Guaranteed Investment Contracts Chapter 9 Tools & Techniques of Investment Planning Copyright 2007,...

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Guaranteed Investment Contracts Chapter 9 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company 1 What is it? Traditional Guaranteed Investment Contract (GIC) An insurance company receives deposits from a benefit plan or other institutional customer, and then issues a fixed-rate contract. They are frequently offered as one of several investment options in 401(k) plans. The deposits paid to the insurer are used to purchase investments that are held in the insurance company’s general account. Fixed-income investments are the most common purchases. The benefit plan is a creditor of the issuing company and has credit risk. Generally, the GIC issuers have high credit-quality ratings.

Transcript of Guaranteed Investment Contracts Chapter 9 Tools & Techniques of Investment Planning Copyright 2007,...

Page 1: Guaranteed Investment Contracts Chapter 9 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Traditional.

Guaranteed Investment Contracts

Chapter 9Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• Traditional Guaranteed Investment Contract (GIC)– An insurance company receives deposits from a benefit plan or

other institutional customer, and then issues a fixed-rate contract.• They are frequently offered as one of several investment options in

401(k) plans.– The deposits paid to the insurer are used to purchase

investments that are held in the insurance company’s general account.

• Fixed-income investments are the most common purchases.

– The benefit plan is a creditor of the issuing company and has credit risk.

• Generally, the GIC issuers have high credit-quality ratings.

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Guaranteed Investment Contracts

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What is it?

• The insurer offering the GIC is contractually obligated to repay the principal and specified interested guaranteed to the 401(k) or other benefit plan.

• The plan’s provisions permit the participant to withdraw funds from the fund at book value (also known as account or contract value) for reasons such as:– Loans– Hardship withdrawals– Transfers to other investment options offered by the plan

• Companies can choose between two types of GICs:– Participating: Offer the investor a variable rate of return based on

interest-rate fluctuations– Nonparticipating: Earn fixed rates of return

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When is the use of this tool indicated?

• When a company or other organization wishes to have secure funding for its obligations under various qualified retirement plans– Including 401(k) or 403(b)(7) plans

• When an organization does not wish to have the responsibility of investing and managing assets under a retirement plan– The organization elects to transfer those responsibilities to an

insurance company.

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Advantages

• Rate of Return– GICs typically offer a higher rate of return than other relatively

low-risk investments, such as money market funds or certificates of deposit.

• Moderate Risk– They are backed by the insurer’s contractual obligation.– The risk of nonpayment of interest or principal is very low.

• Most insurers are creditworthy.

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Disadvantages

• Lack of Federal Insurance– Unlike some other relatively low-risk investments, GICs are not

guaranteed or insured by the Treasury or any other government agency.

• Despite the term “guaranteed,” they are riskier than any federally insured investment.

• Moderate Risk– Although insurance company insolvencies are unusual, in

certain instances defaulting insurers have failed to make promised payments of interest or principal.

• Credit risk does exist.

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Tax Implications

• Income earned on a guaranteed investment contract and paid into a qualified plan account is not taxed to the participant or the plan until distributions begin.

• All of the income attributable to a GIC is fully taxable to the investor at ordinary income tax rates to the extent that a distribution is made from the plan.– Unless the participant elects to roll over part or all of

the distribution.

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Alternatives

• Certificates of Deposit (CDs)– Debt instruments issued by commercial banks, savings and loans,

and other thrift institutions – Lower return, lower risk

• Federally insured

• U.S. government bonds, money market funds, or corporate debt instruments– Other options, if offered by the plan, when considering a GIC as a

401(k) investment– Corporate debt should be evaluated for creditworthiness

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Where and How do I get it?

• GICs are issued by most major insurance companies.– Firms wishing to fund 401(k) and other retirement plans

should solicit quotes from a number of issuing companies before an investment decision is made.

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What fees or other costs are involved?

• The commissions and fees involved in the issuance of a GIC are likely to vary considerably from one insurance company to another.– A firm wishing to purchase GICs should solicit competitive

bids from at least three different insurance companies before making a decision.

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How do I select the best of its type?

• A potential investor or purchaser of GICs should evaluate the current level of interest rates and estimate the likelihood of future interest rate fluctuations.– If rates are considered “high” by historical standards,

investors should consider purchasing a non-participating contract and “lock in” the attractive rate.

– If rates are considered “low” by historical standards, investors should consider a participating contract.

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Where can I find out more about it?

• Newspapers such as the Wall Street Journal– The WSJ publishes a daily table of rates quoted for GIC

contracts.– The table includes an index of GIC rates prepared by the T. Rowe

Price organization

• Financial Accounting Standards Board Statement No. 97: Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments– Contains the accounting regulations that apply to GIC contracts