With-profits policies

With-profits policies were once the mainstay of investors’ portfolios, sold widely by life insurance companies and financial advisers. But widespread misselling in the late 1980s and early 1990s severely damaged the reputation of with-profits. What little credibility these investment policies had left was further hit by the sustained bear market of 2000-2003 which dragged down bonuses and forced providers to hikeraise their exit charges. It should come as little surprise that with-profits business has dwindled to a trickle in recent years.

What are with-profits?

With-profits are savings schemes often sold as part of a pension wrapper or as the repayment vehicle alongside a mortgage. With-profits funds invest in a broad range of assets from stocks and shares to property. They seek to provide a steady annual return, holding back some money in good years so that they can continue to pay out bonuses in the bad years.

How do they work?

Money invested in with-profits policies is pooled with other policyholders and invested into a fund with a broad mixture of equities, property and lower-risk investments such as government bonds (gilts). The concept is to smooth out the rises and falls in the stock market for the benefit of the investor.

Why were they so popular?

Although these funds are quite complicated, they were popular Because they offered the benefits of stock market investment without exposing investors to the volatility of the stock market. But part of their popularity was also down to the high commissions these policies paid to advisers. An adviser typically received upfront commissions greater than the total of the money paid in by the investor in the first year.

What went wrong?

Quite a lot. Probably the biggest problem was the complicated methodology that life insurers adopted to determine bonuses. This was opaque to private investors and often it took complicated calculations to compare returns on different policies.

In addition, annual bonuses started falling in the 1990s but, even so, many companies still found their funds depleted following the stock market downturn and subsequently cut their payouts even further. Stricter solvency requirements introduced by regulators also forced many companies to reduce the equity content of their funds, unfortunately just before a rebound in markets. The proportion of funds invested in shares has fallen from two-thirds in 1999 to around 30 per cent today. Lower exposure to equities means these funds will benefit less from any upturn in markets and will find it tough to deliver decent growth going forward.

At the same time, life insurers increased exit penalties – known in the trade as “market value adjusters” – meaning that people who cashed in their policies before the set maturity date often got much less than they had expected.

Any other controversy surrounding these funds?

I’m afraid so. Some of the money tied up in with-profits funds has been taken out by the companies running them to pay for other things. In extreme cases, some life insurers raided surplus assetsin their funds that were built up during the good years to pay for the costs of compensating for pensions misselling.

Some life insurers also had significant money tied up in so-called “orphan assets”, surplus cash that was built up mainly from underpayment of returns to previous generations of policyholders. As a general rule surplus assets should be allocated on the ratio of 90 per cent to policyholders and 10 per cent to shareholders. But some companies such as Axa succeeded in negotiating separate deals which allowed them to take a much larger slice of these surpluses.

So how are bonuses allocated?

Each year the insurance company values the fund and then decides what bonuses to pay out. Companies tend to pay annual bonuses set each year – also known as reversionary bonuses – which, provided you hold the policy to maturity, cannot be taken away. Cash in your policy before maturity, however, and these bonuses can be clawed back.

These bonuses are normally added to a basic “sum assured” – an amount determined when you take out the policy. This is also guaranteed provided you hold your policy to maturity.

The final element is a terminal or maturity bonus. If the underlying fund has performed strongly this bonus can account for a large part of the overall payout, although of course the converse is also true.

What does the future hold for bonus rates?

Before 2000, regular bonuses were typically between 6 and 8 per cent. Today they are less than 4 per cent. Whether this continues will depend on what investment returns are achieved on individual funds. But because many funds now have a lower exposure to stocks and shares and property, the long-term returns are likely to be lower than in the past.

However returns are likely to vary in the future more than in the past. This is because some life assurers with larger financial reserves in their with-profits funds such as Liverpool Victoria, Wesleyan or Prudential can invest more heavily in volatile assetssuch as property or stocks and shares where potential returns are higher.