GICs vs. a Balanced Stock-Bond Portfolio
Recently, I’ve been thinking about saving versus investing or the idea of engaging in “risky” investments versus “safe” interest-bearing deposit products. This idea came to mind again because of the findings presented in my last blog post that financial planners in Japan did not tend to advocate for investing in the securities markets. Instead, they focused on accumulating savings. Perhaps this attitude is a holdover from the crash in Japan around 1990 and that is still struggling, at least it is if that’s where you measure your investment starting point. What’s the point of investing if 30 years later you have barely made any headway? still haven’t gotten out of the investment hole you fell into? Instead, pure cash savings, with a minuscule interest rate, is the best you can reasonably expect.
That’s not the situation in Canada, however. In October 1993, the S&P/TSX Composite Total Return Index closed at 8,050.97. Thirty years later, that same index is at 77,478.17, growing nearly 10 times (9.62 times to be more precise) over those three decades.
Risk Avoidance is Alive and Well in Canada
This is not to say that Canadians are experts in probability and, therefore, choose to place a significant portion of their savings in risky assets. Despite there being a reasonable expectation that returns from stocks and bonds will outperform the returns from cash and cash-equivalent deposit products like Guaranteed Investment Certificates (GICs), many Canadians choose to avoid that kind of risk altogether. This probably makes more sense given where GIC rates are today, but even when rates were quite a bit lower a few years ago when I worked at a discount brokerage, I still saw many accounts where the holdings were entirely made up of GICs.
To be clear, I am not yet another of those “in the industry” who are berating the poor benighted investor who prefers GICs to bond funds (whether mutual funds or ETFs). In my view, they can play a useful role in investors’ portfolios. Yields for brokered GICs, including those available through discount/online brokers, are currently superior to the weighted average yield to maturity available from most, if not all, bond ETFs.
However, I am concerned about younger investors who are so risk-averse that their long-term investment performance leaves them with inadequate savings to support their retirement income needs. The same concern also applies to retirees. There is a 50 percent chance that one of a 65-year-old male-female couple will live to age 94.[i] Depending on the other financial resources available, a portfolio exclusively invested in GICs may not be adequate to cover living expenses for the next 30 years.
What a Difference the Return Makes
To see how much of a difference investing in a balanced stock-bond portfolio can make to one’s long-term returns versus a collection of laddered GICs, I ran the following scenario through a spreadsheet.
Assumptions
For the most part, I am following the Projection Assumption Guidelines of FP Canada with the following nuances:
Inflation: As of the latest Consumer Price Index (CPI) data from the Bank of Canada, the median CPI is 4.10%. I assume that drops gradually until reaching 2.10% in 2028 and holding steady going forward.
Taxation: I assume no taxes are paid. A Tax-Free Savings Account (TFSA) would be suitable to replicate this projection.
GIC Yields: For 2023, I used the interest rates for 1-to-5-year GICs available as of Friday, October 13, 2023 at the online brokerage where I hold the bulk of my investments.
Again, by 2028, I assumed a gradual reversion to my estimate for the long-term expected rates for a 5-year GIC. The Projection Assumption Guidelines recommend using 2.30% for short-term returns and 3.20% for fixed income. Short-term figures are based on the estimate for 91-day T-bills (short-term, low-risk loans made by the governments; 91 days is approximately 3 months or one-quarter of a year). For fixed income, I used the average duration of several of the most common “aggregate” or “universe” bond ETFs. That duration worked out to approximately 7 years. Plugging those figures in, I estimate that a 5-year GIC should return about 2.93%. However, as rates are relatively high right now, it took until 2028 for the yield in the GIC portfolio to fall that low.
I assume that, at the beginning of 2023, a 23-year-old person invests $5,000 in a 5-year laddered GIC, i.e., $1,000 in a 1-year GIC, $1,000 in a 2-year GIC, $1,000 in a 3-year GIC, $1,000 in a 4-year GIC, and $1,000 in a 5-year GIC. At the beginning of each new year, the matured GIC, both principal and interest, is reinvested in a new 5-year GIC along with an additional $5,000 (not adjusted for inflation). I repeated that process through to the year 2065, the year the GIC investor turned 65.
ETF Return: These days, it seems that both equity and fixed income are experiencing a fairly high degree of volatility. Nevertheless, I continued with the FP Canada Projection Assumption Guidelines and assumed the following rate of return throughout, based on a 60% equity/40% fixed income asset allocation ETF, Vanguard’s VBAL, to be precise.
Of course, given the volatile nature of securities investments, including bonds, the annual returns would fluctuate above or below 4.927%, as would the 2.93% rate for GICs for that matter. However, I assume that, over the long term, the results can be useful for our purposes.
As is the case with the GIC portfolio, the ETF investor adds $5,000 (not adjusted for inflation) to the portfolio each year until the year 2065, and all distributions are reinvested.
Results
Nominal Returns
The GIC portfolio grew from $5,000 to $436,000 in nominal terms. It should be remembered, though, that $215,000 of that final figure represents contributions.
The ETF portfolio grew from $5,000 to $735,700 in nominal terms. Again, $215,000 of that figure is represented by contributions.
Real Returns
Both of the above figures sound pretty good. However, if we consider inflation so that those numbers can be more comprehensible to us who spend today’s dollars, the real return of the GIC portfolio will be worth $168,300 in 2065 while the ETF portfolio will be worth $412,900.
Conclusions
Investing in GICs is not nothing, even after inflation, and given the high rates today, it makes sense to put a portion of your fixed-income investments in GICs. It may also make sense to focus exclusively on GICs if you cannot tolerate any fluctuation in your investments. However, know that you may need to save a lot more to reach your target. Alternatively, you may need to seek and hold a career with a solid inflation-adjusted defined benefit pension plan so that your GIC portfolio is more of a nice-to-have than a necessity.
My suggestion is that in the case of most of us, there is a need to take some modest risk in your investments to improve the long-term expected returns for your portfolio. Consider reducing the risk as you near retirement because of a phenomenon known as sequence of returns risk, but after about five years in retirement, you can probably increase the risk a bit more to give you some extra growth in your later years.
Having said that, if you have “already won the game, why keep playing?” While I do not think investing is a game, if you have enough to support your financial needs throughout your longest expected lifespan, there is no need to take more risk.
Definitions
Yield to Maturity: the annual return an investor would receive if the bond was held to maturity and all interest payments were reinvested.
Weighted Average Yield to Maturity: the weighted average of the ETF’s individual bond holdings’ yield to maturities.
Risk aversion: the investor’s tendency to choose the preservation of capital over the potential for a higher return.
Nominal return: the amount of dollars generated before factoring in inflation.
Real return: the amount of dollars generated after factoring in inflation.
This is the 219th blog post for Russ Writes, first published on 2023-10-16
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
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[i] Projection based on the IQPF and FP Canada Standards Council Projection Assumption Guidelines.