Is criticism of with-profits fair?

4 May 2010

Holding a with-profits product can feel a little like an unsatisfactory relationship – not good enough to put the effort in, but not bad enough to make it worth packing your bags.

Each year, the annual bonus announcements from the insurance companies that sell these products prompt another round of hand-wringing from investors and advisers alike.

Should they stick with their holdings because of attractive guarantees or the hope of improved investment performance, or move on to a more modern, transparent product?

What is a with-profit investment?

With-profits investments – which encompass endowment policies, pension policies, annuities and fixed-term bonds – aimed to offer a smoothed return to investors by holding back money in the good years to pay out in the bad ones.

Many came with attractive guarantees. The theory was fine, but many performed badly, were expensive and opaque.

Worst of all, in the post-dotcom market slump many started applying market value adjusters (MVAs), which are effectively exit penalties.

Thousands of policies are now the subject of investigation by the Financial Services Authority (FSA), but in the meantime as many as 10 million people may still be holding a with-profits product.

A number of factors inform investment decisions on with-profits, depending on whether the decision is between selling an existing policy, continuing to contribute regular premiums or investing for the first time.

For existing policyholders, the associated bells-and-whistles can be valuable and any guarantees may be strong enough to trump weak investment performance.

Some stronger than others

Some underlying with-profits funds are notably stronger than others and there has been increasing polarisation.

The asset mix of these funds will also be important, as a reflection of both the financial strength of the insurance company and the likelihood of stronger investment performance in future.

Equally, the price that could potentially be obtained on the secondary market will help inform the stay-or-go decision.

Unearthing an adviser who admits to having recommended with-profits to a client is a little like finding a fund manager who admits he invested in banks immediately prior to the financial crisis.

That said, some funds are still seeing new inflows of money. Ned Cazalet, founder of Cazalet Consulting, says with-profits funds took in £350 million in regular premiums and £6 billion in single premiums (although this includes pension top-ups) in 2008.

Of this, £4.1 billion went into just two funds run by Prudential and Aviva.

Are with-profits a dying product?

Cazalet points out that with-profits only makes up around 7% of all new business written by life companies. In 1980, it was more like 10 times that figure.

But with-profits funds are a dying product. With one exception, the funds have negative cash flow – they pay out more than they generate in new business.

Cazalet says the average ratio is around 15 times that, but stronger funds may have lower ratios. Prudential's ratio, for example, is 1.7 times.

This has an impact on financial strength and the asset allocation of with-profits funds.

Stronger funds have more flexibility in their asset allocation, as they do not have to stock up on fixed-income securities such as gilts to meet their regulatory and bonus obligations, so can hold higher weightings in equities.

Although equities have been weak over the past 10 years, with-profits funds that have the flexibility to switch between asset classes are likely to perform better over the long term, which translates into higher annual and terminal bonuses for investors.

It is no secret that an alteration in the asset allocation of with-profits policies has taken place. "Going back to 2000, the average equity weighting was 68%," says Cazalet. "By the end of the decade the equity weighting was 33%.

These are big changes, particularly as some people bought into the funds seeking a high equity content. Some funds have seen an even more dramatic shift. Equitable Life, for example, has gone from 65% to 7%. NPI has gone from 47% to 1%."
Cazalet sees the pressure on the balance of equities in with-profits funds continuing.

He says it will depend on whether guarantees held by a fund are relatively light or onerous, but investors are likely to have to accept a lower equity weighting permanently. Few funds have embraced an alternative to the straightforward equity/bond split.

Gary Bown, senior actuary at consulting actuaries AKG, says absolute return funds are being used by more progressive with-profits providers, but exposure is still relatively low.

Asset allocation is key

The asset mix has been important for the overall performance in with-profits funds.

The change in maturity values for with-profits policies varies wildly. Looking at 25-year endowment policies for a £50-a-month contribution, the Wesleyan Ordinary Long Term Business fund recently reported a maturity value of £65,957.

This compares to a value for the same contribution of £25,099 from the Pearl Group National Provident Life With-Profits fund. Maturity values have dropped steadily as many funds digest the weaker markets of 2007-08.

The weaker markets have also had an impact on annual and terminal bonuses, which have tended to be flat or falling.

For example, Legal & General froze its annual bonus for policyholders in March despite a 14% rise in the underlying fund. It also cut its terminal bonus. Aviva and Standard Life also froze annual bonuses this year.
Jo Bridger, head of marketing at traded life policy group Policy Plus, says there is more polarisation between weaker and stronger funds on bonus payouts.

"The bonus rates that came out this year have been more of the same," she explains. "The strongest companies have slightly improved their rates and the weaker ones have cut slightly.

There were some smoothing effects during the financial crisis. Stronger funds were still paying bonuses and values of endowments were still going up, but rates had been cut quite significantly up to that point. Funds are still being cautious."

Bown suggests that annual and terminal bonuses are unlikely to change significantly, with most funds lacking the investment flexibility to deliver outperformance. "Annual bonuses have been going down in recent years," he says.

"They are not likely to go down much further, but they are not likely to go up much either. This reflects the performance of stockmarkets over time – some of these were 25-year policies and have been invested during periods of huge market increases."

For those who want to exit before their policies mature, surrender values become all-important. They dropped between 2008 and 2009, according to Bown, and he believes there are unlikely to be any great increases.

Bridger says investors should still consider a sale through the traded life policy market, even though surrender values offered by life companies has moved closer to those on the secondary market.

"There is value in the secondary market and we still have active investors," she continues.

"The price you will receive for your policy will come down to its capital strength, how much it holds in equities and therefore how much it has benefited from the rally."

When should investors withdraw their policies?

While most advisers are clear that they would no longer recommend with-profits, most need a strategy for dealing with new clients in legacy with-profits policies.

"These products are opaque, with the returns at the discretion of an actuary, but we only take people out if they are not going to be significantly penalised," says Jason Witcombe, a director at Evolve Financial Planning.

Jason Butler, a director at Bloomsbury Financial Planning, notes: "We haven't recommended a policy since 1997, but there can be reasons to hang onto a with-profits fund, such as the life cover or guarantees.

In general, we sell unless there is a strong reason to keep them. There is usually no investment case for them, but if someone is a higher-rate taxpayer now, and may be a lower-rate taxpayer in retirement, there are tax and logistical reasons for deferring a sale."

Gavin Haynes, investment director at Whitechurch Securities, adds: "We don't recommend them, but it’s wrong to tar them all with the same brush.

Prudential, for example, has performed well. A lot have disappointed, but you don’t have to get out at all costs."

Advisers have access to "with-profits analyser" tools, which rate with-profits funds on capital strength, performance, payouts and asset allocation, among other factors.

But investors without advisers may find information harder to come by – one of the biggest criticisms of with-profits has been lack of transparency.

The first port of call for anyone thinking of cashing in is to ask the provider how much the fund is worth, whether a MVA will apply and what benefits or guarantees are in place.

For some with-profits endowment policies, it can be more profitable to sell them on the secondary market.

Groups such as Policy Plus ( or The TEP Exchange ( will offer a secondary market price that can be compared to the information from a life company.

This article was originally published in Money Observer - Moneywise's sister publication - in May 2010

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