One of the first concepts that it is important for people to understand when investment planning is Real Rate of Return. You may have heard people say that if you have your money in GICs or high interest savings accounts you are actually losing money. On the surface this doesn’t make any sense, if you are getting 2% interest, for example, and the principle invested is also guaranteed (Usually CDIC insured in fact) then how can you be losing money? What they are referring to is the Real Rate of Return on your money. More properly they should say that you are losing buying power if you are invested in a GIC or any investment with a low interest rate return.
What the Real Rate of Return refers to is the total return on your investment after accounting for inflation, taxes, and costs/fees. Continuing with our 2% GIC example if the inflation rate is 1.5% then at the end of the year you would only have .5% (or 50 basis points) more spending power than you did at the beginning of the year. Inflation is the reason that money “doesn’t go as far as it used to”.
Unfortunately Canada Revenue Agency doesn’t factor inflation into the calculation. Should you receive a T5 tax slip from the institution that sold you your GIC then that full amount must be included in your income when you complete your tax return. Should you be fortunate enough to earn a good income in Ontario then your marginal tax rate could be approximately 46%. This means that if you should earn an additional $100 in interest income, then you would have to pay an additional $46 in taxes. This would leave you with only $54 of “after tax income”.
Let’s return to the example of the GIC that pays 2% interest. We will say for this example that the GIC was purchased for $5,000 and paid $100 interest for the year. Assuming that the investor is in a 46% tax bracket then she will be able to retain $54 in after tax income leaving her with $5054 at the end of the year. While this isn’t exactly great many people accept this as they are risk averse and there is virtually no risk involved in purchasing a GIC. When we factor in inflation however this is where the problem arises. In order to be able to purchase the same amount of goods or services at the end of the year as she could have at the beginning of the year our investor would need to have $5075 assuming an inflation rate of 1.5%. Unfortunately in this example she only has $5054 after she has paid tax so she has actually lost purchasing power of $21. Assuming the interest rate, inflation rate, and her marginal tax rate remain the same she will incur this loss to her purchasing power every year that she chooses this investment.
The last component that we usually take into account when calculating a real rate of return are the fees and or costs associated with acquiring, holding, and/or selling the investment. It is rare to see any fees associated with a GIC investment (the exception being if there is some sort of annual fee for the account that the GIC is held in). For the purpose of this example we can ignore the fee/cost component when calculating the Real Rate of Return which in this case is negative .0041% or negative 41 basis points. This is calculated by dividing the actual amount of after tax money by the amount of after tax money that would be required in order to break even at the end of the year. In this case it would be 5054 divided by 5075 which shows that she would have 99.586 percent of the buying power she had at the beginning of the year. This is why some people might say that you are actually losing money when you invest in a GIC.
Should you have any questions about the Real Rate of Return please leave a comment below.