In the current low interest rate environment, many people, not least the ever-increasing number who are retired, are looking for ways in which to generate a ‘meaningful’ level of income. While the high-street banks and building societies offer what at first glance are attractive rates, quite often these rates are only available for a limited time, generally six months.
As a result of this situation, there still remains a large void for those want a good level of income over the longer term, and this is where structured products can assist by offering sustained and higher levels of income than those available on the high street. In addition to offering a greater level of income over a longer period, some structured products also offer the ability for income to be generated in a more tax-efficient manner.
In most cases, the structure will guarantee the income throughout the term, typically five years, with the capital return being linked to the performance of an investment index, which is typically the FTSE 100, but not always. The level of income varies depending on the level of protection and the volatility of the indices to which the plan is linked.
While most advisers prefer the use of only one index, it is worth noting returns can sometimes be increased quite significantly by utilising two indices that have historically performed in parallel, such as the FTSE and S&P 500. If, however, the indices involved do not perform in tandem, then the risk to capital of using two indices can increase significantly.
While growth products generally offer either capital protection or downside protection, it is generally only the latter that are available for income products, with the level of downside protection normally being somewhere between 25-50 per cent. It is, therefore, the level of protection and/or the volatility of underlying indices that affect the risk to investors’ capital. One final issue that can affect the capital risk and the returns is the strength of the underlying issuing bank – the counterparty risk. Consequently, income payments on plans underwritten by stronger counterparties is generally lower, reflecting the greater security provided.
The last component affecting the level of income is the frequency of payments. Generally, there is a choice of annual or monthly income where the annualised version provides a slightly higher rate due to the lower administration involved in the payment process.
This just about covers the key issues relating to income products, but there are some issues advisers and their clients should consider before investing. The most obvious is that the capital is tied up for some time, typically five years. Nevertheless, the need to tie-up capital for a period of time in many cases will suit a number of investors. For example:
- Pension planningWhether advising an individual Sipp or a company, structured products have the potential to offer the investor a near perfect investment solution. Unlike an individual investor, the trustees of a pension fund are able to invest for a finite period without any need to draw on the money, and, therefore, funds can be designed for a fixed period to each fund’s specific needs, especially to provide income for clients in drawdown.
For more general pension planning, a variety of plans can provide an excellent core investment to a portfolio, safeguarding against – or providing a return in – flat, volatile or bear markets, as well as enabling the investor to reap the benefits of a bull market, whatever the asset class.
- School and university feesStructured products can provide secure investments that are able to be established in a tax-efficient manner, allowing parents and grandparents to invest capital sums initially for capital growth and later to provide income/capital drawdown to pay the fees.
- Long-term careUnlike many of the alternatives, structured products can provide a high level of income for a known period, with the capital being returned in full depending on market conditions. Most other solutions to funding of this nature either require the erosion of capital as fees are paid or the loss of capital, although the income is secured. However, structured products can, in the right market conditions, provide a balance between the two and may have uses when looking to fund long-term care.
In conclusion, the dramatic increase in recent years in the variety of structured products and alternative asset classes means the tools are now available to allow clients to match their risk-reward profiles almost exactly. The consistent growth in the demand for structured products both in the UK and particularly in Europe suggest this market will continue to grow for the foreseeable future – which is no surprise given the advantages they offer investors.
Graham Devile is managing director at Meteor Asset Management
Originally published in FT Adviser on October 12, 2009