FOOL'S EYE VIEW
With Profits? No Thanks

By James Carlisle
January 11, 2002

Great Titchfield Street, London -- The Financial Services Authority has been looking into 'with-profits' investments and they're all set to introduce new rules to make them more transparent and understandable. Hooray for that. According to the FSA research, 'most people who take out with-profits investments have only a rudimentary understanding of how the products work'. All I'd add to that is that the people who sell the things quite often have only a slight better grasp of it. In the case of Equitable Life, whose compromise vote closes today, it's ended up taking 9 judges plus an army of lawyers, accountants and actuaries and still no one's entirely sure about who gets what.

To understand how 'with-profits' investments work, it's easiest to take a step back in history to see how they developed. In the very old days, mutual societies would take money from depositors at, say 5% and lent it out at, say 6%, with one per cent in the middle to cover their costs. Then they worked out that they could do more with their money than just lend it out again at 6%. They could invest in Government bonds and shares and property and, over the long-term, they could make better returns than the 6%.

As mutual societies, they had to pass on the benefits of this investment, and other profitable activities, to their members, the depositors. The trouble is that they couldn't tell in advance what these profits were going to be. So they introduced the concept of 'with profits'. That way, they could take money from people, invest it and then give them however much it's worth at the end - the money they put in, together with the profits of the investment.

So, 'with profits' funds are not unlike most other types of investment fund. You put your money in, it gets invested and you're entitled to a share of it at the end. The big difference comes in how the rewards of the investment are shared out. With normal companies and unit trusts, you simply own a percentage of the fund. So at any time, you might own, say, 0.1% of a £100m fund and you'd know you had £100,000.

In a with-profits fund, there's the money that you put in and then 'bonuses' get added to it as you go along. The idea is that this can't be taken away from you. Because it can't be taken away, the trustees of the fund are very careful with what they give you by way of annual bonuses. For instance, if the fund's investments increase by 15% in one year, they might only give you 6% as your annual bonus, so that they've got something tucked away and can still add 6% in a year when the market falls. When you come to take your money at the end, the fund will add an extra 'terminal bonus' that's designed to make up for what you've not been given along the way.

This process is called 'smoothing' and it's supposedly the big selling point for with-profits products. The idea being that the risks are lower because your investment creeps up in value more steadily over the years. The truth is, though, that this is nonsense. The only thing that is being smoothed is the way the trustees of the fund are allocating the investment returns of the fund. The fund itself is still being invested in the same underlying investments as the non-with profit types of fund.

You just can't take the same investments, call them 'with profits', wave a magic wand and, hey presto, you've got a better balance of risk and reward. It just can't work like that. A thousand shares in Vodafone, a hundred pound's worth of Government bond or an office building in the City are the same investments, whatever you decide to call them. The fund's trustees will speak with their actuaries and the regulators to be as sure as they can to pay you what you've been promised, but ultimately there's only what's there to keep all the members happy, as unfortunate Equitable Life members are no finding out.

In fact, depending on the fund, there may be some form of rabbit that they can pull out of the hat, in the form of 'reserves'. But these 'reserves have to come from somewhere and they come, of course, from previous investors that haven't been given their full dues. If those reserves are to be maintained for the future and, in fact, grow along with the economy, then the fund probably won't be able to pay you fully what you're due as well. The fund might also buy some insurance, to cover any shortfalls in the event of difficulties, but any insurance has to be paid for (and if large with-profits funds start getting into trouble you'd have to be worried about the solvency of the insurance companies anyway). So any moderation of risk can only be obtained at the expense of your returns. You can achieve the same result yourself, without all the confusion and expense, by just having a little more cash in the bank, together perhaps with some insurance, on top of your (not 'with profits') index tracker, or whatever.

So this bonus reward structure, and the smoothing it produces, doesn't produce an improvement of in your 'risk to reward ratio'. All it can do is alter the balance slightly. If you're making regular contributions to an investment over the very long-term, which is what you're doing with typical with-profits products like pensions and endowments, this is likely to have a relatively small impact. All the 'with-profits' structure really achieves is to obfuscate, metagrobolise and generally confuse the consumer.

You have to wonder what the point of 'with-profits' products is. The answer is probably just that they're there and the financial services industry is too fond of them to get rid of them. The industry is fond of them because they're easy to sell and they lack accountability. When these things combine in the world of financial services, high commissions and charges are normally not far behind and any good Fool will know that high charges generally means poor performance.

That lack of performance takes place over a very long time-scale, so it's less easy to spot, but the damage is there. Over 25 years, an investment returning 9% per year would end up being worth half the value of an investment growing at 12% per year. Yet it's a lot easier to explain that away than an index tracker that fell by 20% last year.

Perhaps the biggest factor, is simply that 'with-profits' is such a marvellous name for a financial product. Let's face it, when most people are asked by their financial adviser whether they'd like an investment to be 'with profits', they're hardly likely to say, 'er, no, without please'.

The FSA will take an important step in the right direction by removing the confusion and disinformation that surrounds 'with-profits' funds - ultimately they'll wilt under the spotlight of public scrutiny. This is exactly how the FSA can help to create an effective free market for financial products. Consumers are able to make sensible choices, but they need products to be transparent and clearly explained.