Is a guaranteed investment a smart investment? 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 £4.3bn was invested.
Taking one step back, investors tend to forget 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. 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 stock market indices and often capped ' on the investment over a period of years. Some products pay out earlier if growth in the underlying stock market 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).
While 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 stock markets, 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 the bond will achieve little or no growth and 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 these products. 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 stock market 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 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 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 developed recently is constant proportion portfolio insurance (CPPI). 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, recently companies have been adapting the CPPI structure so it protects funds in a new way. For example, Zurich-owned Sterling has introduced its Protected Profits product. It offers a different approach to most other protected funds, in that it does not rely on derivatives to produce capital growth. The key benefit of this type of fund is that its value will never fall lower than a certain percentage 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 and minimum cash. Benefits include no lock-in period, no MVR, a transparent charging structure and free fund switching at any time. However, 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? Speaking to your clients to find out would be a good idea.
Key Points:
• Be sure that clients have the appropriate needs and risk profile before offering them guaranteed products.
• There is an opportunity cost to purchasing guarantees ' returns are lower to maintain protection.
• Investors do not receive dividends on guaranteed cavity-linked products.
• Constant proportion portfolio insurance (CPPI) products have become more popular and offer new features and flexibility.
Paul Wright, Zurich Financial Services
