GICs and the inflation argument

In today’s unstable economic environment, investing in GICs is the safest and smartest way of staying ahead of inflation.

I have a confession to make. I love guaranteed investment certificates.

Why? When it comes to saving my hard-earned money, I like to see gains and I hate to see losses. As an investment vehicle, GICs are almost perfect for me. They never lose value. They are arguably the easiest things in personal finance to understand, and there are no hidden fees I have to worry about.

The only problem is that the current interest rate you get on GICs is very low. And this makes them an easy target for critics, those who would rather sell you money-draining products such as mutual funds.


One of the main arguments used to convince us to stay away from GICs is the inflation argument. I have heard variations of this thinking hundreds of times. It goes like this: GICs make about 2% a year and the consumer price index is 2%. Your real rate of return is therefore zero. Why would you invest in a GIC?

The people making this argument are then most likely to follow up with this: you should therefore invest in the stock market to keep ahead of inflation.

But it’s not as simple as that. The stock market does have a long-term history of beating inflation but, depending on the time frame you are talking about, it may not. For example, in 2008 the S&P TSX composite total return index (the one that includes dividends) lost 33% of its value. How did that loss help investors keep up with inflation?

So, how well have GICs done versus inflation? I am looking at a chart that shows the average annual interest rate of five-year term GICs (according to the Bank of Canada) versus the CPI all-items index from 1958 to 2014.

The average annual GIC rate was 6.78% and the average for the CPI index was 3.86%. GICs beat inflation by an average of 2.92% per year.

Of those 56 years, inflation only exceeded the five-year GIC rate four times, in 1974, 1975, 2011 and 2014. With the ultralow interest rates of recent years, we are in very unusual times, but there is nothing you or I can do about it.


Another reason I like GICs — there is logic to them. The reason GIC rates tend to stay above inflation is that monetary policy dictates it. In other words, interest rates change depending on what inflation does. That is because the key mandate for most central banks, including the Bank of Canada, is to maintain inflation at about 2%. If inflation takes off, the bank will raise its key interest rate, called the overnight rate, to send a message to the commercial banks to raise their prime rate. That makes borrowing more expensive to consumers, who then scale back on debt and, as a result, spend less. This tends to cause prices to decline as supply starts to exceed demand.

The scary thing that no central banker wants to talk about is the opposite of inflation: deflation. Reversing deflation is much more difficult than stopping inflation, because interest rates can’t really go below zero (although some countries in the euro zone are actually toying with this strategy). If we head into deflation, the argument about what you are invested in will shift significantly to the preservation of capital. And GICs win that argument hands down over the stock market, which is likely to nosedive in that scenario.

So what does that mean to your investing strategy? How can you make 5% a year with no risk?

You can’t. Anyone who promises you a guaranteed rate of return of 5%-plus is probably running a Ponzi scheme.


Do I wish GICs would pay 5% or more and beat inflation by 3% or more? Yes. But that’s not going to happen in the foreseeable future. Low interest rates seem here to stay because of the incredible amount of government, business and personal debt. A big increase in interest rates would put many organizations and individuals over the edge, unable to service their debts.

In my opinion, we need to get used to the fact that consistently high investment returns won’t be making our retirement dreams come true. That means we need to focus on an alternative strategy that always works — living within our means so we can put more money away to ensure our golden years are just that.

So don’t fall for the inflation argument. It is simply a ruse to convince you to take on more risk with your investments than you should. And in this unstable economic environment, when the next financial disaster happens, you’ll be glad you thought about keeping your money safe.