Investment Road Test: MLC MasterKey Investment Protection

Investor research tells us that many are now looking for the “next thing” after the honeymoon of relatively high term deposit rates has come to an end.

The “post cash” investing environment brings its own set of risks, especially in the sharemarket where sentiment often prevails over fundamentals. MLC has now joined the rush among major investment platforms to deliver capital protection options for investors, following the recent launch of the new BT capital protection platform (analysed in Eureka Report in June this year). The MLC “Investment Protection” platform has some interesting features which may be of benefit to investors, potentially offsetting the downside of a relatively expensive and complex protection facility: http://www.mlc.com.au/protectmysuper/home.

AXA North

In 2009 I covered the detail of the first investment platform to offer capital protection (i.e. AXA North, which pioneered this concept before the GFC). I concluded at the time that the AXA North facility offered the benefit of capital protection, but did so at an expensive cost – with fees of 12.5% payable over a six-year period for just the capital protection component of the “growth” portfolio. Those fees are in addition to the underlying fees for the investments, and on top of the base fee for the AXA North platform.

The AXA North protection is hedged by the platform buying “put options” to protect the value of the investments – these have the benefit of certainty of outcome, but apart from the cost they typically reduce flexibility. In the case of AXA North, once a specific investment profile is selected, the investment mix for the protected component can’t be changed. So, in the case of AXA North, investment certainty comes at the price of a relatively high cost and with the loss of some investment flexibility.

MLC Investment Protection

The new MLC Investment Protection facility uses “put options” as the hedge for the capital protection facility, and as a result suffers from the twin problems of expense and inflexibility. Interestingly, the MLC facility also has scope to protect income payments, and in this regard may be a very interesting alternative to the rapidly growing annuity market. Like the AXA North platform, MLC also includes an annual profit lock-in mechanism – and in practice this gives some real world opportunity to use the product in a way which may overcome the headline expense problem.

The MLC facility gives access to a wide variety of managed funds, including lower-cost index funds as well as more expensive fund managers. Pleasingly, the list includes managers using a concentrated, low turnover style – exactly the long-term approach favoured by many SMSF investors. Disappointingly the menu does not include portfolios of direct shares, which seems to be a deliberate commercial choice taken by MLC, since externally provided put options over direct share portfolios are commonly available.

Protection terms are fixed at either 10 or 20 years, and these terms cannot be changed once they have been selected. That means your money is locked in for that period – unless you want to exit the capital protection facility and suffer the “wastage” of fees already paid during the investment term. Fees vary depending on the term and also the composition of the underlying portfolio:

Source: MLC MasterKey PDS dated July 1, 2013

In comparison with the AXA North protection fees, the MLC costs are on par to slightly more expensive – for example, the AXA North fee of 2% pa for a growth portfolio is around the same cost as MLC charges for the slightly less risky (and hence cheaper to insure) “balanced growth” option. The costs of protection decline when a longer term is selected or when a less risky style of portfolio is chosen.

Pleasingly both AXA North and MLC provide investors with a “rising guarantee”, where any annual gain in the portfolio is locked in. That means that the amount of the portfolio that is subject to the capital protection will rise as investments go up in value – but won’t then fall back if markets subsequently correct.

In practice this is a very important feature and the main way in which the overall adverse impact of protection fees can be offset. The typical problem with “put option” based protection is that the cost is a deadweight loss, which imposes a rising break-even cost to investing. For example, over a 10-year period the MLC facility cost to protect the capital value of a “balanced growth” portfolio is a total of 20% –meaning that the portfolio has to rise by a total of 20% over 10 years just to break-even. Remember, that’s just for the cost of protection: the costs of the underlying funds and the general platform costs are on top of this amount.

Taking account of the rising guarantee can be an important way to offset these costs: by capturing the benefit of capital growth, the investor can utilise the benefits of protection in two ways:

• After a severe crash, a very strong rise is needed to recoup losses in an unprotected portfolio (whereas any rise will be of immediate benefit to a protected portfolio).
• When the protected capital value has risen during the protection term, this benefit will be enhanced.

The MLC facility does offer the ability to protect income payments, although the fees for this are substantially higher than the costs of capital protection; the after-cost protected income returns may be on par with those offered by annuities:

Apart from the inflexibility around changing investment styles during the protection term, the MLC facility has some other potential limits. You can’t choose to protect some but not all of your portfolio – unless the protected part is a different investment style to the part you wish to keep without protection. Increasing or decreasing your investment amount during the transition to retirement is also cumbersome, reducing the flexibility around “transition to retirement” strategies. Check the detail of how you can make ongoing contributions or withdrawals from the MLC facility.

In comparison with the BT Protection Facility, the new MLC facility suffers from the same relative cost problem as AXA North. This stems from the relatively high cost of “put option” based protection (used both by AXA and MLC) compared to the “ICPPI” protection used by BT. As noted in our Eureka Report of the BT facility, its costs may be up to 50% less than AXA North (and MLC). For investors seeking peace of mind the growing range of solutions is pleasing – but keep a firm focus on costs and flexibility when assessing these new facilities.

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He provides asset consulting and financial product services but does not receive any benefit in relation to the product reviewed. Twitter: @TonyRumble.