With Profits Investments
I have been extremely surprised to see posts discussing recommendations to buy With Profits investment bonds given the huge body of experience from the UK following the spectacular fall from grace of these contracts. I have therefore researched the following by way of an analysis of some of the key issues. This perspective is guided largely by experience from the UK. I personally have much experience of advising clients with this type of contract.
Warning to existing investors: Generalised advice offered on a one-size fits all basis to with-profits policyholders may, at worst, result in individual policyholders making the wrong choice given their particular circumstances. Before making any decisions regarding an existing contract, you should always seek competent, qualified, professional advice
That said, I believe that it is essential that consumers have sufficient information available to them to at least ask the right questions
In order to appreciate the complexity of with-profits policies and the challenges they present to the investor, it may be helpful to know a little about their history.
Background
Briefly, with-profits policies were the main retail investment in the UK until the early 1990s. At the end of 2001, the estimated capital value of with-profits funds was £385bn.
Coincidently, initial commissions of up to 7% were available to advisers selling these contracts often with no initial charges or bid-offer spreads being paid by the client and a first year bonus rate of 8% net of starting rate tax.
Although they aimed to offer the inexperienced and more cautious investor significant exposure to growth assets, such as equities and property, but with returns that were ‘smoothed’ to reduce year-on-year volatility, it should be clear that much of the popularity of these investments was down to the relatively easy sell to a cautious saver with their money on deposit looking for a better return than a traditional cash deposit combined with the high commissions on offer.
Indeed many of the UK Banks and Building Societies employed large salesforces who sold these investments to their savings clients.
Opaque – profits at the discretion of an appointed actuary
An important function of the with-profits ‘appointed actuary’ is to decide what proportion of the investment return to withhold in years of rising markets in order to maintain an attractive return when markets were falling. This smoothing mechanism was – and still is – largely discretionary for most funds. Even where companies have prescribed their smoothing mechanism in the PPFM, they reserve the right to change this if circumstances dictate.
There is much evidence of Insurance Companies setting bonus rates (especially first year headline rates) with reference to the marketing department rather than the prudent interests of the policyholders.
Asset Mix
Typically, until the turn of the century, funds invested about 70% in equities and property (the equity backing ratio), with the balance in fixed interest assets and cash.
Funds that are mostly invested in equities have the potential to produce far greater returnsthan those that are more heavily exposed to bonds, but obviously come with a higher level of risk.
The asset allocation of with-profits funds should be the focus of reviews by advisers as changes may mean the current mix is not what either they or the client may anticipate.
Money from all with-profits policyholders is combined, or pooled, into a with-profits fund. The insurance company uses the money in this fund to invest in different types of assets, normally shares, commercial property, gilts, corporate bonds and cash deposits.
Different insurance companies invest different amounts in each type of asset; some have mainly gilts and corporate bonds, others have more shares or property.
A question of trust
The type of customers targeted by providers and advisers bought on trust, on the assumption that the policy would meet their long-term investment objectives for mortgages, pensions and other savings purposes, while at the same time smoothing year-on-year volatility. It is fair to say that very few customers really understood how the product worked.
By 2007, new with-profits business levels had fallen dramatically, even for the small number of companies that were still actively marketing and selling bonds. According to Cazalet Consulting, the majority of funds now have negative cash flow – that is, claims (maturity, death, early surrender) are greater than inflows from premiums.
For most providers, therefore, it appears that the with-profits fund is, in effect, in run-off even if is not formally closed to new business.
In the late 1980s and early 1990s most life offices replaced their conventional with-profits policies with the ‘unitised’ version, which aimed to make charges more transparent through the introduction of an annual management charge (AMC). The payout from a unitised policy comprises the value of units plus a final bonus, which is discretionary.
Factors to consider:
Financial strength of a fund and whether any guarantees are in place
A significant exposure to liabilities reduces a fund's financial strength and that has two implicationsfor investors. The need for these funds to hold reserves in low-risk investments in order to cover the guarantees reduces the fund managers' freedom to make pure investment decisions. Also, when these weaker funds generate investment returns, there's an increased risk that some categories of policyholder will have some of those returns withheld from them in order to subsidise the valuable guarantees enjoyed by other holders.
Market Value Reduction (MVR or MVA)
An important and controversial feature of unitised policies is the ‘market value reduction’ (MVR), a discretionary adjustment for early surrenders at times of falling markets. The MVR aims to offset the difference between the ‘current’ or face value of a policy, as set out in the unit value on the annual statement, and its actual ‘asset share’, which may be lower at times of falling stockmarkets.
Asset Share
The asset share is an important concept for with-profits. This is equal to total premiums paid, less expenses, tax and other charges, increased by the rate of investment return achieved.
The asset share may be determined for specimen samples of policies and the result applied to groups of policies for which it is considered appropriate.
The Actuarial Profession, in its February 2007 Briefing Note on with-profits endowment payouts, says that asset shares are ‘the main tool insurers use to establish the fair maturity value of a policy’. At maturity, where the asset share is larger than the face value of the policy, ‘the insurer will determine a rate of final bonus which will largely make up the difference’. If the asset share is less that the face value of the policy at maturity, the insurer will make up the difference by drawing on assets, which it holds for this purpose. The report adds, ‘Generally, no market value reduction (MVR) can be applied at maturity.
Bonuses
Bonuses depend on profits yet to be earned and decisions by the Insurance Company Board as to their distribution. The amount, if any, of any bonus addition to a With Profits policy cannot be predicted in advance. The Interim bonus rate can change at any time.
Bonuses are a way for the insurer to add investment growth to a policy.
Typically, there are two types of bonus: the annual bonus (which may also be called a regular or reversionary bonus) and the final bonus (which may also be called the terminal bonus).
The amount of bonus, and whether a bonus is added at all, mainly depends on how well the investments in the fund have performed and how the insurer expects them to perform in the future. But instead of sharing out the profits the fund makes each year, insurance companies use a process called smoothing.
This means that they hold back some of the investment returns in good years and use it to top up bonuses in other years. This gives you some protection from poor market conditions, particularly if your policy matures in a year of low investment returns. But if investment returns are poor year after year, this can result in very low annual or final bonuses – or none at all.
Bonuses may not be added if investment returns are poor year after year or if there is a large market fall in one year followed by a slow recovery. But once any annual bonuses have been added they cannot be taken away, provided that you continue to meet the terms and conditions set out in your policy documents.
The payment of bonuses in the 1980s and 1990s were high relative to returns and reserves (up to 124% of asset share), in the UK, the cost of compensation payments for mis-selling personal pensions, increasing longevity, and the impact of annuity rate guarantees that were by now ‘in the money’, were some of the reasons why many funds were in a financially weak position when they entered the equity bear market of 2000-2002.
Solvency
To maintain solvency, in terms of the regulatory requirement to hold sufficient assets to meet guarantees, many funds sold equities when prices were historically low and bought bonds, when prices were historically high, leading to significant net losses for the fund. The allocation to equities typically fell from about 70% to 30%, while a minority of funds moved entirely into fixed interest. Annual bonuses fell, in some cases to zero.
The introduction by the FSA of capital requirements based on the ‘realistic balance sheet’ (RBS) in 2004, aimed to prevent insolvencies and appears to have been successful in this respect, helped by rising equity returns and bond yields.
Cazalet Consulting has provided evidence that with-profits policyholders’ capital is being used by providers to fund new business ventures, which are unlikely to be profitable and, therefore, which are not in the policyholders’ best interests. This is partly due to poor persistency rates and partly due to the fact that the initial commission paid to advisers is not recouped by the provider through the annual management charge before the commission clawback period is over. This, Cazalet Consulting argues, encourages advisers to churn policies after three or four years, creating a net loss to the provider.
Since the turn of the century, regular reports in the personal finance and trade press have suggested that customers could be suffering as a result of the significant changes in asset allocation associated with closed with-profits policies, which comprise the majority of policy types in closed funds and which are the main focus of our report. The personal finance press has argued that customers were, in effect, trapped because with-profits funds have the discretion to make a ‘market value reduction’ (MVR) to policy values where the policy is terminated early. In addition, the relatively weak financial strength of most closed funds means that they may be unable to improve bonus prospects in future.
This weakness is not only due to falling markets. The Actuarial Profession’s February 2007 briefing note on with-profits endowment payouts demonstrates that in the period 1984-2005 some insurers were making payouts at maturity well in excess – up to 124% - of the policyholder’s asset share. While this may have enabled providers to maintain league table positions at the time, the result is that reserves were depleted. This is a good example of management decisions that benefit earlier generations of policyholders at the expense of current and future policyholders.
Conclusion
With-profits are not simple products to understand. Even though the concept of a smoothed investment product is relatively straightforward, how it operates in practice is still difficult for policyholders to comprehend.
Concerns, in particular, over the complexity and opacity of the products, and a lack of consumer understanding of the risks attached, have grown against the backdrop of several major problems in the life industry including pension mis-selling, the performance of mortgage endowment products and controversy over the ownership and attribution of inherited estates. The problems experienced by Equitable Life have thrown these concerns into even sharper focus.
Whilst the theory behind with-profits may make sense, ie you pay money into the policy where it is pooled with the premiums of your fellow policyholders and invested in a mixture of equities, property and lower-risk investments, such as gilts. The with-profits fund is then supposed to protect you from falls in the stockmarket by smoothing out investment returns. Rather than allowing the fund to grow as an ordinary stockmarket investment would, it pays bonuses - holding back some of the returns in good years, so that it can still pay out in leaner years.
Such qualities made these funds particularly attractive to people who wanted to produce either a lump sum at a known date in the future - principally endowments- or to provide an income, along with the possibility of growth.
The fact is that the idea worked better in theory than in practice - a number of companies made fatal mistakes, such as investing too heavily in the stockmarket[FONT="],[/FONT] paying too much out in bonuses or in the case of Equitable life offering crazy contractual guarantees when a lot of your clients were lawyers.
When the stockmarkets fell, triggered by the dramatic collapse of over-hyped technology stocks, many with-profits funds found themselves in dire straits, from which many have never recovered.
In addition, the new cautious investment strategies (in part imposed by regulation) that have since been adopted mean that many funds have not benefited from the rebound in the markets seen since March 2003. In the UK, between 2000 and 2004 life offices sold £100bn of equities.
The imposition of market value reductions led to thousands of angry consumers making complaints that the risks were not properly explained to them.
It is impossible to make generalisations and dangerous to focus purely on the stated bonus levels. In fact guaranteeing to pay bonuses can weaken the long-term prospectsof a with profits fund, which is why policyholders need to delve a little deeper into the make-up of a specific fund rather than making a snap judgement based purely on a pay-out.
The guarantees that were promised at maturity may no longer apply. Guarantees can be very valuable so before ending a policy early you should check whether your policy includes any of these. If it does, consider whether these are so valuable that you would be better off keeping the policy.
If investment returns have been low the insurer may also apply a market value reduction or adjustment (MVR or MVA) to ensure you do not leave the fund with more than your fair share of its assets. This is to protect policyholders who remain in the fund, but it may mean that you receive less than you expect.
If you decide to end your policy early, and if your policy includes some life cover, you will lose that protection. So you should think carefully about any security you need to provide for your family. If you still need life cover find out how much it will cost to replace it; the cost of taking out life cover can go up as you get older, and if your health situation has changed, a new insurance company may charge you more to replace your life cover.
Some pension policies have a guaranteed annuity rate (GAR). This means that when you retire the insurance company will pay your pension at a particular rate, which may be much higher than the rates available in the market when you retire. GARs only normally apply on a particular date, normally your expected retirement date, which would have been specified when you took out your policy. If you retire before or after this date you may lose this guarantee.
Some polices may also have MVR-free dates when you can end your policy early without paying the MVR. These dates are often at particular points, like five or ten years after you started the policy, or at a particular retirement age. Your insurer should tell you when these apply.
I have been extremely surprised to see posts discussing recommendations to buy With Profits investment bonds given the huge body of experience from the UK following the spectacular fall from grace of these contracts. I have therefore researched the following by way of an analysis of some of the key issues. This perspective is guided largely by experience from the UK. I personally have much experience of advising clients with this type of contract.
Warning to existing investors: Generalised advice offered on a one-size fits all basis to with-profits policyholders may, at worst, result in individual policyholders making the wrong choice given their particular circumstances. Before making any decisions regarding an existing contract, you should always seek competent, qualified, professional advice
That said, I believe that it is essential that consumers have sufficient information available to them to at least ask the right questions
In order to appreciate the complexity of with-profits policies and the challenges they present to the investor, it may be helpful to know a little about their history.
Background
Briefly, with-profits policies were the main retail investment in the UK until the early 1990s. At the end of 2001, the estimated capital value of with-profits funds was £385bn.
Coincidently, initial commissions of up to 7% were available to advisers selling these contracts often with no initial charges or bid-offer spreads being paid by the client and a first year bonus rate of 8% net of starting rate tax.
Although they aimed to offer the inexperienced and more cautious investor significant exposure to growth assets, such as equities and property, but with returns that were ‘smoothed’ to reduce year-on-year volatility, it should be clear that much of the popularity of these investments was down to the relatively easy sell to a cautious saver with their money on deposit looking for a better return than a traditional cash deposit combined with the high commissions on offer.
Indeed many of the UK Banks and Building Societies employed large salesforces who sold these investments to their savings clients.
Opaque – profits at the discretion of an appointed actuary
An important function of the with-profits ‘appointed actuary’ is to decide what proportion of the investment return to withhold in years of rising markets in order to maintain an attractive return when markets were falling. This smoothing mechanism was – and still is – largely discretionary for most funds. Even where companies have prescribed their smoothing mechanism in the PPFM, they reserve the right to change this if circumstances dictate.
There is much evidence of Insurance Companies setting bonus rates (especially first year headline rates) with reference to the marketing department rather than the prudent interests of the policyholders.
Asset Mix
Typically, until the turn of the century, funds invested about 70% in equities and property (the equity backing ratio), with the balance in fixed interest assets and cash.
Funds that are mostly invested in equities have the potential to produce far greater returnsthan those that are more heavily exposed to bonds, but obviously come with a higher level of risk.
The asset allocation of with-profits funds should be the focus of reviews by advisers as changes may mean the current mix is not what either they or the client may anticipate.
Money from all with-profits policyholders is combined, or pooled, into a with-profits fund. The insurance company uses the money in this fund to invest in different types of assets, normally shares, commercial property, gilts, corporate bonds and cash deposits.
Different insurance companies invest different amounts in each type of asset; some have mainly gilts and corporate bonds, others have more shares or property.
A question of trust
The type of customers targeted by providers and advisers bought on trust, on the assumption that the policy would meet their long-term investment objectives for mortgages, pensions and other savings purposes, while at the same time smoothing year-on-year volatility. It is fair to say that very few customers really understood how the product worked.
By 2007, new with-profits business levels had fallen dramatically, even for the small number of companies that were still actively marketing and selling bonds. According to Cazalet Consulting, the majority of funds now have negative cash flow – that is, claims (maturity, death, early surrender) are greater than inflows from premiums.
For most providers, therefore, it appears that the with-profits fund is, in effect, in run-off even if is not formally closed to new business.
In the late 1980s and early 1990s most life offices replaced their conventional with-profits policies with the ‘unitised’ version, which aimed to make charges more transparent through the introduction of an annual management charge (AMC). The payout from a unitised policy comprises the value of units plus a final bonus, which is discretionary.
Factors to consider:
Financial strength of a fund and whether any guarantees are in place
A significant exposure to liabilities reduces a fund's financial strength and that has two implicationsfor investors. The need for these funds to hold reserves in low-risk investments in order to cover the guarantees reduces the fund managers' freedom to make pure investment decisions. Also, when these weaker funds generate investment returns, there's an increased risk that some categories of policyholder will have some of those returns withheld from them in order to subsidise the valuable guarantees enjoyed by other holders.
Market Value Reduction (MVR or MVA)
An important and controversial feature of unitised policies is the ‘market value reduction’ (MVR), a discretionary adjustment for early surrenders at times of falling markets. The MVR aims to offset the difference between the ‘current’ or face value of a policy, as set out in the unit value on the annual statement, and its actual ‘asset share’, which may be lower at times of falling stockmarkets.
Asset Share
The asset share is an important concept for with-profits. This is equal to total premiums paid, less expenses, tax and other charges, increased by the rate of investment return achieved.
The asset share may be determined for specimen samples of policies and the result applied to groups of policies for which it is considered appropriate.
The Actuarial Profession, in its February 2007 Briefing Note on with-profits endowment payouts, says that asset shares are ‘the main tool insurers use to establish the fair maturity value of a policy’. At maturity, where the asset share is larger than the face value of the policy, ‘the insurer will determine a rate of final bonus which will largely make up the difference’. If the asset share is less that the face value of the policy at maturity, the insurer will make up the difference by drawing on assets, which it holds for this purpose. The report adds, ‘Generally, no market value reduction (MVR) can be applied at maturity.
Bonuses
Bonuses depend on profits yet to be earned and decisions by the Insurance Company Board as to their distribution. The amount, if any, of any bonus addition to a With Profits policy cannot be predicted in advance. The Interim bonus rate can change at any time.
Bonuses are a way for the insurer to add investment growth to a policy.
Typically, there are two types of bonus: the annual bonus (which may also be called a regular or reversionary bonus) and the final bonus (which may also be called the terminal bonus).
- Annual bonus
Once a year (or more regularly) the insurance company will decide the amount of annual bonus it will add to a policy – the way in which these bonuses are added will vary depending on your policy. Insurers do not have to add a bonus each year. But once an annual bonus has been added it cannot be taken away – provided that you continue to meet the terms and conditions set out in your policy documents. If you decide to cash in your policy early you may lose any annual bonuses that have been added.
- Final bonus
A final bonus is calculated when your policy matures and it is used to top up the value of your policy so you get your fair share of the with-profits fund. If you decide to cash in your policy early you may also receive a final bonus, but it is likely to be less than the bonus you would receive if you kept your policy to maturity.
The amount of bonus, and whether a bonus is added at all, mainly depends on how well the investments in the fund have performed and how the insurer expects them to perform in the future. But instead of sharing out the profits the fund makes each year, insurance companies use a process called smoothing.
This means that they hold back some of the investment returns in good years and use it to top up bonuses in other years. This gives you some protection from poor market conditions, particularly if your policy matures in a year of low investment returns. But if investment returns are poor year after year, this can result in very low annual or final bonuses – or none at all.
Bonuses may not be added if investment returns are poor year after year or if there is a large market fall in one year followed by a slow recovery. But once any annual bonuses have been added they cannot be taken away, provided that you continue to meet the terms and conditions set out in your policy documents.
The payment of bonuses in the 1980s and 1990s were high relative to returns and reserves (up to 124% of asset share), in the UK, the cost of compensation payments for mis-selling personal pensions, increasing longevity, and the impact of annuity rate guarantees that were by now ‘in the money’, were some of the reasons why many funds were in a financially weak position when they entered the equity bear market of 2000-2002.
Solvency
To maintain solvency, in terms of the regulatory requirement to hold sufficient assets to meet guarantees, many funds sold equities when prices were historically low and bought bonds, when prices were historically high, leading to significant net losses for the fund. The allocation to equities typically fell from about 70% to 30%, while a minority of funds moved entirely into fixed interest. Annual bonuses fell, in some cases to zero.
The introduction by the FSA of capital requirements based on the ‘realistic balance sheet’ (RBS) in 2004, aimed to prevent insolvencies and appears to have been successful in this respect, helped by rising equity returns and bond yields.
Cazalet Consulting has provided evidence that with-profits policyholders’ capital is being used by providers to fund new business ventures, which are unlikely to be profitable and, therefore, which are not in the policyholders’ best interests. This is partly due to poor persistency rates and partly due to the fact that the initial commission paid to advisers is not recouped by the provider through the annual management charge before the commission clawback period is over. This, Cazalet Consulting argues, encourages advisers to churn policies after three or four years, creating a net loss to the provider.
Since the turn of the century, regular reports in the personal finance and trade press have suggested that customers could be suffering as a result of the significant changes in asset allocation associated with closed with-profits policies, which comprise the majority of policy types in closed funds and which are the main focus of our report. The personal finance press has argued that customers were, in effect, trapped because with-profits funds have the discretion to make a ‘market value reduction’ (MVR) to policy values where the policy is terminated early. In addition, the relatively weak financial strength of most closed funds means that they may be unable to improve bonus prospects in future.
This weakness is not only due to falling markets. The Actuarial Profession’s February 2007 briefing note on with-profits endowment payouts demonstrates that in the period 1984-2005 some insurers were making payouts at maturity well in excess – up to 124% - of the policyholder’s asset share. While this may have enabled providers to maintain league table positions at the time, the result is that reserves were depleted. This is a good example of management decisions that benefit earlier generations of policyholders at the expense of current and future policyholders.
Conclusion
With-profits are not simple products to understand. Even though the concept of a smoothed investment product is relatively straightforward, how it operates in practice is still difficult for policyholders to comprehend.
Concerns, in particular, over the complexity and opacity of the products, and a lack of consumer understanding of the risks attached, have grown against the backdrop of several major problems in the life industry including pension mis-selling, the performance of mortgage endowment products and controversy over the ownership and attribution of inherited estates. The problems experienced by Equitable Life have thrown these concerns into even sharper focus.
Whilst the theory behind with-profits may make sense, ie you pay money into the policy where it is pooled with the premiums of your fellow policyholders and invested in a mixture of equities, property and lower-risk investments, such as gilts. The with-profits fund is then supposed to protect you from falls in the stockmarket by smoothing out investment returns. Rather than allowing the fund to grow as an ordinary stockmarket investment would, it pays bonuses - holding back some of the returns in good years, so that it can still pay out in leaner years.
Such qualities made these funds particularly attractive to people who wanted to produce either a lump sum at a known date in the future - principally endowments- or to provide an income, along with the possibility of growth.
The fact is that the idea worked better in theory than in practice - a number of companies made fatal mistakes, such as investing too heavily in the stockmarket[FONT="],[/FONT] paying too much out in bonuses or in the case of Equitable life offering crazy contractual guarantees when a lot of your clients were lawyers.
When the stockmarkets fell, triggered by the dramatic collapse of over-hyped technology stocks, many with-profits funds found themselves in dire straits, from which many have never recovered.
In addition, the new cautious investment strategies (in part imposed by regulation) that have since been adopted mean that many funds have not benefited from the rebound in the markets seen since March 2003. In the UK, between 2000 and 2004 life offices sold £100bn of equities.
The imposition of market value reductions led to thousands of angry consumers making complaints that the risks were not properly explained to them.
It is impossible to make generalisations and dangerous to focus purely on the stated bonus levels. In fact guaranteeing to pay bonuses can weaken the long-term prospectsof a with profits fund, which is why policyholders need to delve a little deeper into the make-up of a specific fund rather than making a snap judgement based purely on a pay-out.
The guarantees that were promised at maturity may no longer apply. Guarantees can be very valuable so before ending a policy early you should check whether your policy includes any of these. If it does, consider whether these are so valuable that you would be better off keeping the policy.
If investment returns have been low the insurer may also apply a market value reduction or adjustment (MVR or MVA) to ensure you do not leave the fund with more than your fair share of its assets. This is to protect policyholders who remain in the fund, but it may mean that you receive less than you expect.
If you decide to end your policy early, and if your policy includes some life cover, you will lose that protection. So you should think carefully about any security you need to provide for your family. If you still need life cover find out how much it will cost to replace it; the cost of taking out life cover can go up as you get older, and if your health situation has changed, a new insurance company may charge you more to replace your life cover.
Some pension policies have a guaranteed annuity rate (GAR). This means that when you retire the insurance company will pay your pension at a particular rate, which may be much higher than the rates available in the market when you retire. GARs only normally apply on a particular date, normally your expected retirement date, which would have been specified when you took out your policy. If you retire before or after this date you may lose this guarantee.
Some polices may also have MVR-free dates when you can end your policy early without paying the MVR. These dates are often at particular points, like five or ten years after you started the policy, or at a particular retirement age. Your insurer should tell you when these apply.
