FOOL'S EYE VIEW
Equitable Life -- What Have We Learned?

By Rob Davies
December 21, 2000

The closure of The Equitable Life Assurance Society to new business on Friday 8th December was a profound shock to investors throughout the UK. That such a long-established and well-known institution was revealed to have major fundamental weaknesses sent a strong signal to our nervosa walletus, our investing reflex: if you can't trust these guys who can you trust?

Not only did 450,000 individual savers place their trust in this institution but so did a huge number of professional managers who are paid to analyse these things on a full-time basis. Some Fools have said it is the fault of the amateur investors that they did not do their own due diligence, and have suffered as a result, but how did the experts get it so wrong as well?

In truth, there is no single simple reason. If there were it probably wouldn't have happened. In reality there were a number of factors that caused this problem and, if we are to learn anything from this tale of woe, we need to understand what these were. It seems to me that the following factors were the major reasons for this crisis.

* Over-reliance on brand
* False comfort from the benefits of mutuality
* Poor comprehension of the meaning of "with profits"
* Complacency by the regulators
* Rapid changes in the economic conditions
* Lack of accountability of the money managers
* Poor disclosure

Over-reliance on brand

Branding is the marketing man's holy grail, the Nirvana where the customer buys the product without quibbling about details like price and quality. Equitable Life had reached that stage. It had a corporate client list to die for. It included the BBC, the NHS, the House of Commons and a host of large companies where it was established as the pension provider of choice. Its strong message that it did not pay commission to its sales force was superb marketing and enabled the Society to sell its products that much more easily. Buyers just felt relieved that they weren't being taken for a ride. And of course they weren't. Its salesmen could point to a host of historic performance data without fear of being questioned. It had the feature all brands strive for: trust. No one asked it any hard questions and that allowed it to do things it shouldn't.

False comfort from the benefits of mutuality

Alongside its brand Equitable's customers could take comfort from the fact that they were the owners as well as its clients. No grasping shareholders were going to take them for a ride. All the benefits would accrue to the investors. However, what this quaint 17th century capital structure did not do was protect the owners from risk. Being a capitalist means placing your money at risk to earn a higher return. The fact that you do it together with thousands of others does not reduce that risk. The problems at Equitable were compounded by the misunderstanding by its owners of what a mutual company is. Too many assumed that investing in a mutual was a one-way bet: any gains were theirs, and any losses were someone else's problem. In this they had been lulled into a false sense of security by products like endowments which provided some insurance elements as well that did indeed offer a floor to the investment, albeit a not very high one. The great desire of mutual societies to totally avoid discussing the concept of profit actually led to a blurred understanding of what was really going on with the capital at risk.

If investors had been told that their investments were at risk from bad decisions by management I imagine there would have been an appreciably lower level of interest. But the worst aspect of all in mutual societies is the lack of accountability of the board to the owners. In theory of course it is possible to question the directors once a year at the AGM, but in practice it is not possible to have a constructive conversation between a dozen people on one side and several hundred on the other side. Moreover, when the owners are not given all the relevant information it is much harder to know what to ask.

Poor comprehension of the meaning of "with-profits"

Perhaps the most complicated part of the whole saga is concerns the issue of "with profits". The concept that everyone pays into a fund, and then gets a share of the profits is very communitaire. But the problem lies in defining what the profits are and how much everyone gets. When your name is not on your money the scope for vagueness is enormous. The crucial phrase is "reasonable expectations", but what is reasonable to one is unreasonable to another. Other companies, like the Prudential (LSE: PRU) and AXA have the reverse problem to the Equitable. In the past they have kept too much profit back, so earlier generations of investors were short-changed. The whole subject is so complex that it seems likely that the FSA is going to persuade companies to gradually move away from this concept altogether. And that must be a good thing.

Complacency by Regulators

Perhaps we take regulation too much for granted. We assume that the railways will be safe and that assurance companies will be around for a long time. Few of us have the skills, or the time, to fully investigate every company we use. When we get on a British Airways (LSE: BAY) jet we assume it meets our Government requirements, but if we fly on Trashcanistan Air we surmise that different standards might apply.

Much the same applies to finance. If we buy bonds in a Bulgarian brewery we know that if it goes wrong we can't complain to anyone. But in the UK we pay tax to the Government to fund the FSA as well as bankrolling it though levies on financial service companies. We pay someone to do our due diligence for us, partly because it is so specialised. In the case of Equitable Life there appears to have been a massive failure by the various regulators to appreciate the scale of the problem. And it seems that when they did became aware they failed to take robust action to contain it.

Now it seems too late to do anything about it. But does that mean from now on we have to read all the small print in all our financial documents to protect ourselves?  If we do, then what is the point of funding the FSA?

Rapid changes in the economic conditions

The Equitable Life was brought low by a rapid change from high inflation to low inflation. That occurred in less than 30 years, probably about the same timeframe as most investors are concerned with. It reminds us that we should not assume that today's financial conditions will exist forever. It is of course nearly impossible to construct an investment portfolio that will cope with every conceivable economic scenario. But we should be alert to the dangers of having our finances too dependent on one type of asset. To my mind the risk today is too much of our assets are concentrated in housing. It has been the right strategy for the last twenty years, but will it be for the next twenty?

Lack of accountability of the money managers

Giving our money to the Equitable to manage was a mistake. It didn't do a very good job for a variety of reasons. But looking at the accounts it is difficult to see what they have done with it, and why. The arrogant attitude of the actuaries with their "we know best, leave it to us" style was one reason why it all went wrong. If the Society had detailed in full what it's investments were, and why they were made, it would have given investors some idea of what to expect as future returns. Instead we are totally in their hands as to what constitutes a good performance and what can be paid out as a bonus.

That degree of aloofness is no longer acceptable and investors must now expect the fund managers to explain their portfolios and their actions. An AGM once a year is not a good forum to hold managers to account. At least listed companies get grilled twice a year by analysts; mutual companies should offer something similar.

Poor disclosure

The fundamental problem with the Equitable Life was taking a gamble with interest rates on its GAR policies. Yet as an investor and owner of the company I had no idea that it had even entered into these sorts of contracts. Public companies are obliged to report twice a year and disclose items. Mutually owned companies should have the same, or even higher, levels of disclosure. At the very least, quantification of policies: their number and size of liabilities should be revealed. Then we would have some idea of what we owned and what we owed, and that would make us much more involved with the company.

So what?

The Equitable Life saga is going to roll on for a long time yet. But to me the messages this crisis sends to investors are clear.

* Don't trust a brand name. Look at the product.
* The era of mutual societies is over. They are simply too unaccountable.
* With-profits funds should be avoided at all costs. No one understands them.
* Investors should have as much control over their investments as possible. That means owning equities directly or through unit trusts so that your name is clearly identified with your assets.
* Sadly, you can't rely on the regulator to look after your interests. Make your own inquiries.
* Don't invest if you don't understand what you are investing in
* Don't assume today's economic conditions will last forever. They won't.

Where Next?
The Equitable Life Assurance Society discussion board