The Principal-Protected Note
Wen is 58 with $1.4 million in an RRSP. She plans to retire at 62, will need $45,000 a year from the plan from age 62, and describes herself as conservative - she says she cannot lose principal. A representative is offering a principal-protected note issued by a life insurance company: eight-year term, 100% of principal returned at maturity, 60% participation in the price return of a basket of 20 large-cap Canadian stocks, capped at 40% total return, no dividends credited, a 3% selling commission embedded in the price, and early redemption only through the issuer at a 3% discount to calculated value. The minimum investment is $50,000. The advisor notes that the TSX has returned about 9% a year over the long run and that Wen will get the upside with none of the downside. She currently holds $300,000 in a five-year GIC ladder yielding 4.2%.
1. Calculate the note's payout under three eight-year basket price-return outcomes (-20%, +30%, +80%) and compare each to a GIC at 4.2%.
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Work in dollars on a $50,000 investment.
- -20% basket price return: principal returned, $50,000, a 0% eight-year return. The GIC would have grown to $50,000 x 1.042^8 = $69,490.
- +30%: 60% x 30% = 18%, payoff $59,000. GIC: $69,490.
- +80%: 60% x 80% = 48%, capped at 40%, payoff $70,000. GIC: $69,490.
The note only matches the GIC when the basket's price return reaches about 65% over eight years - the GIC's 39% divided by 0.6 - roughly 6.45% a year, and it must exceed that to win.
The 9% figure the advisor cites is a total return that includes roughly 3% of dividends. The note credits price return only and pays no dividends, so the realistic driver is about 6% a year - essentially breakeven. In effect the note is a bet that the market delivers above-average price returns for eight consecutive years, with all upside above 40% handed to the issuer.
The 3% commission also means only about $48,500 of her $50,000 is actually at work.
2. What risks does 100% principal protection not eliminate?
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Principal protection is only as good as the issuer. The note is not a deposit and is not CDIC-insured; if the life insurer fails, the guarantee fails with it. Check the issuer's rating and any applicable policyholder protection regime, and assume no protection covers the full amount.
Liquidity. An eight-year lock-up with early redemption only through the issuer, at a 3% discount to calculated value, means an exit in year three or four could return less than principal despite the guarantee. The secondary market is the issuer, and the issuer sets the price.
Opportunity cost. In the flat and moderate scenarios she gives up the GIC's guaranteed 39%. The protection only pays in a scenario where the index is lower after eight years - the least likely of the three.
No income. She needs $45,000 a year from age 62, four years into an eight-year term, with no distributions and a penalty to exit. That is a structural mismatch, not a risk-tolerance question.
Transparency and concentration. Twenty stocks, a participation rate, a cap, and a commission embedded in the price she cannot see. She cannot assess the true cost of the structure from the marketing document.
Finally, the cap converts a good decade into the same payoff as an average one, while the participation rate converts an average decade into a poor one.
3. What would you recommend, and how would you document the suitability discussion?
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She says she cannot lose principal and needs income in four years. An eight-year, no-income, capped, 60%-participation note fits neither statement.
Recommendation: keep the income years in guaranteed, liquid assets. Extend the GIC ladder - five years, non-redeemable, at 4.2% - sized so that rungs mature in years 4 through 8 to fund the $45,000 withdrawals, splitting deposits across institutions to remain within deposit insurance limits. For the portion she can genuinely leave alone for ten years or more, use a low-cost diversified equity ETF in a size she can tolerate seeing fall 30% - perhaps 20-30% of the plan - which keeps uncapped upside and pays dividends.
If she insists on a guarantee, compare a segregated fund with a maturity guarantee: it carries explicit annual fees and the same issuer-credit dependence, so it is not free protection. Show her the note's payoff table, the breakeven, and the 3% exit cost before she decides.
Document: her stated objective, the alternatives discussed, the eight-year term versus four-year horizon mismatch, the absence of deposit insurance, and a signed acknowledgement if she proceeds anyway. If she still proceeds, size it at an amount she will not need before maturity.