FOOL'S EYE VIEW
How To Survive Battered Bonuses

By Cliff D'Arcy
February 4, 2003

Standard Life, Europe's largest mutual life assurer, is the latest in a long line of life companies to announce major reductions in the bonuses paid to holders of with-profits savings plans. This is grim news for its 2.3 million policyholders with mortgage endowments, personal pensions and with-profits bonds.

In the past, many investors in with-profits plans regarded them as safe and secure investments - a way of getting stock-market returns without the associated risk and volatility.

Nevertheless, policies maturing (paying out) now will be worth around 15% less than similar policies that matured a year ago. All customers whose plans invest in Standard Life's with-profits fund will be affected, but not those in unit-linked policies, whose plans have already fallen in line with the stock market.

The company has cut both the annual bonuses it adds to plans and the final ("terminal") bonus added to maturing plans.

Worst hit are holders of old-style with-profits endowments, whose annual bonus has more than halved, from 2.25% to a miserly 1% (down 56%). Furthermore, bonuses on similar pension plans will be cut from 3% to 1.25% (down 58%).

This will create more problems for mortgage endowment customers, whose policies need to achieve growth of at least 6% a year to produce a sum large enough to pay off their mortgages. See Tackling Failing Endowments for more information.

A mortgage endowment for £50 a month over 25 years that last year paid out £89,537 will pay out £75,984 this year - a drop of £13,553 (15.1%). Personal pensions are also hit hard: a pension of £200 a month for 25 years now pays out £500,414, a massive drop of £86,545 (14.7%) on last year's figure of £586,959.

In order to prevent savers from cashing in plans early to avoid future bonus cuts, Standard Life has adjusted its penalty, the Surrender Value Adjustment. Surrendering before maturity will reduce the value of life policies by 15%. For pension policies, this penalty rises to a whopping 25% - a quarter of the entire fund.

Along with most other investment companies, Standard Life expects future investment returns to be lower than those of the last 25 years. This means that current policyholders can expect lower bonuses and smaller payouts on existing contracts.

In fairness, Standard Life, along with all UK life assurers, has been hit very hard by the decline in world stock markets. Over 55% of its with-profits fund is invested in shares, which have been tumbling for more than three years. The remainder is invested in bonds, property and cash, which have risen in value, helping to offset the decline in shares.

It's not all bad news: since 1998, Standard Life's with-profits fund has actually out-performed the typical managed fund and the FTSE All Share index. Over the last five years, the fund grew by about 17% (3.2% a year), whereas you'd have lost a little money investing in these other two areas.

This is because of smoothing, where some of the returns generated in good years are held back and applied to payouts in bad years. This smoothing has helped to lessen recent stock market falls, but these reserves are not endless, hence life assurers are cutting back on policy payouts and surrender values. Because bonuses have been too high in the past, they will be depressed in the future.

Without sufficient reserves, it will be very difficult for with-profits funds to smooth any future falls in the stock market. This means that they will tend to behave more like other balanced funds by rising or falling in line with shares (and, to a lesser degree, property and bonds). As with-profits plans have much greater charges than many simpler investments, falling returns could see investors shunning them in future.

Even if shares do rebound, it could take many years of positive stock market returns before companies have rebuilt sufficient reserves to resume higher bonus payments. With a large slice of future profits earmarked for rebuilding reserves, plus low interest rates and inflation, it's possible that bonuses will never again reach the levels of the last thirty years.

For some people, it may be worth leaving now and paying the exit penalty if you're doing better than your underlying fund. For example, if you invested in a with-profits bond four years ago, you may have the same amount as you started with (and thus not made any money). However, in a typical managed fund, you could easily be down 20% or more, so it may be worth pulling out your money now while you're even or ahead.

Other investors may feel that now is the time to direct future investments into unit-linked funds, so as to take full advantage of any stock-market recovery. After all, with-profits funds invest around 50% of our money into shares but we won't see the full benefit of this growth.

If, thanks to falling investment returns, your policy is looking unlikely to perform as expected, one thing can improve your situation - saving more money.

Don't pump more into your with-profits policy trying to fill any gap. If you want a risk-free product, you could try a cash mini-ISA, a deposit account that pays tax-free interest. For longer-term saving with some risk, a stock market-linked index tracker or shares ISA may provide better investment returns.

Alternatively, you can keep on working and saving for longer than you originally planned, which won't be the first choice for many of us!

The writer has a Standard Life unitised with-profits mortgage endowment (bought before he became Foolish) and wishes he hadn't.