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MONEY COMMENT
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Numerous reports have highlighted the decline of with-profits policies in the last week or so. John Chapman, formerly of the Office of Fair Trading, has said the schemes are in terminal decline and that the government should step in to ensure they are closed down in an orderly fashion. Market researcher Datamonitor found that 56% of IFA customers had a 'negative' or 'very negative' reaction to the term 'with profits'. It's a widespread problem. It's reckoned that twenty million of us have a with-profits policy, whether through an endowment mortgage or a pension plan. Some six million are believed to be in schemes that are closed to new members, the most notable being Equitable Life. So, what's gone wrong? With-profits funds invest in shares, bonds, property and cash, as many investment funds do. The difference is that they attempt to 'smooth out' their returns and thus offer a product that is more risky than a savings account, but less risky than direct investment in shares. They hold back gains in the good years in order that they can still pay out in bad ones. To do this, they have to keep some of their gains in reserve. Therefore, the long-term returns you get (through the annual bonuses you receive) are likely to be lower than other collective funds, such as unit trusts or investment trusts. A significant proportion, typically 20%, of a policy's entire value is only paid at the end, in the form of a terminal bonus. The trouble is that the majority of policyholders (some estimates are as high as 90%) don't hold their policies for the full term, and thus miss out on this final payout. Those that leave early are also likely to suffer from the dreaded Market Value Reduction. This discretionary exit penalty is meant to ensure that people don't leave with more than their fair share of the fund. Those who hold their plans right to the end actually do quite well compared to other investments but, arguably, only at the expense of those who cash in early. You could make a fair case for with-profits funds being the UK's largest pyramid scheme! In recent years, falling stock markets have wiped out a large chunk of many companies' reserves. According to Money Management, average 'free asset ratios', a crude measure of reserves, fell from 16% in 1999 to 4% in 2002. This has forced many funds to switch out of shares and into bonds. As bonds tend to provide lower returns than shares, plus part of these returns will be held back to rebuild reserves, future annual bonuses are likely to be very poor indeed. Policyholders wanting to take their money out are likely to find themselves victims of market value reductions as high as 25%. Those in closed funds are even worse off: without new money coming in, bonuses are likely to be even lower. With-profits policies are among the least transparent financial products available. So, we're not their biggest fans here at the Fool, to put it mildly! Although the smoothing aspect has arguably enticed more people to invest than would have done otherwise, the benefits of this are dubious if so few people stay in for the full term and miss out on terminal bonuses. If with-profits funds were to disappear, there would be few tears shed at Fool HQ.