It sounds like a no-brainer. You put money into the stock market and if it goes up in value you get a return or a regular income. On the other hand, if the stock market falls during the term of your investment – usually three or five years – with some provisos you get your original capital back. You win on the upside and don't lose on the downside: that's the theory behind guaranteed return products.
The government-backed National Savings and Investments issued its latest guaranteed return product last week, hoping to key into nervousness among investors over the prospects of future stock market returns. The NS&I Guaranteed equity bond offers returns linked to moves in the FTSE 100 index but with a 100 per cent capital return guaranteed. If the FTSE 100 goes up, they will see returns of up to 40 per cent over a five-year term, but if the FTSE rises by less than 40 per cent, then returns will be lower.
The big selling point of NS&I is that its 100 per cent capital back guarantee is backed by the Treasury. In theory, it should be 100 per cent safe, but this security comes at a cost, according to some independent financial advisers (IFA). "As with virtually all National Savings products, you pay a price for the extra security blanket of treasury backing. In this instance, the potential growth of the investment is limited compared to other guaranteed products," said IFA Jonathan Fry. The 40 per cent growth offered by NS&I is lower than a similar product from Barclays paying 43 per cent over five years, which also has a 100 per cent capital guarantee, he said.
How can providers offer this guarantee of returning capital to investors even if the underlying investment – in most cases the FTSE 100 or FTSE All Share indices – does badly? "The firm offering the product uses 60-70 per cent of the investment cash to buy a bond which pays 100 per cent of the original investment in, say, five years time," said Adrian Lowcock of Bestinvest. "The rest of the cash goes in charges and in buying derivatives linked to stock market growth which are meant to supply investment growth or a regular income."
Some guaranteed products pitched at the newly retired are designed to pay an income rather than a final lump sum return at the end of the investment term. "Plenty of these guaranteed products don't have much going for them but some return a good level of annual income while offering a capital-back guarantee," said Anna Sofat, a director of IFA Addida.
In particular, Ms Sofat likes Investec's guaranteed product paying an annual income of 6 per cent a year, as long as the FTSE doesn't fall by more than 50 per cent during the term. If it does, the capital is still guaranteed but the income stops. Another guaranteed product favoured by Ms Sofat is from Aria and pays 6.5 per cent a year with a capital guarantee of 80 per cent of the amount invested.
However, when it comes to the capital guarantees offered by financial institutions, many experts have their misgivings. "The guarantee is only as sound as the company which is offering it," said Mr Lowcock. "What happens is the bank or building society buys the guarantee from another financial institution, which becomes the counterparty. If the counterparty fails, then the guarantee is potentially worthless. Lehman Brothers used to be a big counterparty for these products and even AIG had a presence and look what happened to those institutions. Don't just look at which firm is selling it to you but also who is the counterparty." But it's not always clear who the counterparty is.
Charges are another bugbear. Initial charges of 2 per cent are not uncommon, and over the life of the product management fees can swallow up another 5-6 per cent. "Some of the charges in this sector can be quite high, while others equate to the sort of fees you would pay on a standard actively managed unit trust, if you consider that the investment runs for, say, five years," Mr Fry said.
But as far as Mr Lowcock is concerned, of greater concern is the lack of flexibility. "You buy these products for five years and you are tied in. If you cash them in before the maturity date you probably won't get the initial investment back," he said. In the case of NS&I's guaranteed equity bond, no withdrawals are allowed during the five year term, except upon death.
So with inflexibility, high charges and lack of transparency, are guaranteed products another potential mis-selling scandal? The warning signs, it seems, are there.
"The difficulty is that in the current economic climate many investors don't want to know about straightforward investment in the stock market. Therefore, either cash savings or these guaranteed products are being recommended," Ms Sofat said.
And as with mis-selling scandals of the past, commission payment to financial advisers may be playing their role. "These products can pay high commissions and are often built quickly to take advantage of fluctuations in investor sentiment," said Mr Fry. "I'm also concerned that they are being sold by bank and building society sales staff to relatively unsophisticated investors. It is difficult for people to truly understand these products, how they work, what they offer and how firm the guarantees on offer actually are."
"There is a place for these products but I don't think they should be mass market," added Mr Lowcock. "After all, if the stock market performs well, you only get a fraction of those returns so you could be giving up a lot on the upside."
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