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Why protected plans look bad value

Investment | Protected

By Justin Modray, published 03 June 2010.
Helpful? 1

During these volatile markets you’d expect capital protected plans to be selling like hotcakes. Yet those on offer look distinctly unappealing and are unlikely to seduce many investors.

The plans that fully protect your money are struggling to offer potential returns of more than a few percent above cash, with the risk of delivering far less. While plans offering possible returns of up to 10% or more a year put your original investment at risk, so you may earn less or even lose money.

Of course, you never get something for nothing when it comes to investing. And protected capital plans are no exception.

The reason these plans are struggling to offer attractive terms at present is largely due to a combination of low interest rates and volatile markets.

In simple terms protected plans work something like this. You invest £100 in a 5 year capital protected plan. The manager takes, say, £80 and puts it in a fixed rate cash account to return £100 after five years – so they can return your initial investment if markets fall. Of the remaining £20, the manager pockets £5 - £10 to pay a sales commission and still leave them with a healthy profit. The balance is used to buy financial instruments, called derivatives, from an investment bank that provide some returns linked to a stockmarket index, e.g. the FTSE 100.

When interest rates are low the manager must keep more of your £100 in cash to ensure they can return it at maturity, whatever happens to markets, leaving less money to buy derivatives.

Derivatives also tend to be more expensive when markets are volatile, as there’s a greater chance they’ll have to payout. For example, suppose I buy a derivative that allows me to buy shares at 110p in a year’s time and the shares are currently priced at 100p. If markets are pretty flat the bank selling the derivative will probably take the view that it’s not that likely the share price will rise above 110p (meaning they’ll lose money). But if markets are up and down like a yo-yo then there’s a greater chance the share price could be higher than 110p after a year, so the bank will charge a higher price for the derivative to compensate for the extra risk of them losing money on the deal.

So with less money to buy derivatives and the derivatives themselves more expensive to buy, the protected plan manager can afford to buy less stockmarket exposure than in the past.

Despite this, plans that fully protect capital with a decent chance of returning just above cash do hold some appeal to higher rate taxpayers provided the returns are subject to capital gains tax and not income tax. If gains on maturity are within their annual capital gains tax allowance then it’s a reasonably safe way to enjoy tax-free returns. Trouble is, protected plans don’t generally mature for five to six years, by which time capital gains tax allowances could be a lot smaller than today – leaving the owner potentially facing a big tax bill.

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Readers' Comments (2) - To post a comment please register or login .

Comment by webwiz at 11:49am on 05 Jun 2010:

One extra risk that you don't mention is the key company in the complex instrument failing. Thousands of investors have lost money in plans which depended on Lehmans surviving.

Comment by justin at 12:13pm on 06 Jul 2010:

Thanks, good point. The financial strength of the bank/institution that provides the financial instruments underpinning the plan is v important. Always check this, although it's difficult as the large ratings agencies weren't exactly on the ball re: Lehmans.