Investment Masterclass: Be Wary of Guarantees

Ian King, Wednesday February 26, 2014

Guarantee is such a strong and powerful word in the English language.  When attached to something positive, such as capital security, it can be very alluring.  Who wouldn’t want a guarantee of capital security over their investment?

Problems with Guarantees

Given such a natural instinct to wish to have a guarantee it is hard to objectively consider the offer of such a guarantee.  However, in my opinion the problems concerning guarantees can be summarised as follows:

  • How secure is the guarantee? A guarantee is only as strong as the person or persons providing it.
  • What is the guarantee over? Is this really important to me?
  • What is the cost of the guarantee, and by extension, what is the value for money which it is giving me?

Financial Guarantees

In our minds once we have secured something that is guaranteed it can never be taken away from us.  This in reality is not always the case.  Most financial guarantees are backed by an institution such as an investment bank.  As we saw, however, during the financial crisis at the end of the last decade, the value of such guarantees can at times not be worth the cost of the paper which they are written on.

In such circumstances a direct and in-direct impact needs to be noted. For example, those investors who had guarantees backed by Lehman Brothers were in many cases directly affected by the loss of their guarantee (and by extension of some or all of their money).  Many other investors were also impacted indirectly by market concerns that the institutions supporting their guarantees; who whilst otherwise were well capitalised, were also thought to be at the risk of default.  Whilst the guarantees may have remained, many investors in, say, structured products saw significant paper losses on their investments when the capital value was in theory guaranteed.

When offered a guarantee often our first instinct is to accept it.  However, we always need to be careful as to what the guarantee covers.  In the simplest sense guarantees connected to investments usually cover either the capital value or income derived from the investment.  Each investor who is offered such a guarantee needs to ask themselves how important the security of income or capital is for this tranche of funds? What would the impact be upon my standard of living if the capital or income fell significantly?  If the answer in both cases is “not much” then you need to ask yourself why do you need the guarantee?

Guarantees in Right Circumstances

Guarantees are very useful in the right circumstances. For example an individual who has capital available but following a comprehensive budget planning exercise requires a substantial and ongoing income from the investment would commonly benefit greatly from a lifetime guarantee over the income derived from the investment.  The volatility in the capital is of limited concern when making sure that the individuals’ income needs are met. If however the income need was neither that high (say as a percentage of the investment value) and/or likely to be of a shortened duration, then the risk of the capital being eroded, and hence the income ceasing would be much reduced. In such cases the guaranteed income is of lesser value.

Cost of the Guarantee

Finally, even when a guaranteed income or capital is of value we need to consider the cost of the guarantee.  We now inhabit a world were investment returns are likely to be lower than those seen in decades past.  Volatility in investment markets does however remain high. The price offered for a guarantee, either explicitly as a direct charge or implicitly within the terms of a product, can eat into a significant part of the after tax returns made by the investor. In other words, the price of the guarantee is high.  A case by case analysis is clearly needed but in many examples which we have seen even in a case where the guarantee offered some value, its effectiveness is offset by a high charge which in most cases would see the investor receiving a very modest return.

Financial Planning

The issue of guarantees lies at the heart of financial planning. It really does take a skilled financial planner to be able to properly understand their clients’ requirements and needs, both financial and emotional to be able to properly appraise the suitability of an investment guarantee.  In far too many cases expensive guarantees are sold to clients as a result of poor understanding on behalf of the adviser when in reality they were never required.

If you have any experiences or comments concerning investment guarantees we would be delighted to hear from you.

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