By Brad Thomason, CPA
It is only logical for a person who's considering several choices for investing money to want to know what the respective returns are going to be. When a number is offered, the most natural question in the world is whether it's an estimate, or if it's for sure.
The key to the question is actually very straightforward. In the US, in general, banks and insurance companies are the only kinds of issuers that can offer guarantees.
Now, to clarify, I'm talking about financial guarantees. When a company selling goods or services guarantees customer satisfaction, that's a different thing. Such a company can very easily provide a replacement or refund the purchase price. McDonald's can give you a new order of fries if you think the ones you have are too cold - and even throw in a free apple pie for your trouble - without missing a beat.
But to be able to guarantee a financial outcome, especially given that we could be talking about hundreds of thousands or even millions of dollars, that's a whole other matter.
In order for a guarantee of that second type to have any validity at all, the institution making it has to be able to stand behind it. Banks and insurance companies are subject to far more regulatory oversight, not to mention statutory requirements for financial strength, than any other kinds of companies in the US corporate landscape. Because the regulators monitor these factors and know that the guarantee has substantive backing, they allow the guarantee to be made. Or if you prefer to come at it from the other angle, you could say that since banks and insurance companies want to be able to offer guarantees, they submit to the higher level of regulation. It's two sides of a coin, but the effect is the same.
The significance of this aspect of the financial system's framework is that you should know automatically that anything in the stock, bond, fund, etf or real estate world does not have the same kind of assurance.
None of those things are issued by banks or insurance companies, right?
This differentiation is so stark that it is explicitly illegal for a securities issuer or investment company to offer or even imply a guarantee. That's why every prospectus you've ever seen has all that language about past performance not being an indication of what the future may hold.
A bond with a coupon of 7% may be legally binding for the issuer, but it is not guaranteed, because the issuing company or municipality may not be financially capable paying it. That's why bonds get rated by Moody's, etc.
A preferred stock with a 7% dividend is not guaranteed, because even if the company is obligated to pay such dividends before other classes of stock, there's no guarantee they will pay a dividend in the first place. That's a decision which must be made each year, and requires a volitional act of the board of directors. If the board doesn't ok a dividend, then the preference is irrelevant.
A mutual fund which earned an average of 7% over the last few years is not guaranteed, because the fund managers have no idea what the market is going to do in the future; nor do they have any funds in reserve to offset negative results.
On the other hand, if an insurance company issues an annuity with an income rider paying 7%, that actually can be guaranteed. You have to read the contract to be sure. But it is something that is certainly within the realm of what they can (and frequently) do, legally speaking.
There are trade offs in everything, and the desirability of a guaranteed result differs from one retiree to the next, and even between different buckets of money owned by the same person.
But to the extent that you want or need a guarantee, you're going to have to look to a bank or insurance company. Because in this country, you can't get them anywhere else.
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