When you save for retirement through investing, you have two main goals: to grow your money but also to protect what you put in from being wiped out.
So, for most people, it makes sense to put a portion of their money into fixed-income products that keep their principal safe and provide a steady stream of income, usually through interest.
One type of fixed-income product is a Guaranteed Investment Certificate (GIC).
One downside is that regular GICs carry a penalty if the owner wants to “cash” them before the date they reach maturity. A strategy to consider is to “ladder” several GICs.
What is a GIC?
A GIC is an investment that has a set term, and you get repaid with interest for your trouble while protecting your principal (as long as the institution doesn’t default and is a member of the Canada Deposit Insurance Corporation).
You can get GICs with terms ranging from one month up to 10 years. Usually, the longer the term, the higher the interest rate.
A GIC can be held in several types of savings plans, such as registered accounts like an RRSP or TFSA. However, before putting your GIC in one of these plans, consider the different tax implications of registered or a non-registered account.
GICs are protected by the Canada Deposit Insurance Corp. (CDIC), which protects an investor’s deposits in savings and chequing accounts and GICs up to $100,000 (but not for terms more than five years).
Types of GIC
There are many types of GICs. Here are a few:
You get the same interest rate on your principal throughout the whole term of your GIC, making it more predictable than a variable-rate one.
Over the term of the GIC, interest rates may go up or down, depending on what the benchmark they are tied to does, usually the financial institution’s prime rate. If interest rates go up, your return will be higher. If rates go down, so will your rate of return.
Similar to variable-rate GICs, market- or equity-linked GICs offer a return based on the performance of a stock-market index. If the market goes up, your returns do too. If the market drops, you may get no returns on your investment, but your principal is guaranteed.
These are GICs that don’t lock in your money and let you take it out when you want to without penalty. But most longer-term GICs that you will use for a laddering strategy are not cashable.
Short-term and long-term
Short-term GICs can be as short as three months or six months. Longer-term GICs are for one, three, five, or even 10 years. Usually, the longer you hold the GIC, the higher an interest rate you will get.
The laddering strategy
With a laddering strategy, it’s usually best to use fixed-rate GICs.
Generally, the longer the time frame until you can withdraw from your GIC, the higher an interest rate you get.
So why not put all the money you want to invest in a higher-interest long-term GIC?
- If you need the money, you may be forced to cash it in early, potentially losing all interest earned up to that point.
- If interest rates rise, you are locked in at a lower rate until the GIC matures.
- If rates fall, when your GIC comes due and if you want to invest in another GIC, you will renew all your money at a lower rate.
A strategy to maximize your GIC returns without locking in all of your money for a longer-term is to ladder, or stagger, the amount of money you want to invest across different time frames.
This also helps reduce the influence of interest rate changes on the investment.
How to ladder:
- Decide how much you want to invest in GICs.
- Divide the amount into the number of individual investments you want to make into different time frames, for example, one to five years.
- Look for the best rate.
- Reinvest each investment into 5-year GICs as your original investment comes due.
Here’s an example:
Let’s take an example of a total investment of $10,000.
Dividing this by five gives you five investments of $2,000.
Here is an example of how laddering might work, with assumed interest rates (your situation may be different).
Amounts are reinvested with interest earned at maturity, using the Royal Bank of Canada’s GIC laddering calculator:
The pros and cons of laddering
- Safety: It’s a low-risk product, especially if you invest in a fixed-rate GIC.
- Cash flow: You have access to 20% of the portion you put into GICs every year.
- Discipline: It takes the guesswork out of where interest rates will go and gives you a disciplined investing strategy.
- Average interest: You average out the interest you earn overall, so it is higher than if you had put all your money into shorter-term GICs.
- Rising rates: When interest rates rise, and it’s time to reinvest a portion, you get the benefit of higher rates.
- Inflation: Generally, with interest-bearing fixed-income products, not just in terms of laddering, the amount you earn through interest may not keep up with inflation. So, what you can afford with your future dollar may be less than what you can buy with the same amount today. While inflation is low right now (other than for food, and certain items like cleaning supplies and many grocery items), there is potential risk long term.
- Dropping rates: If you invest in a variable-rate GIC, you may experience dips in interest rates.
- Market dips: If you invest in a market-linked GIC, you participate in the downswings of the stock market.
GICs as part of a larger strategy
With stock markets reacting to the economic consequences of the COVID-19 pandemic, nervous savers are turning to safer investments.
With GICs, the give and take is that you get higher interest rates at the cost of locking in your money for longer. To give yourself the gift of higher interest rates while also having the flexibility to be able to withdraw money when you need it, consider a GIC laddering strategy.
But over time, as markets go up and down, fixed-income investments that rely on growth through interest rates won’t grow your investments as much as the historically higher returns through stocks and other equities. This is why most investors prefer to invest only a portion of their money into fixed-income products like GICs.
The safety they provide, though, is an integral part of your portfolio.