Would you spend €28,000 over the next six years for an expected payback of €21,000? Stupid question. Yet hundreds of well-heeled individuals are queuing up for just this type of investment, oblivious to the risk of a serious pre-Christmas financial hangover when their geared tracker bonds mature in 2009. The geared trackers are being sold as a free ride on the stock markets, your chance to cash in on the market rally without putting any of your own cash on the table. But industry insiders predict trouble ahead, warning that the high rollers taking a punt on geared trackers are unaware that the stakes are loaded firmly against them. The product has sparked heated arguments in the rarefied world of actuaries, who are well aware of the limitations of tracker bonds. But because their debates are conducted in private and behind closed doors, the punters signing up for geared trackers are blissfully unaware of the risks they are taking. Key elements of the actuaries’ debate, seen by the Sunday Tribune, call in question the very foundations on which trackers bonds are based. Their conclusions will make grim reading for the thousands of small savers who have poured hundreds of millions of euro into trackers as an alternative to the paltry rates of interest paid on bank deposits. The actuaries now admit that there is a one-in-three chance that these trackers will return nothing more than the savers’ original cash at maturity. Because the money may have been locked up for six years or more, this means that the nest eggs of unlucky savers will have been ravished by inflation. The actuaries also concede that that investors may have little or no chance of hitting the jackpot returns highlighted in the glossy marketing literature.
Fans of trackers reply that the actuaries’ expected returns are little more than guesstimates of how the products are likely to perform and can vary enormously depending on how you do the maths. They believe that the pessimists have got it wrong by assuming that there is an equal chance that stock markets will go down as well as up. This flies in the face of reason when the concensus view is for continued growth in equity values, albeit at a fairly modest pace, they claim. Whoever is right, there is no denying that the people most at risk are the new crop of high-rollers who are borrowing the full cost of a flutter on the markets by signing up for the geared trackers sold by institutions such as Irish Life and ACC Bank. The borrowed cash is then invested in a tracker bond safe in the knowledge that, whatever goes wrong, the money will at least be returned at maturity to pay off the loan. So the most investors can lose is the interest on the borrowings. With interest rates at an all time low and stock markets bouncing back to life (the benchmark Euro Stoxx 50 index has rallied 10% so far this year), this looks like a pretty safe bet. Irish Life puts it like this: “The benefit of being able to borrow to invest is that you can access the potential rewards that a stock market-linked investment could provide without having to release any of the capital you have invested elsewhere.” The big problem is that, based on the actuarial guesstimates, the trackers will not deliver enough to cover the interest bill, leaving investors seriously out of pocket. In a confidential discussion paper prepared for the Society of Actuaries, Brian Woods, finance director at Ark Life, the life and pensions subsidiary of AIB Bank, ran the rule over a typical geared tracker. He concluded that investors could expect a 27% return after six years. But there is a 30% chance of a nil return and only a 1% chance of getting the maximum return because this would require all of the underlying shares to grow by 80% in six years. This means that people making the minimum €100,000 investment could expect to make about €21,000 after tax at 23%. But if they borrowed all the money at a fixed rate of 4.9%, the interest bill would come to about €28,000 over the six years.
Woods told the Sunday Tribune: “On this model the customer pays in around €28,000 in interest over the six years and expects on average to be paid €21,000 after tax, a loss of 25% of his outlay. There’s a 30% chance of losing the lot and a 1% chance of hitting the jackpot of €61,600 [an 80% return on the €100,000 investment after tax], which would give a profit of €33,600 after interest.” Not surprisingly, the brokers selling geared trackers are putting a different spin on what their clients could expect from geared trackers. In a letter to clients, Allied Insurance Consultants, a Dublin-based authorised advisor, has claimed they would cover their interest bills once the tracker grew by 21%. But this assumes that today’s rock-bottom interest rates will continue throughout the next six years. In his paper for the Society of Actuaries, Woods also highlighted other big drawbacks to geared trackers. He believes they are not tax efficient because, while investors must pay 23% exit tax when the tracker matures, they will get no tax breaks for the loan interest. Investors also risk being fleeced by charges, which Woods estimated at €1,750 a year for a €100,000 geared deal. Over a six-year investment term that amounts to over €10,000 in charges, including a €4,000 up-front brokers’ commission, for a net investment of €28,000. Irish Life insists that geared trackers are sold only to sophisticated investors why understand exactly what they are getting into. They are available only from a limited network of investment brokers and cannot be bought at Permanent TSB branches. The sales literature is covered in “wealth warnings”, highlighting that geared trackers are only for seasoned punters with prior experience of borrowing to invest. It also requires prospective investors to prove that they earn at least €75,000 a year. Anticipating that geared trackers could cause controversy when they hit the street, Irish Life consulted the government’s new financial watchdog before launch and it is understood that no objections were raised by regulators at the Irish Financial Services Regulatory Authority. According to Bill Hannan, chief operating officer at Irish Life and a major contributor to the actuarial debate, geared trackers are intended for investors who are convinced that this year’s rally is sustainable in the medium term. He added that Irish Life trackers maturing between July 2001 and September 2002 had yielded healthy returns of 27%-100%, although he conceded that more recent maturities have been disappointing. Hannan said that that assumptions used when second guessing expected returns must be rooted in reality. “The actuarial models are based on the assumption that markets are equally likely to go down as well as up,” he said. “This is one view of things but there are also those who believe that markets are cyclical and that currently an upward movement is stock prices is more likely than a downward movement. Whether we agree or disagree with this view, there is some demand for products that provide an opportunity to follow this trend.” If markets rumours are to be believed, this demand now runs into hundreds of millions of euro. Despite the considerable risks, there seems to be no shortage of punters chasing a free ride on a market recovery.