The huge increase in guaranteed structured product sales in Ireland reflects a financial services industry that is letting the consumer down.
Guaranteed investment products sell in huge quantities but mostly investors simply gets what it says on the tin – their money back. After a painful decade for both equity and property investors the idea that you can invest in a risk-asset fund with the prospect of much higher than cash deposit returns and where the downside is limited via a guarantee has significant attractions for both the investor and advisor. But in perhaps four out of five occasions the upside proves illusory because most of the time markets range with an upward bias in the medium to long term, and the high costs within guaranteed products weigh too heavily on the normal returns available.
For the investor, a guaranteed product appears to offer equity-like returns without the risk while the advisor gets to sell a product offering good commission and with only minimal downside. A potential win-win if you like!
But the simple fact is that there is no free lunch in markets. Someone has to pay for the guarantee, the product manufacturing costs and the often considerable distribution costs. Without too much of a stretch, one can estimate the aggregate costs within a guaranteed product to be circa 3% per annum on average.
The trouble is that long term returns from the stock markets have been circa 9% per annum over the past 100 years. Less the 3% product costs leave circa 6% per annum as possible upside. And in the current lower inflation and potentially lower returns environment, market returns on a five-year view are most likely to be lower than the historical average of 9%. Against this backdrop, costs become an even bigger weight. The inevitable conclusion is that guaranteed investment products reward the seller, not the investor!
And there is a further hitch – because the guarantee must have a defined timeline these products normally have a limited lifespan of four to five years. If markets hit a poor patch during the lifetime of the product, the investor may miss those returns due to nothing more than bad luck.
A guarantee makes no sense for the investor who can save or invest regularly, which includes the ordinary saver and the person who is contributing to his/her pension fund each month or even annually. ‘Dollar (or Euro) Cost Averaging’ is the time honoured approach for dealing effectively with the volatility that is part and parcel of stock market investing – where you add to your investments in both good and bad market conditions.
Chart A & B highlight this very well. Investing $500 each month since 2000 into a simple global equity exchange traded fund (ETF) is today showing a positive return (even before the 2.5-3.0% annual dividend income is included) even though the global equity markets remain below the 2000 level. How was this possible? It is possible because one invests the same dollar (or Euro) amount when prices are lower and receives more shares than when prices are higher. This lowers the weighted average cost considerably.
A guarantee has more merit for the lump-sum investor who has no chance to average down and take advantage of lower prices. But the lump-sum investor also has a plausible alternative – an investor might instead consider putting 50% of his/her intended investment on cash deposit earning interest and the other 50% into a global equity exchange traded fund (ETF). If the world stock markets decline by, say, 20% over the same four to five year timeline (as the alternative guaranteed product) the investor’s equity investment will be down 20%. Overall, however, the investor is down only 10% in capital terms when you factor in that half the monies were on cash deposit. Indeed, the interest earned and dividends received will possibly eliminate the loss entirely over a 4-5 year period. And the investor will participate in 50% of any upside in equity markets as well as still owning the investment at the end of the period.
In other words, the guaranteed product serves no useful purpose most of the time other than to pander to investors’ fears. While many investors may not understand the alternative choices outlined here, the advisor should. Indeed, is that not the advisor’s primary purpose – to understand and advice on the most suitable and cost-effective course of action?
I would go further and argue that the banking and insurance industries in Ireland are not equipped to serve the consumer. They are product sellers. But the IFA industry, which should be the trusted independent source of financial and investment advice, has muddied the waters for itself by accepting payments from the product sellers rather than charging the customer. This has turned them, too, into sellers.
In many other service areas of the economy like accounting and tax, legal and medical services, the advisor and client sit on the same side of the table. Their goals are the same and the client can be sure that the accountant, solicitor or doctor has his/her best interest at heart. Can we say the same in financial services? It may be a harsh and unpopular view but my experience is that we cannot!
The UK Retail Distribution Review (RDR) undertaken by the FSA in that country concluded the same in 2009 following a three-year study. The result has been a ban on the upfront commission structure from 2013 onwards in the UK market, which will be a significant change, if carried through.
Critics argue that consumers do not want to pay for financial or investment advice and even if they did only the wealthy could afford to. Fair points – but they are not reasons for staying with a model ill-suited to serve the consumers’ needs. Solutions can and no doubt will be found to overcome likely hurdles in any new system.
In my view, the IFA market in Ireland has a huge opportunity to grasp change, indeed lead change. Truly independent financial and investment advice is what consumers want and the banks and insurance companies, or should I say product sellers, cannot and never will be able to provide it.
Enter the IFA – the market is there waiting for the right service offering. But fundamental changes are required – training needs to be upgraded, the message from the much larger UK market needs to be accepted and the upfront commission-driven model needs to be modified allowing trust to be rebuilt with the consumer. The day when consumers by-pass the banks and insurance companies in favour of the local IFA for financial and investment advice is within reach.
But the IFA industry and representative bodies must enable their members to become truly independent. With the UK having already grasped the nettle surely it is only a matter of time before the Central Bank in Ireland takes a similar course of action. Why not pre-empt the inevitable changes and grab the market from, and then dictate terms to, the product sellers. The consumer will respond well.
