SPECIALS
Lifting The Lid On With-Profits Policies (part 2)

In Part 1 we saw how with-profits funds can smooth out the ups and downs of the stockmarket: both by diversifying into other assets like bonds and property, but also by smoothing returns across the years. We've also seen how the life companies like to hold a little bit more in reserve than is really fair, just in case things turn bad; and that if things turn really bad then they can hit you with the dreaded Market Value Adjustment.

If you thought that was complicated, just wait!

Unitised with-profits funds

A relative of mine has a pair of unitised with-profits investment bonds. She bought a specified number of units; day by day, the unit price ticks gradually upwards. One of the bonds publishes unit prices daily in the FT; the other doesn't, revealing the value of the units only in the annual statement. But both work in the same way: the company declares that over the next year, the value of each unit will rise by say 6%.

And so it does, going up broadly by 0.5% per month until the next declaration date, when a new annual rate is declared. Some of this return is guaranteed (the 'reversionary' bonus); some is not. The total 'value' goes up smoothly. The issuing company takes a bit of a risk by declaring the bonuses for 12 months ahead, but of course they compensate for that by being a little bit mean with the rate.

Even for the bond that doesn't publish the price daily, we can use the current rate of increase to work out what the bid and offer prices should be on any given day. But is this what the bonds are really worth? Not necessarily!

When the bond is cashed in, the issuing company will look at how its investments have done over the term of the bond. If they have outperformed the smoothed value, there may be a terminal bonus. If they have done badly, the Market Value Adjustment may apply. In other words, the current value is merely notional.

Traditional with-profits funds: will they pay the mortgage?

Amazingly, there is yet another complication hidden away in the with-profits labyrinth: the 'traditional' with-profits fund. Instead of increasing the unit price by a single percentage each year, these beasts use two different percentages: one that applies to the 'sum assured', and another that applies to 'accumulated bonuses'.

Take for example a 25-year endowment policy designed to pay off a mortgage. A portion of each monthly payment will be the life assurance premium, which will pay off the mortgage if the policyholder dies before the policy matures. The premium will be higher in the early years than later on (because the shortfall between the mortgage amount and the accumulated investment gradually decreases).

But for simplicity, let's neglect this life assurance premium and assume that a constant £100 per month goes into the underlying investments. The total payment over 25 years is then £30,000, which will (perhaps approximately) be the sum assured.

Suppose that the bonus rates are 5% on the sum assured and 6% on accumulated bonuses. The bonus declared at the end of the first year is therefore 5% of £30,000 or £1,500. At the end of the second year, the bonus is another £1,500, plus 6% of the first £1,500 (£90), giving a grand total of £3090. Continuing the calculation for another 23 years gives a total bonus of £82,404; adding the £30,000 sum assured produces a total return of £112,404.

There may be an additional terminal bonus on top, but even without it the effective annualised rate of return on the £100 per month investment is 9.4%. Note that this is higher than both of the underlying bonus rates used: the actuarial trick of splitting the bonuses into two makes it tough to work out what the underlying return on the investment really is.

The £100-per month policy above may well have been set up to back a £100,000 mortgage: the initial bonus rates would have produced a final amount that paid off the mortgage with some to spare, even without a terminal bonus. But now suppose that the bonus rates start to fall. Rates of 2.25% on the sum assured and 3.25% on accumulated bonuses, which are all too common these days, produce just £55,490 (equivalent to 4.6% p.a.) after 25 years. Of course, a big terminal bonus may well make up the difference, especially if low reversionary bonuses give the life company enough free assets to invest aggressively for high returns. But many holders of endowment policies are praying nervously that bonus rates don't fall any further.

The current value of a traditional with-profits fund is almost impossible to work out. It's certainly not equal to the bonuses declared to date, either with or without a suitable fraction of the sum assured. One approach is to project the current bonuses to maturity, then discount back to today using the present annualised rate of return, subtracting off the returns to be earned by future payments. But that's a tough calculation, and I'm not going to go into it here!

The message is that the current value of any with-profits fund, unitised or traditional, is imaginary. Even if you think that you can calculate it, the life company may give you more (by declaring a terminal bonus) or less (by imposing an MVA). And then there are the charges...

Charges

All these complications give the charges plenty of places to hide. Ask what are the charges on your with-profits endowment or pension, and you'll probably be given the initial charge. Annual charge? 'I'm pleased to tell you sir that there isn't one.'

Not explicitly perhaps, but you won't be surprised, Fool, to find that it's there. After all, for a non-mutual, how do the shareholders get their 10% slice of the profits? The answer is that all the bonus rates we've been considering so far are calculated after the all the costs have been subtracted. That's the shareholders' slice, the fund-management expenses, the advertising budget and the sales commission. And the 'hidden' cost of the smoothing: the regular transfers to reserves. Plus anything else, like unforeseen losses on Guaranteed Annuities and legal costs for fighting court cases: you name it, it comes from the with-profits fund. (That's why some Equitable Life policyholders are referring to their fund as the 'with-losses' fund.)

For with-profits funds, the number to look for is the reduction in yield. For an endowment it should be towards the back of the Key Features document; for a pension, you'll probably have to request a personalised illustration. Over a long period like 25 years, the reduction in yield is approximately equal to the annual charge. I was shocked to find that one with-profits fund, sold for Additional Voluntary Contributions (AVCs) to a pension, had an implicit annual charge of over 2%. This could gobble up a third of the potential final value! Fortunately, the advent of stakeholder pensions drove down the annual charges for this particular arrangement first to 1.5% and then under 1%. Hurrah!

Mis-selling

Pensions and endowments, particularly the 'traditional' with-profits contracts, are notoriously inflexible. Once a life company has got you, it wants to keep your money flowing. The large sums at stake mean that they're prepared to offer big commission payments to salesmen: £1000 or more on a typical mortgage endowment policy. Whence comes this money? From thee, Fool!

Whereas most unit trusts pay initial commission of 3% of the investment and a steady 0.5% of fund value 'renewal' or 'trail' commission each year (in addition to other management charges), life assurance companies tend to pay most of the commission up front. (This may or may not be due to the problem of calculating how much the fund is actually worth year by year.)

Here's an example, from a 1989 policy issued by a well-known strong mutual company:

Commission payable, as percentage of annual premium

Period          initial        trail
             commission   commission

years 1 to 3        30%            -
year 4               5%         2.1%
subsequent years     -          2.5%

The initial 30% looks pretty bad, but it's actually worse than that. The 'initial commission' payments are all converted into a lump sum payable 'on the issue of the contract of an amount equal to 79.5% of the first year's premium, instead of being payable over the first 4 years of the contract at the rates shown in the second column of the table above'. Wow! No wonder that early surrender values are so low. And no wonder that mortgage endowments were pushed so heavily: an adviser selling a £100-a-month endowment could pocket commission of about £1000 immediately. 

Don't confuse the commission payments with the charges that the investor pays. The company pays the commission to the adviser. The amount that the investor pays, mostly by not having all of the underlying asset growth credited to the policy, covers commission, administration, fund management, advertising, shareholders' dividends and so on. Even when the both the underlying growth and the policy bonuses are made public (and life companies are notoriously reluctant to reveal the underlying growth), the results are all smoothed over decades so are impossible to interpret precisely.

Even today, initial commissions on with-profits funds remain high. A recent flyer for the single-premium with-profits Prudence Bond revealed an initial commission of a whacking 7.5% (compared to about 6% for even the most expensive unit trusts), which gave the discount IFA plenty of scope to refund a 'generous' 6% of the investment and still make a profit. And just why are commissions so high on these products? Could it be, perhaps, because they're so complicated that the charges may easily be obscured? 

So should I get a with-profits policy?

As ever, the answer is 'that depends'. For some people, the peace of mind available from smoothing will make with-profits investments a sensible choice. But others will realise that the smoothing comes at a price: not just slightly lower average returns, but also immense complexity and, frequently, hidden charges.

But bear in mind that even the peace of mind could be illusory. You'll never know the true value of your policy until you've cashed it in.