View more on these topics

Protection downfalls

Protected investments can have nasty surprises for investors

The real test of a protected investment is not how it performs when markets are rising but how it reacts when they fall. I believe this point is important and often ignored.

The issue is not whether the investment will deliver the protection it promises – unless things go disastrously wrong, we can assume it will – but whether it will grow sufficiently when the market falls and then recovers.

The reason for choosing protected investments is that they offer equity-style growth potential with capital security. If they cannot deliver on the growth, they are not meeting investor expectations, even if they deliver on the security.

Some products have an explicit guarantee, so an assessment can be made of whether the security offered is sufficient to justify the reduced return in good times. Others offer capital protection with an element of market participation so it is possible to assess the likelihood that they will beat the return on cash.

As long as the guarantees are clearly understood, this kind of assessment is not fundamentally difficult and should be done as a matter of course before such products are recommended.

The “what if?” scenario modelling is much more difficult but advisers need to be aware that protected investments can suffer severe reductions to growth potential after market falls.

At an adviser seminar a number of years ago, I was asked about a pension product that was flavour of the month at the time. It offered a very significant level of guarantee and was being hailed as much better than with-profits. I suggested an element of caution as it looked as though the product could very quickly end up being invested almost wholly in gilts if markets fell. One adviser reacted to this with some hostility but, sure enough, markets collapsed and so did the product.

Constant protection portfolio investment, which became popular in the UK a few years ago, has the same potential drawback and to some extent the demise of with-profits has a similar root cause. Insurance companies which previously used financial strength to ride out the storms found that they needed to disinvest from equities in falling markets and so lost some of the benefit of the recovery.

A second type of protected investment that could suffer in falling markets is typified by some of the variable annuities that are becoming more common in the UK.

Variable annuities typically offer a guaranteed value at a point – possibly age 75 – which is reduced by any income taken or a guaranteed income as a percentage of a notional guaranteed fund. In either case, there is a notional guaranteed value and an actual value of the units held. The guaranteed value can rise if markets are good but will never fall while the actual value will rise and fall in the normal way.

The issue with these products in a falling market is that income taken reduces the actual value. As the value falls, the monthly income becomes an increasing proportion of that value and so erodes the fund more rapidly than when markets are high. This means the fund value takes longer to recover when markets go up again.

This is a normal feature of drawdown, where early falls always have a significant long-term effect, but it is exaggerated with variable annuities as the ongoing guarantee cost acts as a drag on recovery. Depending on the terms of the guarantee, significant early falls could mean that the fund never recovers sufficiently to increase the guarantees.

Again, this issue is not restricted to a single product – for example, it could apply to investment bonds with regular withdrawals and guarantees – nor does it invalidate the product. If markets rise early on and the guarantee increases, it can be very valuable if markets subsequently fall.

There is real demand for protected investments and we can expect to see continued growth, particularly in the post-retirement market. What we need to avoid is nasty surprises.

To misquote Sven Goran Eriksson from his final press conference as England manager: “If you are the adviser, you are responsible for the good times and the bad times.”

Ian Naismith is head of pensions market development at Scottish Widows

Recommended

Royal Liver set for multi-manager

Royal Liver will introduce a range of multi-manager investment funds in early 2008 as part of its modernisation strategy.

Prime numbers

Some lenders fear that the sub-prime crisis and the credit crunch may begin to have an impact on prime mortgages as well.

David Harrison

The founder of True Potential postponed retirement plans to set up a company which aims to deliver an electronic platform which IFAs can use to run their whole business. Interview by Gregor Watt

Newsletter

News and expert analysis straight to your inbox

Sign up

Comments

    Leave a comment