Guaranteed Investment Contract - Explained
What is a Guaranteed Investment Contract?
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Table of ContentsWhat is a Guaranteed Investment Contract?How Does a Guaranteed Investment Contract Work?Risks Associated with Guaranteed Investment Contracts (GICs)
What is a Guaranteed Investment Contract?
A guaranteed investment contract (GIC), also referred to as a funding agreement, is an agreement between an investor and an insurance provider whereby the investor is provided with a guaranteed repayment of the principal in addition to interest (at a fixed or floating rate) on his investment in exchange for keeping the deposit for a fixed period of time. The term guaranteed can be confusing since GICs do not involve guarantees provided by third parties. As such, these investment-oriented products carry the same risks that are typically associated with any corporate obligation that of insolvency and default by the insurance company. However, the higher rates of interest offered by a GIC compared to conventional U.S. Treasury securities still makes it a viable alternative to a savings account for many pensioners.
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How Does a Guaranteed Investment Contract Work?
A guaranteed investment contract (GIC) is one of at least four different options offered to employees for investing their pension contributions the other three being money-market mutual funds, the company's common stock, and equity mutual funds. A GIC is structured akin to a regular bond and is usually offered as a pension plan with maturity ranging from as low as one year all the way up to 20 years. Such investments are stable and therefore, appeal to conservative investors that do not want to risk their principal investments. However, like most other financial instruments, GICs are prone to the effects of inflation and deflation. Also, guaranteed investment contracts are similar to certificates of deposit issued by commercial banks and credit unions, except that they are offered by insurance providers, which are classified as non-bank financial institutions. There are two primary types of guaranteed investment contracts
- Participating guaranteed investment contracts
- Non-participating guaranteed investment contracts
A participating GIC offers the investor a variable rate of return, thus participating in both the risks as well as the rewards that result from fluctuations in the interest rate. On the other hand, a non-participating GIC only offers a fixed rate of return. Choosing between a participating or a non-participating GIC is at the discretion of the purchaser; therefore, in situations where market interest rates are high, the purchaser would usually opt for non-participating GICs. Conversely, if the interest rates are expected to rise in the future, it may be wiser to invest in a participating GIC. It should be noted here that although the Canadian Guaranteed Investment Certificate shares the GIC acronym with a guaranteed investment contract, it is significantly different in structure and features. Guaranteed investment contracts offered in the U.S. usually pay much higher interest rates than generic savings accounts. However, the interest rates offered by these GICs are still among the lowest available the lower interest is essentially a price paid for the stability of the investment. Insurers typically market GICs to institutions and organizations that qualify to receive favorable tax status. For instance, churches and other nonprofit religious organizations are exempt from paying taxes undersection 501(c)(3)of the tax code, and as such, are excellent markets for GIC products. Insurers often manage retirement or pension plans on behalf of such institutions and offer these products as conservative investment options. On numerous occasions, sponsors of pension plans tend to sell GICs as pension investments with maturity dates ranging anywhere between one and 20 years. Guaranteed investment contracts that are part of a qualified plan as specified by the IRS Tax Code may also be unaffected by withdrawals. Such GICs may also be considered qualified distributions and thus will not incur taxes or penalties. Qualified plans, such as deferred payment plans, 401(k)s and a few types of Individual Retirement Accounts(IRAs) allow employers to receive tax deductions for contributions they make to the plan.
Risks Associated with Guaranteed Investment Contracts (GICs)
Although GICs are generally considered lucrative financial instruments, the term guaranteed in Guaranteed Investment Contracts can be a misnomer this is because GICs do not involve guarantees provided by third parties. So, investing in such contracts will expose investors to the same types of credit risks that are typically associated with various other financial instruments that of insolvency and default. Moreover, in the event of bankruptcy on the part of the insurer, the purchaser is at the risk of not receiving the return of principal or interest payments. Mismanagement of assets by the insurer may also lead to a similar situation. Many a time, guaranteed investment contracts are backed by assets from two different sources (1) the companys general account assets, and (2) separate funding accounts created exclusively to support the GICs. However, irrespective of the source of assets, it is at the sole discretion of the insurer to provide an asset backing for the investment. Lastly, the value of a GIC is dependent on rudimentary market conditions such as inflation and deflation. Since GICs are usually low-risk and low-paying investments, it is easy for inflation to outpace them, leading to potential losses for the purchasers. In order to diversify some of the risks typically associated with guaranteed investment contracts, fund managers may sign contracts with up to 20 different issuers of GICs. A study conducted by Buck Consultants, a global human resources consultant suggested that the archetypal large employer usually purchased GICs from seven different insurers on average. On their part, insurers usually invest the capital accumulated through the issue of GICs in one or more of the following investment vehicles:
- Residential mortgages
- Government bonds
- Corporate bonds
- High yield bonds or junk bonds
- Private placements