Guaranteed investment contracts (GICs) are a type of financial instrument available to investors. Primarily based on an article by Kleiman and Sahu in the American Association of Individual Investors Journal, key characteristics, advantages and disadvantages of owning guaranteed investment contracts are explained in this essay.
Guaranteed investment contracts are one type of financial instrument with certain special characteristics regarding the rate of return on the instrument. Guaranteed investment contracts are similar to certificates of deposit issued by commercial banks, savings and loan associations, and credit unions, except that they are marketed by insurance companies, which are considered nonbank financial institutions. With GICs, corporations and individuals pay money in exchange for a contract that" promises" them the return of their principal at maturity plus an investment yield (i.e., the return on the investment) in line with prevailing money market rates at the inception of the contract. The yields or returns on GICs are generally higher than those on bank CDs by one-half of a percent to one percentage point at the time of purchase.
Guaranteed investment contracts are one of the most popular choices of participants in 401(k) retirement plans. The majority of 401(k) plans offer guaranteed investment contracts as an investment option, and GICs account for a significant portion of the invested financial assets of these retirement plans. Due to a number of reasons (including the spectacular performance of the stock market), the share of GICs declined after 1989. GICs bought for 401(k) plans usually permit deposits to be timed throughout the purchase year so that they coincide with employees' deferred income plans.
When employees of a company join their firm's 401(k) retirement plan, they are offered at least four options for investing their pension contributions—typically a money-market mutual fund, the company's own common stock, one or more equity (stock) mutual funds, and a GIC. For the portion of 401(k) retirement plan contributions allocated by employees to GICs, the company's pension plan manager shops for the best deal among the insurance companies that offer GICs, looking for attractive interest rates and maturities. Furthermore, in order to diversify the risk, fund managers may sign contracts with as many as 20 issuers of guaranteed investment contracts, although a study by Buck Consultants suggested that the typical large employer purchased GICs only from seven different carriers. The insurance companies that receive funds through the issuance of GICs, in turn, invest GIC money in a variety of investment vehicles—residential mortgages; government bonds, corporate bonds and riskier high yield bonds (junk bonds); and private placements. The yield or return that an employee receives on his or her investment represents the blended rate of return from the various GICs selected by the employee's company.
There are two basic types of GICs: participating and nonparticipating. With the first variety of GICs, investors receive a variable rate of return, and thus they literally participate in the risks and rewards resulting from the fluctuations in the interest rate. On the other hand, on participating GICs offer a fixed rate of return. When current market interest rates are high, it may make sense to buy a nonparticipating GIC and lock in the high fixed rate of return for the life of the investment contract. However, if interest rates are expected to rise in the future, it may instead be preferable to invest in a participating GIC, so as to benefit from the expected rise in the interest rate.
GIC contracts bought for defined contribution pension plans are generally quite large. A standard transaction might involve a sum of $10 million or more. The contracts generally have a maturity period between one and seven years. When the term of the GIC contract is up, the employees' pension fund recovers the principal from the maturing contracts and either reinvests it in another GIC or returns it to employees who are either retiring or cashing out of the plan.
Unsophisticated investors are very likely to ask why they even need to worry about the loss of principal in a GIC contract. After-all, aren't these investments guaranteed? The answer to the puzzling question lies in the fact that the "guarantee" refers only to the rate of interest that the issuer of the financial instrument promises to pay for the life of contract. As the holders of GICs issued by the Executive Life and Mutual Benefit Life insurance companies were reminded recently, the principal invested is very much at risk if the issuer of the GIC fails.
In contrast to bank CDs, GICs are backed only by the financial health of the insurance company issuing the contract, not by the federal government. Bank CDs are almost invariably insured by a federal agency called the Federal Deposit Insurance Corporation (FDIC); CDs issued by savings and loans, and credit unions are insured by similar federal deposit insurance agencies. Therefore, a GIC is only as good as the insurance company that issues the contract. Recently, some insurance companies burdened with investments in high-risk junk bonds and non-performing real estate loans, have seen their credit worthiness deteriorate considerably. The well-publicized failures in 1991 of the two insurance companies mentioned above, Executive Life and Mutual Benefit Life, have forced pension fund managers and 401(k) plan members to take a harder look at GICs and to re-evaluate the risk associated with them.
Of course, the chance that big insurance companies will go bankrupt and cost employees their 401(k) retirement money is quite remote. Moreover, since the GICs included in an individual company's pension plan are most likely to be composed of contracts issued by a number of insurance companies, the failure of one insurer would not necessarily cause a significant decline in the value of the pension plan's total assets. In addition, many major insurance companies that market GICs hold only small amounts of noninvestment grade, or junk, bonds.
Does an investor lose the principal amount if the insurance company that issued a GIC goes bankrupt? The bankruptcy courts are now in the process of deciding this issue. The current laws in most states stipulate that holders of guaranteed investment contracts come after the policyholders of the insurance company in question, should the insurance company go bankrupt. Other than Louisiana, all states in the United States maintain a guaranty fund to compensate insurance policyholders in the event an insurance company fails. However, not all state guaranty funds cover the GIC obligations of insurance companies. Almost half of the states are not explicit regarding intent towards compensating holders of GICs.
The traditional GIC issued by insurance companies promises to pay a rate of return based on the earnings of the company's assets. The principal amount, however, is backed by the company's own ability to pay, as embodied in its credit worthiness. This, in turn, implies that a guaranteed investment contract is as good as the insurance company that issues it. Thus, as concerns regarding the financial soundness and robustness of insurance companies have mounted, new versions of the standard guaranteed investment contracts have emerged in the financial markets to address the aforesaid concerns.
With investments totaling hundreds of billions of dollars in GICs, a loss of confidence in insurance companies could potentially lead to a gigantic outflow of cash from the insurance companies participating in the GIC market. Although most insurance companies have solid asset bases, especially those that are not threatened by risky real estate loans or a heavy concentration in junk bonds and are most likely to keep much of their customer base, many types of financial institutions are rushing to provide alternative financial instruments to calm the nerves of worried pension fund managers.
Basically, the new varieties of guaranteed investment contracts carry additional protection against default by issuers of the contract. The improved versions of guaranteed investment contracts include bank investment contracts (BICs), which are issued by financial institutions such as Bankers Trust and J.P. Morgan, and GIC "alternatives," which are sold by major securities firms such as Merrill Lynch and Shearson Lehman Brothers. It is useful to examine the nature of extra protection built into the newer instruments.
In contrast with the holders of guaranteed investment contracts issued by insurance companies, buyers of contracts marketed by banks and investment firms purchase the underlying securities outright. The relevant securities are then held in a trust fund for investors. This arrangement seems to clearly put the securities beyond reach of the banks' and investment firms' creditors in the event that these institutions default or go bankrupt. Thus, the arrangement spreads the risk beyond the issuer of the contract. Some institutions have taken added precautions—some banks deposit additional securities as collateral to make up for any shortfall in the market value of the original investments in case of a default, while some investment firms guarantee the book value of the newer versions of the standard GIC by obtaining a letter of credit that cannot be revoked.
Investors in the contracts sold by banks might be tempted to assume that BICs would be protected by FDIC insurance, which insures bank deposits up to $100,000. Because, bank investment contracts (BICs) are like bank deposits in principle, they too can be federally insured for as much as $100,000. However, this insurance should not be assumed automatically—it is up to the banks issuing BICs to decide whether FDIC insurance is offered for those contracts. At present few banks offer FDIC insurance on bank investment contracts. The cost of the premium is the key deciding factor—the premium is about 0.25 percent of the deposit, which would make the new instrument less competitive with non-FDIC insured GICs if the increased cost is passed on to buyers of the contract, and less profitable to the financial institutions if it is absorbed by the issuers. Therefore, some investors, lured by somewhat higher returns, are continuing to stick with traditional GICs issued by the most credit worthy of insurance companies.
While BICs have pulled in more than $20 billion, they face tough competition from a number of other GIC alternatives. These alternative instruments have been dubbed as SynGICs or synthetic GICs—sometimes referred to as "participating" or "separate-account" GICs.
With synthetic GICs, an employer is allowed to examine what is in the portfolio of investments and, in some cases, is permitted to choose the specific assets that would back the contract he or she is buying for the employee pension fund. Thus, rather than relying on all assets in the portfolio of an insurance company, the investor could, for instance, pick mortgages backed by Fannie Mae or Treasuries, which are considered virtually risk-free with respect to the repayment of the principal. Under this arrangement, the assets earmarked for the guaranteed investment contracts are transferred back to the pension fund in the event that the insurance company goes bankrupt.
Although synthetic GICs are designed to shift the credit risk away from the insurance company, investors do pay for the sense of added security in other ways. The synthetic guaranteed investment contracts no longer embody the long-term guaranteed rate of return. Instead of a guaranteed rate, these new securities are subject to annual interest rate adjustments. In addition, buyers of synthetic GICS assume at least some of the default risk associated with the underlying investments. If an investment backing a synthetic GIC sours, the investor's return would also be reduced.
Several securities firms are promoting the alternative instrument known as synthetic GICs. Moreover, insurance companies themselves have joined the fray, issuing several varieties of the synthetic GICs. Insurance companies such as Metropolitan Life are offering a version of synthetic GICs that spreads credit risk by placing underlying securities in an account that is separate from the insurance company's general assets. By placing the securities in a separate account for the purposes of GICs, default risk is essentially designed to be passed on to the issuers of the underlying securities. This arrangement also puts the underlying assets out of reach of the insurer's creditors, in case the insurer goes bankrupt. Under this arrangement, the issuers of the underlying securities would have to default in order to jeopardize the GIC investor's principal. The aforesaid arrangement, however, is not without difficulties. Some legal experts question whether the arrangement will withstand challenges in courts, since the insurance companies continue to maintain the legal ownership of the securities, which is also the case with traditional GICs. In other words, some believe that a mere separation of accounts may not be enough to keep the underlying securities from the reach of the insurer's creditors.
Rising concern about the financial soundness of insurance companies has prompted some pension fund managers to re-examine the wisdom of GIC investments. A survey by Buck Consultants suggested that a majority of employers are considering, or have already made changes, such as examining vendors of GICs more closely, raising required credit standards, or adding other fixed-income options to their retirement plans. In fact, the proportion of company retirement plans offering GICs and BICs has also declined, according to a study by Greenwich Associates.
As mentioned earlier, a guaranteed yield is one of reasons for growth in GICs (and now BICs). Some experts, however, question whether GIC/BIC yield levels are adequate to be suitable investments for retirement plans (note that a pension or retirement plan is, by nature, a longer term investment, and the return over the long period should be attractive enough to warrant inclusion of a financial instrument into the pension plan portfolio). The study by Kleiman and Sahu in the AAII Journal examined average yields for GICs/BICs from 1989-91. They found that the average rate of return on three-year GICs/BICs was 8.24 percent per annum. The Kleiman-Sahu study also suggested that, as with other fixed rate financial investments, the yields increased as the term to maturity increased—the average yields on five- and seven-year GICs/BICs were 8.62 percent and 8.78 percent, respectively. In addition, the study found that yields increased as the size of the GIC contract increased—the average yield on $1 million denomination GIC/BIC contracts was 8.49 percent over the time period studied, whereas the comparable figures for $5 million and $10 million denominations were 8.56 percent and 8.59 percent, respectively.
Are these yields on GICs/BICs high enough to warrant investment? As Kleiman and Sahu reported in their study, the yields on GICs/BICs were only slightly higher than those prevailing on U.S. Treasury securities of comparable maturities. Based on data compiled by Fiduciary Capital Management, the average, spread between GICs/BICs and Treasury instruments widened during the 1989-1991 time period—from 0.74 percent in 1989 to 1.07 percent in 1991. This increase is likely due to the well-publicized financial difficulties encountered in 1991 by insurance companies such as Executive Life and Mutual Benefit Life. Over a longer time period covering 1975 to 1990, guaranteed investment contracts yielded an average of 9.2 percent annually, which outperformed the 8.9 percent return achieved by the average Treasury bond fund with a two-year maturity by mere 0.3 percent.
Given that GICs only marginally outperform Treasury securities, the investor can question whether the added risk of guaranteed investment contracts (in relation to riskless Treasury bonds) is commensurate with the extra return on GICs/BICs. Moreover, in concentrating only on the credit and market risks associated with guaranteed investment contracts, investors in these instruments may be overlooking the mortality risk. Mortality risk essentially measures the possibility that the annual long-term returns on a retirement portfolio will not be sufficient to provide retirement benefits that a participant in the pension plan will not outlive. In other words, a pension fund participant's benefits may run out before his or her death.
Financial experts feel that, even if a GIC is performing well, an investor under 40 years of age who has more than 20 percent of his/her pension fund portfolio in guaranteed investment contracts can probably afford to take greater levels of market risk (the risk of fluctuations in the market value of the investment portfolio). The main rationale for undertaking greater market risk by younger investors is based on the potential for greater reward offered by alternative investment vehicles which, in turn, will result in reduced mortality risk. Many alternative investment mediums yield far greater returns over a long period of time. Investments in a well diversified, equity-oriented portfolio are generally considered the best bet for relatively young investors (40 years old or under). Common stocks, of course, are considerably volatile and thus risky. They have, however, yielded returns commensurate with the risk—approximately 6.5 percent per annum inflation adjusted real rate since 1920. More recently, a diversified portfolio of common stocks has yielded a compounded annual return of roughly 15 percent over the 1975-1990 time period. For an initial investment of $10,000, the difference between the investment in common stocks yielding 15 percent per annum and the 9 percent return from a non-participating GIC is almost $45,000 over a 15-year investment period—quite a noticeable amount. Younger investors should therefore consider putting between 70 percent and 80 percent of retirement portfolios into common stocks.
One must, however, remember that the returns on common stocks are also considerably more volatile than those on guaranteed investment contracts. This volatility can adversely affect the retirement funds of participants who are close to retirement. Thus, for individuals closer to retirement, financial experts advise a gradual shift of their pension fund resources into fixed-income securities (such as GICs, CDs, short-term Treasuries, etc.) until these securities constitute the vast majority of their portfolios (perhaps 90 percent or more) at age 65. Such a retirement strategy will have the benefit of portfolio growth fueled by the stock market when the investor can afford to take greater risk during younger days and the safety of fixed-income instruments at the time of retirement, when taking chances with stock market volatility may be too risky to be worthwhile.
The news on both traditional and synthetic guaranteed investment contracts continues to be mixed. According to Julie Rohrer (Institutional Investor), rising interest rates and declining concerns about the credit worthiness of insurance companies has led to a resurgence of the traditional single-maturity guaranteed investment contract in the last few years. Synthetic GICs also seem to be riding a wave of popularity, despite the adverse effect of rising interest rates on the investment performance of underlying bond portfolios.
The return of guaranteed investment contracts to favor was not confined to sales growth alone—the recent investment performance of GICs was also quite noticeable. According to the Pension & Investments Performance Evaluation Report (PIPER), eight of the top 10 performing PIPER commingled funds in the second quarter of 1994 were guaranteed investment contracts stable value funds, while 7 of the top 10 commingled funds for the 12 months ended June 30, 1994 were GIC funds. Note that stable value funds are essentially a new class of guaranteed investment contracts (GIC), under the broad category commonly known as synthetic GICs—they guarantee a stable value, but do not invest underlying assets in a single insurance company's general account; instead, they are 'owned' by the pension plan sponsor.
The news regarding GICs is, however, not uniformly good—uncertainties regarding the financial soundness of contract issuers continue. Barron's reported on September 5, 1994 that a Canadian insurer, Confederation Life Insurance Co., had failed. Its demise created some doubt as to the status of nearly $2.4 billion in guaranteed investment contracts that the company's U.S. subsidiary had sold to pension plan managers across the United States. The Confederation collapse is very unsettling, as there were few outward signs of major financial problems before the insurance company was seized by Canadian regulators in August 1994. Confederation has already stopped making principal and interest payments on its GIC obligations and is not expected to make any payments until an arrangement is worked out to liquidate or rehabilitate the company's American operations. Experts are inclined to believe that the Confederation situation will most likely accelerate the trend toward alternatives to traditional GICs—synthetic GICs and other similar financial instruments.
According to William Fred in Pensions & Investments, two financial services firms, Aldrich, Eastman & Waltch and ITT Hartford Life Insurance Companies, have introduced stable value investment vehicles with some new twists designed to appeal to the growing interest in alternatives to the traditional guaranteed investment contracts.
Jim Connolly emphasized the growth of synthetic GICs in National Underwriter. He reported two recent surveys issued by LIMRA that reported investments in stable value products for 1993 reaching an estimated $47 billion to $48 billion. The survey showed that synthetic products accounted for more than one quarter of all stable value products sold in 1993, compared with 15 percent during 1992.
Not everyone feels comfortable about the move away from the traditional GICs. Charles Clinton (in Benefits Quarterly), for example, expressed his disappointment that many pension plan sponsors were moving away from traditional GICs for the wrong reasons—they believed that the products were flawed. Clinton also believed that traditional GICs were flawed only if they were managed by a financially weak insurance company. The Confederation collapse demonstrated that that logic was flawed.
In sum, one can safely say that while the fortunes of GICs have fluctuated over time, they nevertheless appear to have captured a noticeable place among assets actively considered for retirement fund investing.
[ Anandi P. Sahu , Ph.D. ]
Clinton, Charles A. "Traditional GICs Are Here to Stay." Benefits Quarterly. Second Quarter, 1993.
Connolly, Jim. "GIC Shifts Noted in '93 Sales Totals." National Underwriter. Life/Health/Financial Services, 11 July 1994.
Connolly, Jim. "Equities' Hot Streak in 1995 Dampened the Sales of GICs." National Underwriter, [Life/Health/Financial Services] 20 May 1996.
Kleiman, Robert T., and Sahu, Anandi P. "The ABCs of GICs for Retirement Investing." AAII Journal. March, 1992.
Michels, Antony J. "The Return of the GIC." Fortune, 5 September 1994.
Rohrer, Julie. "GIC Revival." Institutional Investor. August, 1994.
Williams, Fred. "GIC Managers Score Best in PIPER Rankings." Pensions & Investments. 5 September 1994.
Williams, Fred. "Stable Value Funds Feature New Twists." Pensions & Investments, 8 August 1994.