Brandon Horwitz considers why products with long term guarantees still have a role, and how the Long Term Product Guarantees Working Party intends to explore this further
Like many actuaries, I’ve always prided myself on how terribly smart I am, especially when it comes to understanding investments. So, I’ve always turned my nose up at products offering guarantees, thinking to myself that surely anyone can see they’re essentially the same as splitting your portfolio into cash and low-risk bonds plus risky assets, right?
To be fair, these products typically offer some sort of option payoff which isn’t that easy for the lay investor to replicate. But then the sceptic in me chimes in, saying that some of these products are sure to be poor value for money, over-complex or unnecessarily opaque. Who in their right mind would want to buy (or sell) these things?
Here to stay
Products with guarantees have been, and remain, very popular with customers and advisers across the world. Ask the average customer what they want from an investment, and it will be something that gives them a better rate than the bank, but not too much (or preferably any) risk.
Are they all daft? Surely they should all know some basic option-pricing theory and be able to assess the value of these products with just a few inputs, such as the LIBOR rate and the volatility of the underlying assets? They may well be rusty on the old Black-Scholes, but what about the old adage of: ‘if it sounds too good to be true, it probably is’? Surely the average customer would think about that?
If I think I know better than customers and the advisers who serve them, I would be 100% wrong. They love these products. Why? What am I missing?
It’s not about financial value
Like many (terribly smart) actuaries, I’m missing the obvious. It’s not about the technical financial value of the product, but the emotional benefits of the product. And strangely, this emotional benefit can result in a financial benefit too, as I was to learn one day.
A genuinely smart (and patient) financial adviser explained this to me in about 2014. He introduced me to a typical client who he serves – let’s call her Mrs Miggins. She is a lady of a certain age (probably 50s or 60s) and has worked hard for her savings (of, say, £200,000 to £300,000). She is dead set against taking risk, so she’s sat with it in an instant access cash account (not even an ISA) for the past five to 10 years. Many people have tried to explain to her that she’s eroding the real value of her savings, but she’s afraid of losing money.
My smart (and once again, patient) financial adviser enters the frame and builds a rapport with Mrs Miggins, eventually ascertaining that she is financially very comfortable and could take some risk – in the parlance of the world of professional financial planners, she has capacity for some loss.
She starts to open up to the adviser, explaining that she’s no fool and understands she needs to take some risk to get a better return, but couldn’t sleep at night if she were to put it all in investments. The adviser gently suggests a safety blanket of 10% of the portfolio in a capital protected product, where she will get at least her money back in five years’ time. After some thought, she agrees that this will make her feel much more comfortable, and invests the remaining 90% in a medium-risk portfolio where she has some chance of growth to beat inflation. Et voila!
This is where the human angle, which us actuaries may miss, comes in. While we might have argued that Mrs M should have invested 100% of her pot to maximise her return, and that 90% is sub-optimal, it is in fact a brilliant outcome. This is because she was 100% in cash before, effectively losing money in real terms.
This is just one example of how products with guarantees can help to achieve better outcomes for customers. So, surely, we should see them flying off the shelves?
What’s holding these products back?
Numerous headwinds have risen up in years past to blow these products off course, including:
- Reputational challenges: Past mis-selling scandals involving guaranteed products (including with-profits products), as well as examples of product provider failure (eg Equitable Life, Lehman Brothers)
- Changes to distribution/advice: The Retail Distribution Review in the UK, and similar initiatives in Europe, have changed the dynamics of advice, with more focus on wealthier customers (typically with higher risk appetites). This leaves an ‘advice gap’ when it comes to customers with more modest wealth and lower risk appetites
- Product regulation: Regulators have raised the bar on how providers should develop and manage guaranteed products, with increased transparency and explicit requirements to consider value for money
- Economic conditions: Ultra-low interest rates/bond yields and relatively limited market volatility in recent years (before the COVID-19 market impacts of Q1 2020) have resulted in less attractive terms being available for these products.
- Capital requirements: These are more demanding for these products than for pure investment unit-linked products, making insurers wary of providing them.
What about pension freedoms?
Now, even if we could address the issues above, surely guaranteed products are dinosaur products from the halcyon days when people needed protection from market and mortality risk? We’re now in the heady days of pension freedoms, when you no longer have to annuitise and can buy Lamborghinis with your pension pot (admittedly only little plastic ones for many of us, but it’s the principle!).
However, humans haven’t changed all that much, and many folk need and want guarantees – especially those with more modest pensions and savings, who may need to use them to live on, rather than just passing them on to the next generation. There is arguably more need than ever for simple and effective products to promote long term savings and to help protect consumers’ money.
What can we do about it?
We have established an IFoA Working Party focused on long term product guarantees to help explore the following key questions:
- Do long term insurance guarantees have a future in the UK?
- What could be done to make them more affordable and attractive?
Out work is closely aligned with the goals of the IFoA’s flagship Great Risk Transfer initiative. Guaranteed products evolved to address a societal need to pool and manage risk, helping to protect consumers from market and longevity risk in particular. We believe that some of these risks could be best managed by financial service providers, and will explore potential policy solutions that could help promote this.
We plan to consider key issues such as:
- Can guaranteed products be simplified to ensure that the customer understands the features/risks?
- Is there consumer confidence/a market for these products following Equitable Life and mis-selling of endowment mortgages and structured products?
- How viable are these products in a low-interest environment?
- What new products and features could be developed to meet any need?
- Are there any limitations, imposed by current capital requirements, that would need to be overcome?
What happens next?
We plan to produce a number of publications that will be used to engage with product providers, industry organisations, consumer organisations and regulators. Our goal is to produce analysis and recommendations that can be used to help move the debate forward on this theme.
Watch this space for more information and visit our IFoA working party website (bit.ly/2VULxsf) for updates, including opportunities to join informal local sessions to engage with us.
Brandon Horwitz is the chair of the IFoA Long Term Product Guarantees Working Party. He is an independent consultant and non-executive director.
Picture Credit | iStock
