Chapter 7 With Profits Funds

A unitized with profits fund is similar to a unit-linked fund except that the insurance company uses its reserves to smooth out the returns and to guarantee your investment if you hold it to maturity.

At the end of the period, you may get a terminal bonus on top of the annual bonuses.

These funds grow tax free, but a 23% tax is applied on the growth when you cash the policy.

The regular savings versions of with profits funds are discussed in Chapter 9

(Old style with profits funds were not unit linked. These products are no longer sold. What you should do with an existing one is dealt with in the Appendix to this chapter)

WITH PROFITS FUNDS compared with UNIT LINKED FUNDS

With profits funds are usually guaranteed.
Most with profits funds are guaranteed. If you keep your investment until the maturity date, the life company guarantees to pay you back the amount invested plus any bonuses declared. Even if you cash it before the maturity date, you should get your original investment less any charges plus the bonuses.

By comparison, unit linked funds go up and down with the stockmarket. If the stockmarket crashes just before you cash your investment, you will lose out.

The returns on unit linked funds will be higher in the long run
In order to be able to provide this guarantee, the with profits funds have only 60% of their assets in the stockmarket. The balance is in the gilts and cash which are less volatile. Consequently your return is likely to be lower in the long term than a unit linked fund which is invested 100% in equities.

Unit Linked Funds are much more flexible
With profits bonds usually have a fixed maturity date e.g. 10 years. If you cash it before the 10 years is up, you won't get the terminal bonus which further reduces your return. Even if you don't need your money at the maturity date, you must cash it and reinvest it, thus facing all the initial charges again.

Unit linked funds are open ended. You can cash them whenever you want without penalty, apart from exit charges where applicable.

Unit Linked funds are much clearer
You always know how well or badly your unit linked fund is doing. All you know about your with profits fund is how much the minimum value is. Until it matures, you won't know what terminal bonus you are likely to get.

However, it could be argued, that you won't know the value of a unit linked fund either until you cash it. It might be worth £10,000 today and by the time you cash it next week it might drop to £9000.

Market Value Adjustments = Early Exit Penalties
During 2001 and 2002, most with profits funds introduced Market Value Adjustments which is another name for Early Exit Penalties. The big selling point of with profits bonds was that the reserves of the company were used to smooth out the returns in bad years. But, now after only a few bad years, the companies have announced MVAs for anyone who cashes their policy before the maturity date. These tend to be around 10%. They have made with profits bonds much less attractive.

The Outlook for Bonus Rates
With profits bonds are currently paying annual bonuses of 5%. Many commentators have queried whether this is sustainable in the longer term. Companies are dipping into their reserves to maintain these rates. Terminal bonuses now look a lot less likely.

PRODUCT RECOMMENDATION - The Standard Life With Profits Bond

If you decide you want a with profits bond, we recommend the Standard Life With Profits Bond as the best available. Don't buy it from the company directly. Go to one of the discount brokers who will refund you some of the commission.

It is similar to other bonds in that Standard Life uses its reserves to smooth out the returns of the stockmarket. In years when the stockmarket declines, you will still see your with profits bond growing.

But it is different in that it has done away with the terminal bonus. Instead it declares higher annual bonuses. The advantage to you is that you will know exactly how your investment is doing and if you cash it early you will get a much fairer share of the returns.

It is different in that it has also done away with the guarantee. The company reserves the right to reduce the unit value in exceptional circumstances. Two things have to happen - the stockmarket has to go into a prolonged decline. Not just a stockmarket crash, but many years of declining stockmarket prices. Secondly, a lot of policyholders have to cash in their policies. Standard Life has huge reserves, so it seems very unlikely that unit values will ever be reduced. I think this is as likely as one of the major Irish banks getting into financial difficulties. In other words, it is not impossible, just highly unlikely.

Because they have done away with the guarantee, they can afford to invest up to 90% of the fund in the stockmarket which should result in much higher long term returns.

It is open ended - you can cash it whenever you like. However, if you cash it in the first year you pay an early exit penalty of 5%; this reduces by 1% a year, so that if you leave it for 5 years, there are no exit penalties. With a traditional policy, you have to find a new home for your money when the 10 years is up.

APPENDIX 7 WHAT TO DO WITH A CONVENTIONAL WITH PROFITS ENDOWMENT POLICY

Up to about 1998, most with profits policies were not unitized. These were even more complex and obscure. When you started saving you were given a very small guaranteed figure which bore no obvious relationship with anything. Each year, an annual or reversionary bonus was added to this figure. You get a statement telling you what the accumulated guaranteed figure is - but it also tells you that this is not the cash in value of the policy today. You had absolutely no idea of what it would be worth until it matures.

If you try to cash the policy early, you will get a ridiculously low quote from the insurance company. This is because such a high proportion of the return comes in the form of a terminal bonus. To get the maximum value of these products, you must try to maintain the agreed level of contributions right up to the very end.

However, if your premium is increasing every year, stop the increase. This should not affect the value of the policy disproportionately.

If you cannot afford to continue contributing, then make the policy paid up. You will still get a terminal bonus when the policy matures, but unfortunately, it is not possible to estimate what it will be. This is because the calculation of terminal bonuses is so obscure.

If you absolutely have to get your hands on the cash, go to one of the specialist companies who will buy the policy from you. These offer much better value than the insurance company's cash value. Try the Endowment Purchasing company on 01 or ……

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