Income Investors: Beware of GICs

06/11/2012 9:45 am EST

Focus: MARKETS

Patrick McKeough

Editor, Successful Investor

Guaranteed income certificates are in vogue once again, but don't think they're the solution to all your income needs...the devil is in the details warns Pat McKeough of TSI Network.

Index-linked guaranteed income certificates (GICs) promise to safeguard a portion of investors’ portfolios. In volatile markets like the ones we’ve been experiencing, these products may seem like an appealing place to put some of your money.

But if you turn to these investments, you could be making one of the costliest mistakes that investors can make: That is to accept the advice of a securities or insurance salesperson without considering how conflicts of interest may have influenced that advice.

Securities and insurance salespeople sell a variety of financial and investment products that may be suitable for a particular investor. They earn a wide variety of commissions and fees, depending on the product. This arrangement introduces conflicts of interest. What’s best for the salesperson may not be best for the client. It may be bad for the client.

Of course, some salespeople are scrupulous about settling these conflicts in favor of the client. Some go so far as to try to talk their clients out of making bad investment decisions, and thus talking themselves out of a commission. Others sell whatever is easiest and most profitable for them to sell.

Maximum Promises, Minimum Payouts
Index-linked GICs provide the buyer with a return that is “linked” to the direction of the stock market in a given period. The link depends on a formula or set of rules that is buried in the fine print. A quick look at the rules on these deals may give you the impression that the investor can profit substantially with little risk.

These investments are marketed as offering all of the advantages of stock-market investing with none of the risk. But banks and insurance companies aren’t in the business of giving customers something for nothing. The capital gain that holders get depends on an ingenious formula that is cleverly designed to sound generous while minimizing the potential payout.

For instance, the payout may depend on the average level of the index over the course of a year, rather than the year-end value. This will tend to diminish the performance that determines investor returns.

No Tax Advantages
Another drawback is that returns on index-linked GICs (or bonds linked to an index) are taxed as interest. That’s because you’re not actually investing in the stock indexes themselves; you’re just getting paid interest based on the change in the indexes. That’s a drawback because interest is the highest taxed of all investment returns.

Usually, stock-market investing produces capital gains and dividend income, both of which are taxed at a lower rate than interest. These GICs do protect your principal. But few investors if any make a good return on index-linked GICs. Most make less (at times substantially less) in index-linked GICs than they would have made in old-fashioned GICs.

If safety is your primary concern, you’d be better off with “plain vanilla” stocks and bonds. If you already own index-linked GICs, our advice is to cash them in at the earliest opportunity. If you don’t own them, we recommend that you stay out.

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