Guaranteed No Loss? Not Exactly

By Bob Moeller
WEAC Member Benefits

March 2005

Financial Planning Seminars
Achieving Financial Independence

Among the fastest-growing investment products today are the “guaranteed no loss” investments connected to some stock index. I’ve gotten dozens of e-mails asking about them. I generally advise people to avoid them.

There are so many variations on these products that it is difficult to make a specific analysis that will apply to most of them, but there is no question that the guarantee you will not lose money costs you a substantial amount. There are commissions, fees, and typically huge withdrawal penalties if you pull your money out early. But, you say, you intend to leave it in for the whole term, and there is, after all, a guarantee you will not lose money (although sometimes your guarantee is for the amount you invested less any commissions) and you might gain if the market goes up.

Let’s look at one example. This is a brokerage product offered by the Banc of America through its recently purchased brokerage house, Quick & Reilly (now called Banc of America Investment Services, Inc.) It is called “Minimum Return Equity Appreciation Growth LinkEd Securities” or Index EAGLES. Here’s the deal:

1. You invest your money for five years. Unlike an insurance company product, you can only back out by selling your product on the open market and no organized market is expected to exist, although the shares will be listed on the American Exchange. You are warned that you may lose money if you sell early.
   
   
2. You are guaranteed that at the end of five years you will get back at least all your money plus 5%. Not 5% per year, 5% total for the five years.
   
   
3. Your final value will either be #2 above, or the growth in the Russell 2000 Index as calculated on a quarterly basis. It is important to note that you do not get the amount of growth in the index over five years, but the result of 20 different quarterly calculations.
   
   
4. Each quarter, your investment may go up a maximum of 8% (if the index goes up that much or more) or go down whatever the index goes down. There is no limit to your downward movement. (Note: the 8% was uncertain when I got the prospectus; it may have been changed to 9%. Since all the examples used 8%, I will use 8%.).
   
   Now let’s look at how this wonderful-sounding deal can be very so-so in the real world. Let’s start with the index at 1000 just as an example. You invest $1,000.
   
   • First quarter it goes up 10% to 1100. Your increase is limited to 8%, so you have $1,080.
   • Next quarter it goes down 20% to 880. You get the whole down 20% to $864.
   • Next quarter it goes up 17% to 1030. You only get 8% to $933.
   • Next quarter it goes up 7% to 1102. Your value goes up 7% to $998.

You are exactly where you started.

The same type of up and down pattern for the next four years could put the index up 50+% and you would get nothing but your 1% per year guarantee.

Can you make out well? Sure, if the market acts in your favor. But there is a good likelihood that you will not make out nearly as well as the illustrations show. That no-loss guarantee costs you a lot, count on it.

The key question is: “Since my upside is limited, is the downside limited in terms of my final value before giving me my no-loss guarantee?”

Now, for the longer term 10-year type insurance company index annuities with their high fees and penalties, there are some other things you should remember:

1. The stock market, as commonly measured in indexes like the S&P 500 or the Dow Jones Industrial Average, has never had a 10-year period in which it ended lower than it started. At least not in the last 60 years. Putting it another way, you can pick any day you want between 1940 and 1994, and invest some money in the Dow Jones Average, and 10 years later you would have gotten back more than you put in. Why pay a heavy price to guarantee you will not lose money over 10 years?
   
   
2. Technically, you can create your own guaranteed no-loss deal just by buying 10-year Zero Coupon Government Bonds which will mature at the amount of your total investment in 10 years, and investing the difference in the stock market. Example: Today a 10-year Zero Coupon $10,000 bond costs about $6,750. Buying these guarantees you $10,000 at maturity in 10 years. You have $3,250 left to invest in a stock index. You cannot lose money and you have a much better chance of gaining, in my opinion.

Posted March 1, 2005