One of the most interesting, and safest, investments that Canadians have access to is the GIC. With a GIC, you invest your principal at a set rate of return. You receive the same interest yield, regardless of what is happening in the markets. Because of their safety and stability, GICs are popular among those who lived on fixed incomes. They are desirable during retirement because the offer a regular source of income.

Guaranteed Investment Certificates are generally considered to be risk free investments. It's important to understand, though, that no investment is completely without risks. This includes generally safe investments like GICs. While GICs can be a great part of any investment portfolio and long-term plan, there are some risks that you need to be aware of. Understanding the risks involved can help you reduce those risks over time.

What You Should Know about GICs and Risk

Since your principal is guaranteed, and your interest rate is often also guaranteed, there is not much of a risk premium involved. You don't have to worry about losing your principal, and you can expect to see the same return, no matter what is happening in the markets.

Of course, one of the rules of investing is that the greater the risk you take, the greater your potential returns. The relatively low-risk nature of GICs means that the gains you can expect are lower since the risk is lower. So, instead of perhaps seeing a 6% to 7% gain on your investment, as you might see in the stock market, you might only see a 1.5% return on your GIC. While you are insulated against capital losses (that bigger stock market potential also comes with the risk that you will lose some, or all, of your principal) with a GIC, your gains won't have nearly the potential.

As a result of these lower yields, GICs aren't very good when it comes to wealth building. They can preserve your capital, especially if you have a lot of it and just want to generate income through interest returns, but if you rely on GICs to build your retirement portfolio, you run the risk that your money won't grow at a fast enough rate to provide you with a comfortable retirement.

Additionally, while this low interest may be guaranteed, it’s not guaranteed to beat inflation. If your GIC is providing a 1.5% interest rate but the annual inflation rate is 3%, then your real inflation-adjusted rate of return is -1.5%. This means that you are losing money in real terms. Over time, this erosion in your buying power can make a big difference in the size of your nest egg. You can increase your return by getting the best interest rate possible on your GIC. This involves not only looking at what is offered among banks and credit unions, but also ask your banker for a better rate. Like many other bank rates, these can be negotiable.

You can also use a laddering technique. This means that you buy GICs of different lengths (since longer terms come with higher rates). Every time a GIC expires, you reinvest the money into the longest possible term. A proper GIC ladder allows you to take advantage of increasing interest rates, while still locking in higher rates.

There is also a tax liability that needs to be accounted for. Interest on GICs is fully taxable at your marginal tax rate. Because of this, you should consider holding any GICs in a RRSP or TFSA to shelter the gains until you withdraw the money. In the example above, tax could remove at least 0.5% of your return, now leaving you with a real rate of return of -2% after adjusting for inflation. You can see how that can be problematic over time. A shelter can defer the taxes, giving your money a chance to grow more efficiently. However, you will have to pay taxes eventually.

While a GIC can add to a diversified portfolio as a source of fixed income, be aware of the steps you can take to reduce the chance of losing money in real terms. Make sure you get the best rate possible and shelter your income from taxes, and include GICs in a wider portfolio composition that includes assets with better returns.

While Guaranteed Investment Certificates can be a great part of any investment portfolio and long-term plan, there are some risks with GICs to be aware of.

About Tom Drake

Tom Drake is the owner and head writer of the award-winning MapleMoney. With a career as a Financial Analyst and over eight years writing about personal finance, Tom has the knowledge to help you get control of your money and make it work for you.