SPECIALS
Lifting The Lid On With-Profits Policies

By Roger Thetford (rthetford)
May 2, 2001

Have you got an endowment mortgage? Personal pension? Investment bond? Then you've probably got a with-profits investment policy. Designed as a way of combining stability with stock-market performance, these investments turn confusion into an art-form. In doing so, they offer numerous opportunities to impose some cunning charges on the hapless investor. They are also less safe than they first appear. 

So should you buy a with-profits policy? Read on!

A typical with-profits fund is invested in a mixture of shares, bonds, cash and perhaps property. This diversification means that it is less volatile than a pure stockmarket investment like a tracker, but over the long term the tracker will probably perform better, as it has done in the past. Remember the mantra that risk and reward go hand in hand.

The Advantage: Smoothing

The life assurance companies could not have sold so many with-profits policies if they didn't possess at least one distinctive advantage, which has led many advisers to recommend them. And that advantage is... a chunky up-front slice of commission for the adviser. Whoops, I'm getting ahead of myself: that comes later under 'mis-selling'. The advantage for the investor is of course smoothing. With-profits funds don't go down (usually): they just keep on growing.

A life company does this by declaring two sorts of bonuses. Reversionary (or guaranteed) bonuses are added to a policy every year. Once declared, they cannot be taken away. However, in a typical year the reversionary bonus may be only half of the actual return (after expenses) on the underlying fund; the rest of the return goes into the company's reserves.

When the policy matures, it will attract a terminal bonus. This is paid from the reserves, and restores the policy value to its 'fair share' of the assets. Approximately. Because if returns over the term of the policy have been unusually good, not all of the growth is paid to the investor; if performance has been exceptionally bad, the return is topped up by using some of the reserves squirrelled away during the good times.

The Actuaries' Dilemma

This smoothing is a risky game. If investment returns fall 'permanently' to a lower level, but a life company thinks that the fall is only short-term and keeps making high payouts by eating into its reserves, then it will go bust. To avoid this, the life companies tend to play safe and keep back just a little bit more than is really fair. That's partly how 'orphan assets' arise: after a century or two, not even the cleverest actuary can work out who should really own all the accumulated extra 'little bits'.

Also, the companies want to give a nice smooth return to their investors. Most life companies try to ensure that their 25-year payouts vary by no more than about 10% from one year to the next. So if the true asset values for 25-year policies maturing in three successive years were say £1000, £1300 and £900, then the payouts might be set at £1000, £1100 and £990.

To avoid highlighting this unfairness, a sizeable minority of life assurance companies will still not admit the underlying returns on their with-profits funds.

Guarantees, Free Assets and Investment Strategy

Over time, the money in the reserves will stack up. This surplus is known as the free assets of the company, and it's vital.

If a fund has only a low level of free assets, the manager will be scared of the fund value falling below the amount needed to pay the guaranteed reversionary bonuses to the policyholders. The manager will adopt a fairly conservative investment policy: a bit more in bonds, a bit less in equities. If the free assets drop further towards zero then the manager will be under pressure to shift strongly towards government bonds, with their guaranteed payouts. Although government bonds rarely beat equities in the long-term investment race, the manager simply cannot take the short-term risk. So the long-term performance suffers.

Conversely, if a company has got bundles of free assets, then even if the markets do badly it will still have plenty of cash to pay the reversionary bonuses. The company therefore has the freedom to invest those free assets in high-risk, high-return investments, trying to build its position further. And the long-term performance duly improves. 

As with so many things in the financial world, to him that hath shall be given... .

MVA - the Actuaries Bite Back

What happens if the assets drop below the guaranteed return? Or even the smoothed return, if the life company tells you what it is? Well, if you've been good and held the policy to its normal maturity date, then you'll certainly get your guaranteed bonuses and you may well get a terminal bonus on top. But if you're cashing in early then you may get hit with the actuaries' secret weapon: the Market Value Adjustment or MVA.

For example, five years of guaranteed 5% reversionary bonuses will turn an initial investment of £100 into £128. But if the assets are worth only £120, then the company is likely to say 'Sorry, the assets backing your policy have fallen in value. In order to protect policyholders who remain in the fund, we are applying the Market Value Adjustment and paying you only £120.'

Equitable Life provided a high-profile example of this. The extra reserves that were unexpectedly needed to pay for the Guaranteed Annuity Rates held by some members took the free assets dangerously close to zero. When markets fell during 2000-01, Equitable applied an MVA of first 10% and then 15%. (Equitable's problem was that for the previous 200 years it had been commendably honest with policyholders, paying them their 'just deserts' and keeping hardly anything in reserve. It also declared annually what the smoothed value of everyone's policy was. So when hit by the unexpectedly large Guaranteed Annuities bill, which it had failed either to hedge against or to provide reserves for, it had to move to a more cautious investment policy.

This reduced the likely returns on the fund, but policyholders who tried to move to another provider found that Equitable could not afford to pay them their smoothed policy values and so duly applied an MVA.)

Oi, wake up there at the back! Yes you! And tell me, why Equitable declared that the reversionary (guaranteed) part of its 8% bonus for 2000 was zero? Yes, you're right: increasing the guarantee would have reduced even further the free assets (the gap between the actual worth of the fund and the amount that had been promised to policyholders). Equitable would have been forced to adopt an even more cautious investment strategy, lowering the expected long-term returns for everyone.

So far, so complicated. But read on for part 2, in which we discover how the labyrinthine complexities of with-profits funds provide plenty of little-visited culs-de-sac, in which charges can be hidden to nibble away at your investment.

>> Part 2