When they hear that some financial product is “insured” or “guaranteed,” modern-day savers and investors are learning to ask two additional questions:
“By whom?” and “Against what?”
With straight answers to those simple inquiries, they can avoid a lot of confusion. But most of the time, getting those answers requires a little digging.
One place to look is in the fine print of advertisements and promotional literature touting some product for its supposedly generous yield.
In a mutual fund ad promising “greater return potential if you are willing to assume even a small amount of risk,” the potential customer has to read the footnote for the information that “unlike CDs, mutual funds are not insured or guaranteed by the U.S. government.”
That ad touches on a particularly sensitive point--the competition among financial organizations like mutual funds to attract money from savers disenchanted by low yields on certificates of deposit.
Arthur Levitt, chairman of the Securities and Exchange Commission, recently described a lack of understanding of the risks involved in mutual funds as “a clear and present danger.”
Funds may invest part or all of the money entrusted to them in securities that are government-guaranteed--for instance, Treasury bonds, notes and bills. But no fund itself, not even a money fund that customarily operates with an unchanging net asset value, is guaranteed by any government agency. That applies no matter where you buy it.
“The fact that a fund is sold by a federally insured bank does not make it one whit safer than one bought from a stockbroker or purchased directly from a fund,” says Norman Fosback in the newsletter Income & Safety, based in Ft. Lauderdale, Fla.
Brokerage firms, for their part, display the emblem of the Securities Investor Protection Corp., which provides insurance for customers in the event that the firm should run into financial trouble.
That coverage, however, doesn’t provide any protection against market risks or the possibility of business problems at any fund, or any issuer of stocks or bonds, whose securities are bought and sold by the broker.
The federal government insures its own direct obligations, such as T-bills, against loss from default. The same sort of protection extends to U.S. savings bonds and, through the Federal Deposit Insurance Corp. and similar programs, to insured deposits at financial institutions such as banks.
Because Uncle Sam has just about the deepest pockets of anyone in the world, this insurance carries a lot of credibility. But it also has its limits.
Market securities like Treasury bonds are subject to price fluctuation, just like other bonds, when interest rates rise or fall.
Investments whose nominal price never changes, like bank CDs, are also not immune to risk. For one thing, there is the prospect that inflation will erode their purchasing power over time, at a rate that is unpredictable.
“There are many kinds of investment ‘risk.’ Sometimes, the seemingly conservative investments are riskier than you think,” said a spokesman for Kemper Financial Services Inc. in Chicago.
“When a fixed-rate investment matures, any reinvestment must be at current interest rates, which may be significantly less than they were when the investment was purchased. That’s interest-rate risk.”
In retirement investing, participants in employer-sponsored 401(k) plans have become acquainted with investments known as “guaranteed investment contracts” issued by insurance companies.
In this case as well, the questions “by whom?” and “against what?” apply. As the Institute of Certified Financial Planners notes, “These contracts, backed by insurance companies but not by the federal government, guarantee a fixed rate of return for a specific period of time.”
Will that rate or return look as good a year down the road as it does now? On questions like that, there are no guarantees.