first using “training wheels” to guarantee against falling off and losing money.

While index-linked GICs certainly satisfy a market niche, those who are comfortable with market fluctuations could do better using the appropriate balance of equities, bonds, and cash-like investments for their short and long-term goals.

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