Risky Business, the hidden costs of bank deposits

Recently a reader asked me to discuss term bank deposit options, guaranteed investment certificates (GICs), and alternatives considering the crazy low interest rates being offered right now. And that got me thinking about risk.

I just looked up the rates available at a major big bank right now – a 5-year non-cashable GIC pays 1.40% per year¹ You could go to a smaller institute like a credit union and possibly get a bit (but not much) more. The question is, is this risky business and are there hidden costs of bank deposits.

Let’s talk about risk for a minute

Generally speaking, it’s true: the more you risk, the more you make. There are some exceptions that offer lower risk while enhancing return, but as a general rule, this adage holds true. With the banks you have the added benefit of a government guarantee on the first $100,000 deposited. After that the deposit is backed only by the bank, similar to a bond with any other large (and probably solid) company.

Risk comes in many formats. I find that most people focus on volatility risk (short term or temporary loss of value), but what is most worrisome to me (and I believe should be of most concern to you) is the risk of catastrophic loss of capital.

Let’s take a quick look at stocks. For example:

A single large-cap stock has: 

– high volatility risk: it will go up and down a lot.

       › This would usually involve high loss risk in the short run, but a low loss risk over a 5-year timeframe.

– moderate catastrophic loss risk: your money is invested in only one company, so you’re stuck if something happens to them.

A basket of stocks has:

–high volatility risk: a bit less than one stock, but still high. 

     › This option would usually involve high loss risk in the short run, but a low to no loss risk over a 5-year timeframe.

– virtually no catastrophic loss risk, baring global thermal nuclear war.

Contrast that with the risk on bank deposits:

– A single insured bank deposit of $200,000 has: 

     › no volatility risk – it’s nominal value will only go up.

    › no loss risk on a nominal basis, but guaranteed loss risk on a real basis (see below).

     › no catastrophic loss risk on the first $100,000, because of insurance provided by the Canada Deposit Insurance Corporation (CDIC).

     › a small catastrophic loss risk on the second $100,000 because it’s not backed by the government but is still backed by the bank which is likely a fairly secure borrower.

– A single non-insured deposit of $200,000 (such as private mortgage lending or deposits with a denomination):

     › a small amount of volatility risk – it’s nominal value will only go up.

     › a small loss risk in the short run, unless you get unlucky and deposit with the bank at the exact time they get into trouble.

     › a moderate to high catastrophic loss risk, the guarantee is only as good as the guarantor and their backing. We have seen huge losses in both mortgages and deposits held with large well-known church denominations, not out of any nefarious activity, but due to mismanagement.

Making it real

The 1.40% from earlier is a nominal rate of return. Economists like to consider real rates of return which are calculated by adjusting for inflation. Why? Because if inflation is 2% and you make 2% on your deposit, the value of your account has gone up by 2%, but your purchasing power has not. It has stayed the same meaning that you really did not get ahead.

And really, at the end of the day, what’s most important is your personal real rate of return after taxes. So, if we assume a 2% inflation rate and a low-ish 30% personal marginal tax bracket, then the returns from the previous example go down to… negative 1.02%.

So, here’s a question for you: if something was guaranteed to lose a small amount of money each year, is that something you would call safe? Or would you consider it risky? There is absolutely no question about it. At current rates, GICs and term deposits are guaranteed to lose you money. I guess whether you consider that risky or not is academic. What really matters is that this is a horrible deal no matter how you look at it.

Alternatives 

But my reader didn’t ask about that – he asked about GICs and alternatives. So, now that we understand risk a bit better, we can explore some alternatives and their respective risks:

• Short-term bond funds can have a better return than savings accounts with very low risk in all categories.

• Long-term bond funds can offer a better return than 5-year GICs with low risk in all categories.

• Conservative portfolios, my favoured option, will almost certainly be better than 5-year GICs with low risk in all categories and greater tax efficiency.

• Dividend funds. Not that I would advise this, but if all you did was buy TD bank shares instead of lending the bank money for five years, you would (at least initially at the time of writing) take part in a dividend of 3.38%. If you believe that five years from now, the bank will be worth at least 90% of what it’s currently worth, then forget about lending to it and buy it instead. Better yet, buy a basket of similar companies. Ones that pay high dividends and are believed to be of good value. You will face volatility risk. You will face some risk of capital loss, but not much. Still, probably not appropriate for someone looking for something comparable to GICs or term deposits, but interesting to look at in the context of owning a company vs. lending to it.

I’ve written about it in the past – even Jesus considered investments to be superior to bank savings, and so should you. At the end of the day, bank deposits (especially when below the CDIC insurance threshold) will always be “safer” in the short term, but a bad deal in the long run. Now is a good time to seek alternatives.

Sources:

1. TD Non-Cashable GIC rates: https://www.td.com/ca/en/personal-banking/personal-investing/products/gic/gic-rates-canada/?tdtab=cashable 

Arnold Machel, CFP® lives, works, and worships in the White Rock/South Surrey area. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at dr.rrsp@visionvest.ca or through his website at www.visionvest.ca. Please note that all comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary are those of Arnold Machel and may not necessarily reflect those of IPC Investment Corporation. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.  

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