What Is a Guaranteed Investment Contract (GIC)?
A guaranteed investment contract (GIC) is an insurance company provision that guarantees a rate of return in exchange for keeping a deposit for a certain period. A GIC appeals to investors as a replacement for a savings account or U.S. Treasury securities, which are government bonds guaranteed by the U.S. government. GICs are also known as funding agreements.
- A guaranteed investment contract (GIC) is an agreement between an investor and an insurance company.
- The insurer guarantees the investor a rate of return in exchange for holding the deposit for a period.
- Investors drawn to GICs often look for a replacement for a savings account or U.S. Treasury securities.
- A GIC is a conservative and stable investment, and maturity periods are usually short-term.
- GIC values may be affected by inflation and deflation.
How Guaranteed Investment Contracts Work
A GIC is sold in the U.S. and is similar to a bond in structure. GICs pay a higher interest rate than most savings accounts. However, they remain among the lowest rates available. The lower interest is due to the stability of the investment. Less risk equates to lower returns on interest payments.
A U.S. issued GIC differs from a Canadian guaranteed investment certificate, which has the same acronym. The Canadian certificate, sold by banks, credit unions, and trusts, has different attributes.
Insurance providers offer GICs, which guarantee the owner a repayment of principal along with a fixed or floating interest rate for a predetermined period. The investment is conservative, and maturity periods are most often short-term. Investors who purchase GICs often look for stable and consistent returns with little fluctuations in price or low volatility.
Buyers of Guaranteed Investment Contracts
An insurer usually markets GICs to institutions that qualify to receive favorable tax statuses such as churches and other religious organizations. These organizations are tax-exempt under section 501(c)(3) of the tax code, due to their nonprofit and religious nature. Frequently the insurer will be the company that manages a retirement or pension plan and offers these products as a conservative investment option.
Often, the sponsors of pension plans will sell guaranteed investment contracts as pension investments with maturity dates ranging from one to as many as 20 years. When the GIC is part of a qualified plan as defined by the IRS Tax Code, they may withstand withdrawals or be qualified distributions and not incur taxes or penalties. Qualified plans, which allow an employer to take tax deductions for contributions it makes to the plan, include deferred payment plans, 401(k)s, and some individual retirement accounts (IRAs).
AIG used some of the emergency funding it received from the Federal Reserve in 2008 to pay out GICs it sold to investors, according to a New York Times report.
The Risks of Owning Guaranteed Investment Contracts
The word guaranteed in the term guaranteed investment contracts—GIC can be misleading. As with all investments, investors in GICs are exposed to investment risk. Investment risk is the chance that an investment may lose value or even become worthless.
Investors face the same risks associated with any corporate obligation, such as with certificates of deposit (CDs) and corporate bonds. These risks include company insolvency and default, which is the failure to pay back the investor. Should the insurer mismanage assets or declare bankruptcy, the purchasing institution may not receive the return of principal (the initial investment) or interest payments.
The GIC may have asset backing from two potential sources. The insurer may use general account assets, or a separate account apart from the company's general funds. The separate account exists exclusively to provide funding for the GIC. Regardless of the source providing the asset backing, the insurance company continues to own the invested assets and remains ultimately responsible for backing the investment.
Inflation or rising prices and deflation are other factors that may impact the value of the guaranteed insurance contract. Since these investments are low-risk and pay lower interest, it is easy for inflation to outstrip their performance. As an example, if the GIC paid 2% interest over the 10-year life of the product, but inflation averaged 4%, the purchaser would lose money.
Real World Example of a Guaranteed Investment Contract
Let's say biotech firm URobot Inc. wants to invest in its employees enrolled in the company's pension plan and decides it wants to buy a guaranteed investment contract (GIC) from New Year Insurers. New Year Insurers offers GICs that guarantee URobot gets its initial investment back and also pays out either a fixed or variable rate of interest through the contract's end.
URobot can choose to either have a separate account, in which New Year Insurers will manage their money on its own or have a general account, in which New Year Insurers will comingle URobot's funds with that of its other general account customers. URobot picks the general account. Assuming that interest rates are likely to stay low, for the time being, URobot agrees to a fixed rate of interest through the contract's end.
Unfortunately, during the holding period, the economy picks up speed, causing the central bank to raise interest rates to help moderate the pace of growth. Because URobot opted for a fixed rate of interest, it will not benefit from the increase in interest rates. It will still see the return on investments it was promised at the fixed interest rate, but it will lose out on the bigger returns it would have noticed if it had instead opted for a variable rate of interest.