Mixed bag of 'with profits' investments
The perhaps misnamed "with-profits" bonus season is upon us.
At this time of year, insurers update us as to how their funds are doing and what, if any, bonuses are being added to policies.
So far Zurich, Standard Life, Aviva and Friends Life have made their announcements; Prudential and Legal and General are yet to come.
The picture emerging is that 2011 was the year to be in safe assets, with more conservative funds coming out on top, though - looking towards the long-term - their investment strategy is questionable.
With-profits plans were the popular investment destination of their day but their reputation has been extensively damaged by a combination of mismanagement, mis-selling and misadventure.
Mismanagement came in the form of the near collapse of Equitable Life and the subsequent 10-year struggle for its members to gain compensation.
Mis-selling of mortgage endowments prompted the Financial Services Authority (FSA) to issue numerous high-profile fines and gave rise to a swathe of compensation claims.
And misadventure is perhaps a generous description of with-profits providers' gung-ho approach to issuing bonuses in the 1990s.
Despite all of this, there is still about £330bn invested in with-profits funds, spread across 25 million policies, so an astonishing proportion of people in the UK have one of these plans.
A huge number of these policies will mature over the next 10 years as policies reach their 25th anniversary from the with-profits selling spree of the late 1980s and 1990s.
Many policyholders will no doubt be disappointed with their final payout, though some funds have fared better than others.
Money Management magazine compiles a regular survey of payouts which gives us a snapshot of how these funds compare.
Last April's edition shows the payouts on 25-year endowment plans. Eight providers actually failed to beat the payout from Equitable Life, whose investors are currently receiving compensation for their with-profits investment.
The worst offender was National Provident Life (now part of the Phoenix Group), whose fund grew at a paltry rate of 3.3% a year for 25 years. A well drilled mattress might have given them a run for their money.
Some funds did better, of the mainstream providers Prudential and LV= are probably worthy of note.
There is in reality a myriad of different returns provided to with-profits investors because these plans come in a lot of different shapes and sizes.
Standard Life, for instance, has seven different with-profits pools. The most conservative of these has only 17% invested in shares, the most aggressive has 57%, so these funds perform very differently to each other.
To add to the complexity of the picture, these funds were sold in a wide variety of different "wrappers": mortgage endowment plans, pension plans, life insurance plans and single premium bonds.
The central theme which ties all these various strands together is, in principle, an attractive one. The insurance company pools everybody's money together, invests it in the stock market, and each year adds a steady annual bonus to investors' policies.
Seeing as the stock market goes up and down, the insurance company holds backs profits in the good years to pay out profits in the bad years, a magical process known as smoothing. Unfortunately, the reality experienced by many policyholders has been far removed from this rosy utopia. Annual bonus rates have gradually been cut, with many policies now not offering them at all.
Why has an investment which sounds so appealing fallen on such hard times?
Here comes the misadventure, or if you were feeling less generous, the imprudence on the part of insurers.
With-profits providers entered into an arms race in the 1990s, offering investors higher and higher bonuses to try and get to the top of the best-buy tables.
This was probably quite good for you if you were a policyholder early on. Indeed, a report from the actuarial profession shows that throughout the 1990s and early 2000s, insurers were consistently paying out more to policyholders with maturing plans than their fair share of returns.
For example 25-year endowment policies maturing in 2001 paid out on average 24% more than the fair value of the policy based on the investment returns made.
Unfortunately, to pay Paul you have to rob Peter. These extra payouts were predicated on achieving more investment growth than was actually experienced in the lean years to follow.
With hindsight, insurers should have been building up a war chest during these boom times to see policyholders through the difficult investment environment that was to follow.
Unfortunately they entered the last decade with low coffers and high expectations, only to be faced with the bear market of 2000 to 2003 when stock prices plummeted and many "with profits" policyholders were faced for the first time with the dreaded MVR (Market Value Reduction), which cut the value of your policy if you wished to transfer away.
At the same time, the FSA got tough with the insurance companies in the wake of the Equitable Life disaster and imposed stricter requirements on the investments that insurers had to hold to make good the promises they had made to with-profits policyholders.
The result was with-profits funds reduced the amount they invested in shares, and moved into safer bonds and gilts instead.
If you look under the bonnet of a with-profits fund now, chances are you will not find too many shares. Which does beg the question: what is the point of a fund which smoothes the ups and downs of the stock market when it is hardly invested in it?
Policyholders do not have an easy choice to make, because with-profits can be a complicated business.
Each policy has its own terms, so policyholders need to check details of their individual plan before coming to any decision on whether to continue with it.
Some plans do have valuable guarantees attached to them which are lost if the plan is surrendered. Many funds have cut their exposure to shares drastically, preferring to invest in gilts and bonds.
Investors close to the maturity of their policy generally have less to gain from transferring, and might find the investment mix of these more conservative with-profits funds appropriate to their needs. Longer-term investors should probably question whether they should be invested in a fund which has more exposure to shares and less exposure to gilts and bonds.
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