Safe Investment? - Is Anything Guaranteed?
A Fleet Street Letter Special Report
By Rob Mackrill
The word ‘guarantee’ has taken a battering in recent years at the hands of the financial sector. It’s so emotive there should be a restraining order on its use as an adjective within a country mile of any scheme dreamt up by the investment industry. Experience shows the two are as compatible as the proverbial chalk and cheese.
What is an investment? At its core, it is the choice of deferred gratification over instant. Part calculation, part faith – though not always in equal measure – it requires an effort to assess future risk and reward and grow capital rather than spend it. The risk/reward is the tricky bit as it involves looking into the future. So when a financial product splashes the word ‘guarantee’ about, it implies that the essential weighing part of the decision is redundant. It gulls the unwary that the future will hold no surprises. The future often disagrees. A couple of months ago, Goldman Sachs were talking about 25 sigma events in the financial markets in August. In plain
speak, that means 25 standard deviations from the average.Plainer still, it means ‘very, very rare’. Statistically speaking, a bank run, the like of which we witnessed with Northern Rock, would be in the same ballpark.
Safe investment: A copper-bottomed promise?
So what happens when a promoter takes an investment and makes a copper-bottomed promise about it – a guarantee? Well, old style company pension schemes are a classic example of how such a bold gesture can end in tears.
Traditional company schemes – i.e. final salary or defined benefit schemes – were the backbone of private sector provision and often said to have been the envy of the world. Created in the days when jobs were for life and retirees didn’t last much beyond their productive sell-by dates, they promised loyal corporate employees a pension linked to salary and years of service. So ingrained was the faith in the reliability of these schemes, it was propagated at the highest level. Both the Department of Social Security and the FSA put out leaflets assuring workers that the benefits from such pension schemes were safe, indeed ‘guaranteed’. An official endorsement. Scary. What few propagators acknowledged or understood was the promise was only as strong as the company that sponsored it.
This inconvenient fact became all too clear when Allied Steel &Wire (ASW), a Cardiff-based steel company, went bust in 2002. More than 800 workers lost both job and pension and fought all the way to the European Court of Justice for compensation. ASW was not an isolated example, either. In all, there are some 125,000 people out of pocket from more than 400 collapsed company pension schemes, according to the Pensions Action Group.
Another ‘guarantee’ created by the pensions world was the retirement promise that applied to individual pension policies – called a ‘guaranteed’ annuity. After long years of saving for retirement, the promise was that, upon retirement, policyholders were guaranteed a rate of interest (i.e. annuity rate) on their pension pot. These promises were made years ago, at a time when the economy looked very different, and UK interest rates were in double digits. In the intervening years interest rates fell – making them a progressively more expensive promise for providers to keep. In the Autumn of 1989 the bank base rate was 15%, as opposed to 5.75% today. The difference in purchasing power is sizeable. A notional £100,000 pension fund might buy £10,000-15,000 a year in income under the ‘guaranteed’ options, as opposed to £6,000-7,000 a year now.
It was these promises turning toxic that eventually did for one company that had been kicking around since 1762, Equitable Life. It started selling pension policies with guaranteed annuity rate (GAR) promises in the 1950s. As interest rates fell, they found themselves committed to shelling out elevated payments they simply couldn’t afford. Eventually, to protect the business, they tried to welch on the 90,000 policyholders to which the promise applied. This tactic eventually brought the business down. In 2001 a legal challenge succeeded in the House of Lords. In the end some 800,000 policyholders lost money. Some guarantee that proved to be.
Safe investment: Guaranteed income, not guaranteed equity
A further example of a guarantee that went awry is a type of insurance bond that became dubbed ‘precipice’ bonds. This packaged investment product promised very high levels of often ‘guaranteed’ income over a fixed term, typically four to five years. So far, so straightforward. The thing was, underneath this attractive veneer was a complex financial structure which came with a lot of small print.
Said small print related to complicated derivatives linked to stock market indices. Buried within it was news that if stock market conditions went sour, money could be lost. Many buyers, or even those who advised them, didn’t realise this. Either that or, driven by commission incentives, the advisors chose to ignore this unfortunate detail. Lloyds TSB was fined £1.9m by the FSA over the mis-selling of such precipice bonds. Similarly, Bradford and Bingley was fined £650,000. There were others, too.
The severe and prolonged bear market of 2000-03 saw the FTSE 100 slump from 6,900 to near 3,200 at its low point in March 2003. As a consequence, investors in that period found that while income was indeed ‘guaranteed’, their capital was not. Often, the better part of it was utterly lost. It proved a high price to pay for a ‘guaranteed’ income.
Safe investment: Quasi-guarantees and the low-risk fallacy
Another financial product to go down in flames at that time were split capital investment trusts. It stretches the point to say these complicated funds (replete with two or more classes of shareholder) advertised a guarantee – but the leading player, Aberdeen Asset Management, came close. Its sales literature claimed their fund returns provided ‘certainty’ for ‘risk averse investors’ with ‘quasi-guaranteed returns’. So called ‘Zeroes’ – a class of share promising a fixed return at a future date – were deemed ‘low risk’. They were thought appropriate for those needing to call on a sum of money at a given date in the future, such as those saving for school fees or retirement. But when the market tide went out, these funds were found to have considerable borrowings and a cosy arrangement between them – dubbed the ‘magic circle’ – to buy into each other’s funds. The subsequent bear market was presumably another multi-sigma market event that rode a coach and horses through this ‘quasi-guarantee’, and made a mockery of their ‘low risk’ categorisation.
So where does this brief rifle through the annals of British personal finance mishap get us? Nowhere conclusive, save for the obvious point that when the word ‘guarantee’ is used by investment promoters and aligned with the time value of money, unfortunate things result. With such a variety of unpleasant experience behind us, it is clear that the word should be banned altogether for any purpose involving investment. Risk is an unavoidable aspect of investment and all too frequently springs unwelcome surprises.
The future holds no guarantees – get used to it.
Rob Mackrill is a former IFA now advising the Zurich Club on investment and personal finance. He is also the Editor of The Daily Reckoning.
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First published on November 24th 2007
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