Investment: There are no free lunches
Wednesday 03 November 1999
It is a moot point whether it is the consumer or the provider who is most to blame for a state of affairs in which it seems basically simple products have to be dressed up in fancy or beguilingly deceptive wrappers for people to want them.
Take the endowment mortgage. Strip it down into its component parts and what have you got? The answer is: a simple interest-only loan, a bit of bog-standard life insurance and a regular savings scheme managed on your behalf in a relatively tax-efficient format.
In the days before Peps and Isas this was a perfectly sensible and indeed desirable piece of product innovation. As a home buyer, there were good reasons, principally convenience, for going to one provider to get rid of the hassle of having to do all the work yourself.
But how did we go from that simple first step to a world in which a potentially valuable piece of innovation was turned into today's potential mis-selling scandal - a world of excessive commissions, over-expensive loans and absurdly restrictive redemption clauses?
The truth is that most intelligent people can today easily create their own low-cost endowment mortgage without having to pay a fortune to mortgage lenders, insurance companies or intermediaries. The term assurance, the loan and the tax-efficient savings scheme can all be bought individually, and if you shop around, the result should be rewarding. Compounded over 25 years, the chances are the savings alone will enable you to buy a second property by the time you are halfway through.
Despite this, the financial services market remains a highly fragmented one in which providers fall over themselves to sell you things on the basis of inducements that sound tempting, but often turn out to be of little real value. This remains a business in which things are sold, not bought.
The three most necessary elements of any self-respecting financial product these days are: (1) it must have tax advantages in some form; (2) it must offer you a "guarantee" of some kind; and, (3) it must offer some "jam today" inducement (a cashback offer, a commission rebate, an above-average interest rate and so on). But what are these benefits actually worth? Often little or nothing.
You can occasionally find a genuine bargain, say, when a company is trying to build or maintain market share in a competitive environment and is prepared to run up losses to do so (as Prudential is doing with its Egg savings accounts). But, in general, what you get is paid for in some other way.
Higher interest is almost invariably paid for with higher risk or capital erosion. Cashbacks are paid for in the price of your mortgage and the lock-ins that often go with them. And so it goes on. The bottom line is the one given in the finance textbooks - there rarely is any such thing as a free lunch. This means the consumer needs to be extremely vigilant when a tempting new offer comes along.
Most financial product literature has to steer a narrow path between meeting the demands of the regulators, and appealing to the consumer's financial G spots" (tax benefits, guarantees, cash today) on the other. I continue to marvel at the ingenuity with which financial service companies are able to continue dressing up mutton as lamb
I have a leaflet extolling the merits of a fairly standard insurance company investment bond. The headline is: "A with-profit investment guaranteeing a minimum bonus up to 9.5% in year one? with a `regular income' option". There is also a reassuring picture of a managerial figure with glasses, white shirt and tie.
Inside you learn that the IFA will add between 3 per cent and 4 per cent from his own commission as an extra inducement if you buy the bond through him; and standard rate taxpayer will not be liable to income or capital gains tax on returns the bond provides. This product therefore scores reasonably well on my three criteria: tax benefits, a "guarantee" and an upfront inducement.
But the small print tells a less appealing story. It turns out the minimum guaranteed bonus in year one is 9.5 per cent only if you invest more than pounds 100,000; it falls in tiers to 6 per cent if you invest the minimum of pounds 3,000. As this is a bond linked to a with-profits fund, there are no guarantees about annual bonuses, let alone the final bonus, which will account for at least a third of the bond's final return. There are also extra charges if you try to cash in the bond before five years.
There is also a catch-all Market Value Adjustment clause (common in these investments) which says all bets are off if the market takes a really serious tumble and the with-profits fund starts to shrink.
As with all investment bonds of this type, the fact that income and capital are paid tax-free has to be set against the fact that the insurance company's fund has to pay tax before it makes returns to investors.
Finally, while the bond allows you to take 7.5 per cent of its value out each year under the regular income option, this income is rightly always referred to as "income" in inverted commas since this will actually be capital being repaid early.
On this page I show what I calculate the actual returns will be, assuming a 6 per cent growth rate (this is after tax has been paid by the insurance company, so equates to around 7.5 per cent pre tax).
This type of investment bonds has been popular. But is this particular bond the best of its class? I am far from clear about that (the insurance company's investment track record is mediocre, if you check it out). Are there reasonable alternatives? Yes - though few that offer as much commission to the adviser (pounds 600 in this case for a ?10,000 investment).
And do those who take out these policies believe they are being offered more than they are actually getting for their money? To that, all I can say is: "Do you eat sausages?"
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