The short answer is, it depends. It could be argued that too many are rushing to cash in on the guaranteed investment market without fully considering whether these products match their financial planning goals and risk profile. Indeed, consumer demand for guaranteed products has rocketed over the past three years. In 2002 over £4.3 billion was invested.
Taking one step back, investors tend to forget that their first priority should be to conduct a comprehensive review of their finances, taking a wider view of both short and medium to longer term planning. Money for immediate needs, such as holidays and bill payments, should be easily accessible on deposit or bank account. Before considering investment options, debt repayment should also be viewed as a priority. Unless existing debts are interest free, or benefit from low rates, it is always better to repay outstanding loans first – it is unrealistic to expect investments in any other asset class to deliver this level of medium to long term return without a significant level of risk – and anyone who tells you otherwise is being economical with the truth!
Once all these factors have been taken into account, the investor can begin to assess the products which might be best suited to their aims. Individuals have varying attitudes to risk throughout their lifetime, depending on their circumstances, and investment is all about managing risk. Understanding risk and its impact is crucial. In the current climate, investors are seeking to maximise returns with minimal risk – not an easy objective in an environment of low interest rates, low inflation and a volatile stock market. Assessing and comparing the various guaranteed products currently available is important in any buying decision, and the pitfalls - as well as the benefits - should be clearly understood.
Historically, Guaranteed Equity Bonds (GEB) and Guaranteed Income Bonds (GIB) have been popular options, providing security with steady growth or a regular income stream. With Guaranteed Equity Bonds, investors are able to take advantage of the potential benefits of stock market growth, but limit the risks involved. For example, a typical bond may offer a percentage increase – usually linked to one or more stockmarket indices and often capped - on the investment over a period of years. Some products pay out earlier if growth in the underlying stockmarket reaches a predetermined level before the end of the term. If the stock market falls during the period of the investment, the capital is protected and returned to the investor (the amount can vary between products – usually 100%, but sometimes less if ‘income’ has been taken).
Whilst there is usually no risk to the initial investment, bonds will often limit any potential gains. Technically, there is an ‘opportunity cost’ to these investments. Investors need to understand the returns they could have made by investing directly into the underlying stockmarkets, say through a Unit Trust or Investment Bond. Unlike other stock market investments, guaranteed equity linked products do not pay out dividends. The loss in dividends is another part of the price investors pay for having their capital protected within the bond. There is also the most obvious opportunity cost – the chance that the bond will achieve little or no growth and that therefore the investor would have been better off in a building society account.
Also, investors need to be aware that their money is tied up for a period of time – usually a minimum of around three years, but more likely five, six or even seven, with the return paid as a lump sum in the final year. Interest is usually net of basic rate tax which, if the GEB is wrapped as a life assurance contract (they usually are) cannot be reclaimed by non-taxpayers.
It pays to shop around with this type of investment. Some products pay out 100% of any growth in the chosen index; others less. Many offer lock ins, which guarantee that if the index grows by a certain percentage, this gain is protected against any ensuing falls. The FTSE 100 is the index most commonly used.
It is a minefield of choice and buyers should beware before they invest. The guarantee is attractive if capital protection from any stock market falls over the period of the contract is important.
Turning now to Guaranteed Income Bonds. GIBs have found it increasingly difficult to generate high levels of income in the current low interest rate environment. More recently, innovative products such as Precipice Bonds have been developed to pay relatively high levels of ‘income’ during the term and capitalise on stock market opportunities. However, full capital guarantees on these products were mostly linked to stockmarket performance. With poorly performing markets, many Precipice Bonds have not returned investors’ initial capital, have fallen from favour and received a great deal of negative press coverage.
Another risk, often overlooked by investors, is the so called counter-party risk. This has always been an issue and recently resulted in a trend away from the word ‘guaranteed’ to ‘protected’ – to more accurately reflect the fact that there are third-party risks associated with such products.
For all these reasons, the market was ripe for revolution and providers have risen to the challenge. The demand has been for a product which offers a ‘toe in the water’ exposure to potential increases in equities, coupled with the ‘dry land’ security of bank and building society deposits.
With increased calls for simplicity, transparency and clarity, a new generation of guaranteed investment products has found its niche with the more risk averse investors. However, it should be remembered that this new generation of products is not only suited to the more cautious investor. Such products could also appeal to anyone wanting to add balance to an otherwise adventurous portfolio of assets - perhaps seeking an element of peace of mind in volatile markets.
One of the most popular types of cautious investment to have been developed recently is the Constant Proportion Portfolio Insurance (CPPI) – one of the ‘newest kids on the block’. These products employ a mathematical asset allocation model designed to prevent a fund from falling below a set protection level. Early CPPI products were closed end funds designed to run for a fixed period of time.
However, recent innovation from Zurich-owned Sterling has taken the CPPI concept to its next evolution with the introduction of its ‘Protected Profits’ product. This offers a totally different approach to most other protected funds, in that it does not rely on derivatives to produce capital growth. The Sterling fund invests in a basket of three Threadneedle equity funds (UK Institutional Growth, European Growth and North American Growth funds) and cash. Daily adjustments are made to the fund, moving money between cash assets and equities to take advantage of rising markets and offering a safe haven in turbulent times.
The key benefit of the fund is that its value will never fall lower than 80% of its highest ever level. To achieve this, adjustments are made on a daily basis to the fund’s asset allocation, resulting in a maximum equity holding of 70% and minimum of 30% cash. It has benefits that include no lock-in period, no MVR, a transparent charging structure and free fund switching at any time.
However, as with all CPPI products, a downside is that although a proportion of the fund is guaranteed, in rising markets, overall rewards will still be less than a direct investment into the underlying assets.
Remember, if your clients are prepared to accept some risk, they may be better off investing in a portfolio of ‘real’ assets. Adventurous investors may have the appetite for 100% global equities, and the more cautious may opt for a less volatile portfolio of fixed interest securities such as corporate bonds and gilts – either way the investment is likely to be more accessible than most guaranteed products and benefit from any dividend or coupon income.
So, is a guaranteed investment a smart investment? Speak to your clients to find out!
-Ends-
1337 words.
