Savings Products: Know the Basics to Make the Right Choice!
Savings products can be broken down into four categories:
- Liquid securities: money market funds
- Fixed income securities: term deposits, guaranteed investment certificates, Treasury bills, bonds, debentures, coupon bonds, bond funds and mortgage funds, preferred shares, income trusts
- Growth securities: indexed term savings, common shares, equity funds
- Alternative securities: hedge funds
Since each savings product carries its own return potential and risk level, your investor profile should always be taken into account.
The products are also subject to different tax treatments, as described in capsule entitled "Taxation and Retirement Savings." Financial institutions offer a wide variety of products in addition to those listed above and may set minimums on some investments. Talk to an investment advisor or your financial planner for more information.
Pros, Cons and Tips...
Money Market Funds
- Money market funds have minimal fluctuation in share value, so capital is relatively secure.
- They have minimal returns.
- They have potentially high loss, especially if considerable amounts are invested in long term funds.
- Management fees are minimal.
- Money market funds should be used for short terms only, due to low return potential.
- Treasury bills are available in $1,000 increments.
- They can easily be liquidated.
- They are sold at a discount: the difference between the issue price and the redemption price is known as "lender performance" and is taxable as interest income, not a capital gain.
- Bonds provide greater portfolio stability.
- Return of capital is guaranteed by corporate assets or the taxation power of the government in question.
- Bonds provide regular income.
- Popularity and returns are directly tied to the issuer's reputation (governments, municipalities, large companies).
- If kept until maturity, returns are compounded as with term deposits.
- If interest rates rise, bond market values drop.
- Like all fixed income securities, bonds are vulnerable to inflation.
- Contrary to popular belief, bonds may entail a high degree of risk—especially long term bonds of 10 years or more—because there's a greater chance that interest rates will rise and cause the bond value to fall.
- The lower the interest rates, the greater the impact a 1% market variation will have on the bond's value.
- Coupon bonds should be held within an RRSP since they generate interest income. Otherwise, the theoretical amount of interest must be reported annually even if no interest has been paid out.
- The quality of the issuer is important, since it directly determines the degree of risk.
- Debentures are comparable to bonds, except that return of capital depends on the issuer's credit reputation.
- Preferred shares provide regular income.
- They may contain protection clauses (conversion, redemption, cumulative dividends, etc.).
- They are ideal in terms of tax treatment, since dividend income is not as heavily taxed as interest income.
- Preferred shareholders have a priority right entitling them to the company's residual assets if it's liquidated or dissolved.
- The company decides whether or not to declare a preferred dividend.
- The company's profit level has no impact on dividends.
- If interest rates rise, the value of preferred shares has a tendency to drop, as for bonds.
- Dividends are fixed and cannot be increased.
- Preferred shareholders do not have the right to vote.
- Preferred shares are slightly less negotiable than common shares.
- Income trusts provide regular income based on the performance of the business sector. The higher the return, the higher the risk.
- Virtually all profits are redistributed, sometimes as a return of capital.
- Rising interest rates and aging content are among the main factors that affect performance and therefore the amounts redistributed.
- Choose mature companies backed by strong management teams.
- Keep an eye on the sector of the trust, particularly if it's sensitive to fluctuations in the economy.
Bond Funds and Mortgage Funds
- Compared to equity funds, these funds are less sensitive to wide fluctuations and provide relative capital security.
- Bond funds and mortgage funds provide the benefit of professional management at a reasonable price.
- Carefully read the prospectus, which must be provided by law when you purchase your shares.
- Find out about management fees, investment policies, management style and the stability of the management team.
- Before investing, find out about the sources of the income distributed by the fund and the distribution schedule.
- Be careful about year-end distributions, since they'll be taxed as if you've held the fund for the entire year. If possible, defer any purchases to the following year instead. Talk to your adviser if you're in this situation.
- Be cautious about funds that have had very few benefits, since the next distribution could have a substantial tax impact (for non-RRSP portfolios).
- Keep your account statements so you can determine the average cost of each fund, which you'll have to submit to tax authorities.
Guaranteed Investment Certificates/Term Deposits
- These investments provide a capital guarantee.
- They may be redeemable or nonredeemable.
- They are fixed-rate investments.
- They are available in various terms.
- Repeated rises in inflation rates can hit hard, especially if the term is long (5 years).
- Common shares have good growth potential and are easy to buy and sell.
- They receive good tax treatment (dividends, capital gains).
- Common shareholders have the right to vote and are the true owners of the company.
- A prosperous company may split its shares in order to increase the number in the market. If the company runs into problems, it may implement a reverse stock split to reduce the number of shares and lower the value of each outstanding share.
Indexed Term Savings (Guaranteed Capital)
- Indexed term savings are a good way to get your feet wet in the stock market.
- With some restrictions, they provide a capital guarantee, no matter what happens in the financial markets.
- They can be diversified to a certain degree and have different terms.
- There may be a maximum on returns.
- There may be a contribution ceiling for the index in question.
- Indexed term savings produce interest income.
- Since gains are collected at maturity, the tax bill could be high if the interest is taxed at the taxpayer's marginal rate (for non-RRSP portfolios).
- The capital guarantee comes at a cost, which is reflected in the conditions of issuance.
- Equity funds are similar to bond funds and mortgage funds but are more sensitive to wide fluctuations.
- Find out how often the portfolio manager modifies the asset mix, as this can lead to lower rates of return for the shareholder.
- Hedge funds are protective vehicles usually used to reduce the risks inherent to portfolio management.
- Find out ahead of time how the manager will administer this part of your portfolio, in order to minimize risk.