Entering their 50s, Howard and Penny Mark* were looking forward to several years of comfort and relaxation. The Regina couple’s children had completed their education and were pursuing their own lives, and the Marks anticipated playing the role of empty nesters. Then, two disasters struck.
The first was Howard’s involvement in a serious auto accident. A drunk driver struck his car as he was returning from work one evening, leaving Howard permanently disabled. Through a combination of savings and support from Howard’s employer, the couple had enough retirement savings to generate an adequate income. Within a year, the Marks agreed on a settlement with the other driver’s insurance company that netted them about $650,000.
“We didn’t want to take any chances,” Penny recalls, “so we called a financial advisor, somebody whose name we had seen in a newspaper advertisement, and asked his advice.”
The advisor pointed out that the Marks needed a source of steady income with some growth in their portfolio to account for inflation. He had them complete and sign a Know Your Client (KYC) form that identified the ideal combination of investments as 40 percent low-risk and 60 percent high-risk investments, which translated into a blend of bonds and mutual funds.
For six years, the Marks withdrew $1000 monthly from the portfolio before discovering that their portfolio was depleted by about $100,000 during a period of steady growth in the bond and stock market. This was about $30,000 more than the balance should have dropped even without earning any returns on the bonds, which did not make sense. When they confronted the advisor about the loss, he suggested they transfer their portfolio to a new asset-management service and resigned as their advisor.
Taking their complaints to the advisor’s bank-owned brokerage, the Marks asked that their losses be replaced. The brokerage refused, claiming the investments had been appropriate and no compensation would be offered. When the brokerage’s position hardened and it became clear they rejected the claim, the Marks took their case to OBSI (Ombudsman for Banking Services and Investments).
OBSI determined that the advisor’s strategy of selecting low-risk and medium-risk investments for the Marks was reasonable, but the specific investments for the medium-risk portion were too high-risk.
When challenged, the advisor claimed he had performed a correlation analysis to confirm the portfolio fell within the couple’s risk tolerance limits but was unable to either produce a copy of the analysis or confirm that he had discussed it with the Marks.
After performing various calculations, OBSI proposed that the brokerage return almost $43,000 to the couple, less than half the amount the Marks had calculated counting the $30,000 depletion and the loss of anticipated earnings.
The Marks were fortunate. Thousands of other Canadians have lost greater portions of their investment portfolios under similar circumstances and received nothing in settlement. Many more Canadians lost a far larger proportion of their investments during the disastrous market drop of 2008–2009 and cannot hope to claim any settlement. The market rises, they will be lectured, and the market falls; you must be prepared to accept risk.
True, but isn’t it as important to limit the risk of loss, especially for retirement portfolios, as it is to maximize the amount of growth? How can financial advisors explain losses of 50 to 60 percent in an overall market that dropped barely 37 percent in the same six-month period?*
When Canadians raise concerns over losses in their RRSP or RRIF that appear excessive, they’re usually told markets are falling everywhere, and they have no reason to blame the advisor who shaped their portfolio.
This is unadulterated claptrap. One of the requirements of proper living quarters is to protect you and your possessions from the elements. Would you agree with an architect who suggested not incorporating a proper roof in your home because you’ll always be comfortable in good weather anyway? Probably not. So why accept the investment industry’s premise that they’re only responsible for rising markets and can do little to assist you when they fall?
The investment industry needs to acknowledge that its role is to maintain stewardship over the portfolios under their management, a task that extends into rainy days as well as during sunny weather. The task includes paying sufficient attention to defensive strategies that will cushion the impact of extended market slumps on the assets of clients, especially those aged 50 and over.
Severe losses as a result of major market downturns can leave investors traumatized, persuading them to abandon the market entirely and restrict themselves to low-paying bank savings accounts or government bonds. That’s understandable, but unfortunate. It’s not a matter of abandoning the market as a means of building retirement security. It’s a matter of being realistic about the way the market works, and dealing with it accordingly.
Many within the investment industry claim the idea of expecting financial advisors to spend as much effort preserving capital as they spend growing assets is unreasonable. And it may be, until Canadians acquire a minimum of investment knowledge and accept a reasonable degree of responsibility for their actions and decisions. Too many RRSP owners, for example, believed that the years of double-digit annual growth in asset values seen in the mid-1990s would extend ad infinitum, or at least until their retirement. This nonsense was rarely contradicted by promotion-conscious mutual funds or the commissionbased advisors selling them, but it’s a reality that anyone who reads the headlines of a newspaper can grasp.
The trick may be to look both up and down—up toward potential growth and down toward possible losses. Have you ever asked a financial advisor (or yourself ), “What are we doing to protect at least a portion of my portfolio against major losses?” If you haven’t, you should. And quickly.
There Are No Magic Cures in Health or in Finance
I’ve often imagined that somewhere, perhaps in a dusty subterranean vault off Bay Street, dwell people with names like Igor and Elvira who wear pointed hats and keep spiders for pets. I picture them scanning the business sections of newspapers, eavesdropping on telephone calls between investors, and scribbling notes about investor fears between sips of fermented bug juice. This, I figure, is how the industry comes up with ideas like principal protected notes (PPNs).
PPNs sound like one of those household gadgets sold on television at three in the morning. Whatever concern you have about life, love, and the whole damn thing, these products promise to cure it. In the case of PPNs, the promised cure addresses your fears that the money you had in your RRSP or other portfolio will be around two, five, or ten years from now.
That’s a legitimate issue. In fact, it’s the subject of this entire book. But before you rush out to load up on PPNs, please keep reading.
Principal protected notes, like segregated funds and deferred sales charges, exist primarily to generate wealth for the investment industry. Gee, maybe the small investors who buy them will make a few bucks too, but that’s not the issue.
This is no Aladdin’s lamp of riches; it’s a parlour trick that makes you feel good while your pocket is being picked. Here’s how it works:
PPNs guarantee that the money you invest in them will be available at the end of a contracted period, as long as 10 years. This is not a big deal; placing it into a bank savings account will achieve the same goal. Those marketing PPNs—which includes practically every bank, credit union, financial institution, and street-corner loan shark—add the extra appeal of potential earnings based on stock market performance.
You can’t lose: If the market rises, you collect profits; if it tanks, your original investment is returned to you. Hey, is this a good deal or not?
It’s not.
Here’s what goes on inside a traditionally structured PPN, also known among folks who track these things as the “plain vanilla” flavour.
Suppose a three-year PPN appeals to you because you like the idea of a guaranteed full return on your initial investment and the prospect of profiting if the market does well. You hand over $10,000 and sign the deal.
The PPN issuer immediately spends $9000 of your investment on a provincial or federal government-guaranteed strip bond earning perhaps 3.5 percent annually. The remaining $1000 is invested in a sector of the stock market described in the package. At the end of the term, the $9000 strip bond has yielded about $1000 for a face value of $10,000, the guaranteed principal. Whatever happened to the remaining $1000 is irrelevant to the PPN issuer because the only promise in the deal—to return the original $10,000—has been fulfilled. The invested $1000 is like “mad money” you might take to a weekly poker or bingo game. If you win, that’s fine. If you don’t win, well, you took a shot, right?
If the PPN term is five years, the issuer would purchase $8500 in guaranteed strip bonds at a similar rate and put $1500 into the market. Five years later, the original $10,000 is back (in the bonds) and any earnings are added. In a 10-year term, only $7000 need be put into the bond, leaving $3000 for market investment.*
It may occur to you that you could do the same thing yourself. Preserving the principal for a fixed period in this manner employs precisely the same strategy proposed in Chapter 4: From Propagation to Preservation. Whatever is left after the bonds have been purchased goes into the market. If you can simultaneously walk and talk, you can perform this trick on your own.
“Ah,” you say, “but a PPN is convenient.” So is riding to the grocery store in a chauffeur-driven Rolls-Royce. How much convenience are you prepared to pay for? PPN convenience has made a lot of people wealthy in recent years. Unfortunately, few are investors like you.
A Nickel Here, a Dollar There …
No industry is more adept at sliding money out of your pocket while making you feel good about it than folks in the investment business. These are the people, remember, who brought you DSCs, trailer fees, and wrap accounts, and they weren’t going to miss a similar opportunity with PPNs.
Buried under that sheen of PPN security is a layer of fees. The fees are applied to the portion of your investment left over after the PPN issuer purchases the bond. The size and number of fees vary, but expect to find at least some of these methods of siphoning money from your pocket:
• Sales commission. You don’t really expect something to be sold without a commission, do you? The commission will range from 3 to 5 percent of the amount you invest, taken off the top. If no front-end commission is charged, expect a heavy DSC applied over the term of the investment.
• Trailer fees. Is this sounding familiar? A full percentage may be deducted each year you hold the PPN and passed to the advisor/salesperson.
• Start-up and administrative costs. Another 1 or 2 percent off the top.
• Management fees. Also labelled program fees or administrative fees. The amount may vary widely, from 1.5 to 2 percent in the case of passively managed (“plain vanilla”) versions; up to 2.5 percent for actively managed PPNs (see below); and even the classic “2-and-20” fees for hedge-fund managers, if this represents the underlying security—meaning 2 percent off the top each year plus 20 percent of any net profits earned.
• Interest costs and currency hedges. Covering charges incurred from handling your money.
• Miscellaneous charges. Various administration expenses.
Purchasing a PPN is like handing over a portion of your hard-earned cash for someone to fly to Vegas, play roulette, and, if they succeed in winning, returning any profit, after deducting their expenses, back to you.
The odds against you are raised when leveraged investments are involved. Instead of investing the $1000 equity portion of your plain vanilla PPN on a dollar-for-dollar basis, the issuers and managers may leverage it five to one, purchasing $5000 in investments rather than $1000, multiplying your profit potential five times. This involves an interest charge billed to you, plus substantial downside risk to match the upside opportunity.
Should the leveraged investment pay off, the PPN issuer garners a fair-sized chunk of the profit. If the investment tanks—and with a fiveto-one leverage, a drop of 20 percent (one-fifth) in the value of the investment eliminates the entire position—so what? The strip bond/guaranteed element in the PPN earns enough money at maturity to hand you back your original investment. You haven’t made money but the PPN issuer has. Is this a good deal? Do palm trees grow in Saskatoon?
“Well,” you may muse, “at least I didn’t lose money.” Yes, you did.
From 2003 through the 2008–2009 economic crisis, Canada’s annual inflation rate hovered around 2 percent. Should you purchase a 10-year PPN and expect inflation to remain at 2 percent annually during that period—a highly unlikely prospect—a simple 2 10 calculation reveals that every dollar you set aside today will be worth 20 percent less when the PPN matures. Unless the invested portion of the PPN generates a net profit equal to 20 percent of your total investment after all fees have been deducted (an even more unlikely prospect than Canada maintaining a 2 percent inflation rate), you don’t break even, you lose. Even with a more common five- to seven-year PPN, you need from 10 to 14 percent net growth over the term just to counter inflation.
You can always cash in the PPN before the maturity date. Or sell it to some other sucker … er, investor … on a secondary market. Just take your money and go home, right?
Wrong again.
First, there is no secondary market you can count on. Some issuers may offer to assist you in dumping your PPN at face value, but most avoid any obligation. If no buyer shows up, the only option is to cash in your PPN, waive any claim to potential earnings, and pay an early discharge penalty from 5 to 7 percent of your original investment. You may not have to worry about that problem if the company issuing the PPN goes broke. That’s not likely to happen if the issuer is a major bank or giant investment firm like Manulife. But they’re not the only wagons peddling PPNs, and you should know that your PPN investment is not covered by the Canada Deposit Insurance Corporation (CDIC) nor guaranteed by the federal or provincial government. If you honestly believe a company large enough to manage and market PPNs is not likely to roll over and stop breathing, I have two words for you: Lehman Brothers.
Risk-free? Think again.
By early 2006, Canadians had dropped more than $7 billion into PPNs, believing the marketing hype that they couldn’t lose. Eventually, financial commentators began pointing out that the new emperor of the investment kingdom had a serious wardrobe malfunction. Investing in PPNs, they suggested, was like breeding rocks: heavy work with little return. Canadian investors were being scammed, and something needed to be done about it.
Regulators responded with all the alacrity of a rusty drawbridge while PPN issuers kept busy applying new lipstick to old pigs. CIBC called their PPNs “structured notes,” which at least sounded as though a degree of activity was involved. Others injected life into their PPNs with the delightful description, Constant Proportion Portfolio Insurance (CPPI). CPPI is like the magic ingredients that manufacturers of laundry detergents claim improve their product. You never know what it is or exactly what it does, but it sounds so impressive that it must do something.
With CPPI, the entire amount of a PPN is invested in the underlying asset, and the value is monitored. If the investment value begins to sink, some of the money is shifted into guaranteed bonds. Should the value drop to a predetermined floor price, the entire equity portion is exchanged for bonds; the floor price is actually the amount needed to ensure that the initial investment will be around at maturity. CPPI, it was claimed, potentially maximized returns without the risk or expense of leveraging.
In reality, it made PPNs more complex, which made it more difficult for investors to understand all the costs and risk implications riveted somewhere in the boilerplate of the PPN prospectus. Even there, among the literary equivalent of a Beethoven symphony played by a rap artist on a tin drum, PPN issuers were not required to disclose details about fees and penalties.
The Investment Dealers Association (IDA), now the Investment Industry Regulatory Organization of Canada (IIROC), was suitably unimpressed by PPNs in a report. “There is no guarantee that the investor will earn any positive returns on the original investment,” the report’s authors wrote, adding, “If the customer redeems prior to maturity, he/she can realize real capital losses on the investment.”*
By 2008, concerns about PPNs finally attracted the attention of government regulators, who set tighter rules about disclosure of fees, risks, redemption penalties, and other delights.
A concluding observation on PPNs: Instead of searching for a riskfree imagined-growth investment trick, set your own risk tolerance and find an investment solution to meet it.
*Pseudonyms. Based on a case study from the OBSI newsletter, Contact.
*May 30, 2008 (S&P/TSX 14,714.73), to November 30, 2008 (S&P/TSX 9,270.62).
*This assumes an effective bond yield of around 3 or 3.5 percent, which was a little high in mid-2009 but historically very low. The amount separated from the original investment and placed in the guaranteed bond would vary, determined by the available interest rate needed until the original principal was earned back in the contracted time frame.
*Regulatory Analysis of Hedge Funds, Investment Dealers Association of Canada, May 2005, p. 13.