guarantees: real and perceived Editor: Personal Finance

Transcription

1 guarantees: real and perceived Bruce Cameron Editor: Personal Finance

2 guarantees are a safety net Investment t guarantees aim to protect t you against the loss of your savings (capital), namely down-side risk, while maintaining exposure to capped or uncapped upside performance, some or all of which may also be guaranteed

3 but be warned: guarantees are seldom what they are perceived to be Jack Milne guaranteed out-performance of all unit trust funds Tigon backed the guarantee with R100m investors lost R250m Milne went to prison for a year Fedsure guaranteed capital and returns company imploded industrial retirement funds lost 12% of value (R600m)

4 you need to assess the guarantee who or what provides the guarantee the good standing of the guarantor the balance sheet of the guarantor the transparency of the guarantor rating of a credit rating agency (investment grade or not) The regulatory environment of the guarantor the cost of the guarantee what is actually guaranteed do you need the guarantee

5 who offers guarantees banks (term deposits) life assurance companies governments, utilities, companies (bond markets) the dubious (property syndications, unlisted companies) the crooked (pyramid schemes, foreign entities, unlisted companies)

6 beware of implied guarantees unit trust t funds targeted absolute return/real income unit trust funds against an index against a cash benchmark (Jibar) against inflation (CPI) money market funds dynamic floor funds (protect against downside loss)

7 beware of implied guarantees Regulation 28 of Pension Funds Act: aimed at reducing risk to retirement savings but does not provide a guarantee limits asset classes JSE-listed shares - 75% %(with no more than 10% in a company with a market cap of less than R2 billion) unlisted shares - 5% bonds - 100% immovable property - 25% note: no automatic guarantee on retirement savings, note: no automatic guarantee on retirement savings, including prudential flexible unit trust funds

8 beware implied guarantees capital adequacy requirements: apply to life assurance companies and banks stipulate how much money must be held to back deposits or investments taken from the public the higher the risk of the investment (asset), the higher the requirement give comfort - you will get your money back, but are not an absolute guarantee (e.g. Saambou, Fedsure) note: no guarantee on money market funds/accounts

9 different guarantees full, or partial, or variable guarantees are available as: capital guarantees income guarantees capital and income guarantees

10 products banks term deposits structured products life assurance capital guaranteed (traditional products) structured products income annuities (voluntary and compulsory)

11 guarantee order part 1: traditional life assurance guaranteed capital growth product part 2: life assurance guaranteed income products part 3: structured products

12 part 1: traditional life assurance understand d when you invest your money in a guaranteed life assurance product you have no say in the investment. You are promised a direct or indirect linked return on an investment or a predetermined benefit on an event (death occurring) when you invest in a collective investment, the assets remain yours. that is why a life assurance company can offer guarantees

13 life assurance policy guaranteed investment t products features 1: guarantees on endowment and sinking fund policies, retirement annuities capital fully or partially guaranteed returns may be fully or partially guaranteed returns may be smoothed (with-profit products) may be investment t choice, but limited to risk-adjusted portfolios (from cash to high equity)

14 life assurance policy guaranteed products features 2: guarantees only apply if held for full term, namely: maturity (minimum five years) death (if a life assurance, but not a sinking fund policy) retirement (if part of a taxincentivised retirement product)

15 life assurance policy guaranteed products guarantees may have pre-determined anniversary lock-ins warning on costs: the greater the guarantee, the greater the cost the greater the investment risk, the greater the cost or the lower the guarantee

16 smooth/stable with-profit life assurance investment products features 1: investment growth returns declared as fully vesting bonuses; or vesting and non-vesting bonuses note: non-vesting bonuses accumulate, reducing your capital guarantee, but the guarantee fee remains the same example: capital + vesting bonuses = R1million. total non-vesting bonuses = R actual guarantee = 60%

17 smooth/stable bonus with-profit life assurance investment products features 2: smoothing returns are smoothed in good years part of returns are held back for bad years bonus stabilisation reserves when negative you get less for your new investment rand bonuses will lag recovering markets when positive you do not get more at maturity

18 smooth/stable with-profit life assurance investment products features 3: capital adequacy requirements requirement determined by type of asset held. e.g. equities require higher reserve levels than cash temptation to reduce risk of asset mix to lower requirements this can impact on your returns as lower risk = lower returns

19 smooth/stable with-profit life assurance investment products features 4: contractual t obligations If you reduce or stop paying premiums or withdraw your money you will face an early withdrawal penalty (max 30 percent for contracts dated prior to January 1, max 15 percent after January 1) market level adjusters when bonus reserve account is negative (market value of underlying assets = 90% of guaranteed value you lose 10%)

20 when to use and not to use life assurance guaranteed products when you may need to protect t accumulated savings/capital before conversion (e.g. at retirement) but unlikely if already in a life stage product phase in over five years but not more than 10 years before retirement consider both with-profit and cash portfolios avoid with-profit smooth bonus if negative bonus reserves (market value lower than fund value but okay if new series with no discount) consider cash portfolios for pre-retirement protection or resignation with no immediate new job prospects

21 part 2: guaranteed income (annuity) products compulsory purchase annuities bought with pension fund benefits capital and growth taxed when drawn as income voluntary purchase annuities bought with discretionary savings (including provident funds) no tax on withdrawals from capital guarantee on income and capital; or guarantee of income only fully guaranteed or a hybrid (with profit annuities)

22 features of guaranteed income annuity products (1) no switching once purchased you are locked in for life (compulsory) or term (voluntary) cost of annuity increases for: additional lives (joint and survivorship) increasing income (e.g. Inflation-linked) guarantees on term (e.g. 10 years and for life) guaranteed pension determined by: age long-term interest rates gender

23 features of guaranteed income annuity products (2) a problem: seldom individual risk rating (enhanced annuities) the healthy and wealthy are subsidised by the poor and unhealthy so if unhealthy be cautious

24 what to consider compulsory annuity guaranteed versus investment linked living annuity. take account of: age health gender yield voluntary annuity cost of guarantee What is guaranteed liquidity yield Heard about inflation-linked RSA retail bonds?

25 compulsory annuity examples compulsory purchase level annuity costing R , payable monthly in arrears, guaranteed for 10 years and then for life Male Age 55 Age 60 Age 65 Age 70 Age 75 Momentum R R R R R Metropolitan R R R R R Old Mutual R R R R R Liberty Life R R R R R Sanlam R R R R R Female Age 55 Age 60 Age 65 Age 70 Age 75 Momentum R R R R R Metropolitan R R R R R Old Mutual R R R R R Liberty Life R R R R R Source: Retire Right by Bruce Cameron March 2008

26 guaranteed annuities: what to consider level l annuity: purchase amount: R1 million Purchase date: May 11, 2009 guarantee term: 10 years Male Age 55 Age 60 Age 65 Age 70 Age 75 Age 80 Monthly Annuity R8 336 R8 715 R9 234 R9 827 R R Annual Yield 10% 10.5% 11.1% 11.8% 12.6% 13.3% Female Age 55 Age 60 Age 65 Age 70 Age 75 Age 80 Monthly Annuity R7 861 R8 194 R8 619 R9 147 R9 793 R Annual Yield 9.4% 9.8% 10.3% 11% 11.8% 12.7% source: Old Mutual

27 features of with-profit annuities (1) initial iti annuity guaranteed for life increases granted are guaranteed for life pension increases dependent on: underlying investment returns initial purchase discount rate (The higher the discount rate, the lower the increase E.g. Portfolio return 10% - Discount rate 4% = 6% increase)

28 part 3: structured products structuring t refers to a wide-range of engineered financial products whose payments are linked to or based on the performance of a wide range of assets including: single stocks or indices of one or more markets or market sectors interest rates currencies commodity prices

29 structured products features: use full range of asset classes including derivatives provide full, partial or no (but sometimes implied) capital guarantees provide full, or partial guarantees on a predetermined or actual performance of a benchmark or asset provide full or partial income based on a predetermined benchmark allow for investment products and strategies not normally available to ordinary investors

30 structured products structured products include: absolute returns funds (target predetermined, above-inflation returns over rolling periods) dynamic floor funds (aimed at limiting iti the effects of market downturns) hedge funds capital-guaranteed, indexed-linked products

31 e.g. ABSA Index Performa Plus - issue 3 features underlying index minimum opening deposit R FTSE/JSE Top 40 Index subscription period 4 May June 2009 early investment interest rate start date 29 June 2009 maturity date 6 July 2012 investment term interest (7.50% but variable, linked to prime) until 28 June 2009 three years participation rate 100% capital protection initial index level 100% on the maturity date only the level on the Index at close of business on Start Date, being 29 June 2009

32 e.g. ABSA Index Performa Plus - issue 3 final index level maximum potential return 52.5% minimum potential return 0% average index close of last 6 months. Seven observations on: , , , , , , investment growth final maturity amount early redemption charges investment growth = participation x (final index level initial index level) / initial index level. If investment growth is greater than 52.5%, then investment growth will equal 52.5%. If investment growth is less than 0%, then investment growth will be equal to 0% final maturity amount = participation Rate x (initial investment + early investment interest) x (capital guarantee + investment growth) not allowed prior to the maturity date all fees priced into the product and commissions and administrative fees will not exceed 1.5% of the initial investment. These fees will not affect your minimum potential return or the capital guarantee.

33 structured product illustration

34 guaranteed structured products main considerations of guaranteed structure products include: the legal wrapper the guarantees the guarantors the targeted asset or benchmark what is guaranteed returns versus risk liquidity returns versus costs transparency tax

35 guaranteed structured products the legal l wrapper (1): insurance policy wrappers (normally a sinking fund). May be: a linked policy: no guarantees provided by the life assurance company a non-linked policy: the life company provides explicit guarantee if underlying asset is held by, say a bank, and the bank defaults

36 guaranteed structured products legal l wrapper (2) direct contract with an investment bank: known as an over-the-counter (OTC contract) listed structured notes: Similar to an OTC contract but listed on an exchange having a daily price and making it easier to trade

37 guaranteed structured products the guarantees capital fully or partially guaranteed capital guarantees normally provided by a prime broker (a bank) bank invests in bond market and bond market derivative instruments to provide guarantee returns partially or fully guaranteed returns normally track a benchmark or index but are unlikely to be directly invested in the asset class

38 guaranteed structured products returns may be: capped at a percentage of the benchmark (e.g. 80 percent of an index the participation rate) geared to a multiple of the benchmark (e.g. 120 percent of an index the participation rate) returns may be locked in a different stages (e.g. On reaching a predetermined level after a predetermined d time) use of derivatives to provide returns allows use of derivatives to provide returns allows for gearing/leverage (borrowing money to multiply returns)

39 guaranteed structured products the guarantors questions to ask: who provides the guarantee and for what what is the credit rating of the guarantor warning: credit ratings have been shown to be questionable. Lehman Brothers had an investment grade rating

40 guaranteed structured products targeted t asset or benchmark can give you access to different asset classes from commodities to private equity but use the same investment rationales as you would with any other investment.

41 guaranteed structured products for example: diversification: is the index/benchmark/asset diversified in its own right and/or within your portfolio market correlation: does the selected benchmark/asset moving against or in tandem with other assets market movement: what is your view on the benchmark risk of benchmark/asset class: measured by volatility

42 guaranteed structured products returns vs. risk all guaranteed structured products play off: risk against returns (more risk more potential return) risk against guarantee (more risk the lower the guarantee) guarantee against returns (the higher the guarantee the lower the point of return capping and vice versa)

43 guaranteed structured products you need to ensure: the participation rate you sacrifice does not cancel out the risk of direct investment the guaranteed participation p rate will not be lower than the inflation rate

44 guaranteed structured products liquidityidit not as liquid as direct asset ownership (shares, unit trust funds) with life wrapper minimum investment period is five years non-life products available for one year and 30 days notice note: You need to be sure when you need your note: You need to be sure when you need your money

45 guaranteed structured products costs: a problem not fully transparent can be fully embedded (not disclosed) banks do not disclose profits made price can be included in performance caps cost can be layered: Legal wrapper, asset management adviser fees

46 guaranteed structured products transparency are currency fluctuations on growth and capital are dividends excluded is there an averaging of returns volatility of a basket of assets jargon: cliquet

47 guaranteed structured products tax there is no clarity on income tax capital gains are taxable

48 who might need guarantees cautious investors who want to avoid cash (inflation risk) but want safety moderate investors who are prepared to accept limited risk to their capital but want moderate to aggressive (geared) returns

49 who might need guarantees people approaching retirement t who want to protect their savings but not limit it their growth (inflation fear) investors who want to limit tax exposure investors who want exposure to a wider range of assets

50 make sure it is a safety net

51 thank you questions?