Client guide
With profits funds
With profits: How they work and why they should be avoided
The with-profits concept has traditionally been sold as a way to get better than bank deposit rates of
return for minimal risk1. Unfortunately the risk is not somehow ‘magic-ed away’. It is just hidden
from view by the smoke-and-mirrors way in which with-profits funds work.
This worked quite well when the majority of money invested in with-profits was via regular premium
plans and the outflows of money could be predicted easily. However, from the mid-1990s large sums
were invested in with-profits bonds. Now the proportion of with-profits funds that can be withdrawn
at any one time is much larger and more unpredictable.
The 2000 to 2003 downturn in worldwide markets for company shares revealed the weakness of this
business model. Investors rushed to cash in their “guaranteed” fund values and forced the insurance
companies to sell company shares at the bottom of the market.
By 2003 Financial Services Authority reforms had pulled back the curtain on the inner workings of
these funds and revealed a bunch of actuaries furiously trying to hide the true extent of their losses by
counting future profits as assets.2
How a With Profits fund works
In theory the with-profits concept is simple and compelling. The devil is in the detail.
Smoothing
‘Smoothing’ is a process used to cushion the with-profits bond investor from the cold realities of stock
market investment. The returns from with-profits funds are passed to the investor through different
‘bonuses’. When the markets are doing well some of the fund’s gains are passed onto policyholders
and some of these gains are held back so that they can be used to pay bonuses when markets fall.
Annual bonuses
Annual bonus rates are usually declared at the start of a year. The annual bonus rate is ‘guaranteed’ in
the sense that once it is added to the unit price of a with-profits fund it cannot be removed. In practice,
applying a Market Value Reducer can reduce the benefit of this ‘guarantee’. Sometimes life companies
declare an interim bonus during the year.
Annual bonus rates have fallen dramatically over recent years. For example the Prudential declared a
9% annual bonus on their with-profits bond in 1991.3 By 2007 this was reduced to 3.25%.4 This fall
largely reflects the fall in nominal5 investment growth rates as inflation has fallen. As the annual
bonus is a guarantee, more bonuses mean more liabilities for the company to fund. So, some withprofits funds have declared an annual bonus rate of 0% to limit these liabilities.
1 Sandler, R.; “Review of Medium and Long-term retail savings in the UK”; July 2002, section 6.52, p121
2 O’Brien, C.; Nottingham University Business School; “Life Insurer’s Financial Strength: Life insurance companies’ returns to
Financial Services Authority (end-2002) a preliminary survey”, May 2003. Results showed 16 out of 20 companies used
future profits to increase their free assets ratio (a measure of financial strength).
3 Money Management magazine; With Profit Bonds Survey; December 2002
4 Prudential press release, 10/12/2006. This will be the 5th year in a row they have held the annual bonus at this rate
despite the almost doubling of the FTSE100 since March 2003. So, we see that even with a ‘good’ with-profits fund the
‘guaranteed’ investment return has been less than cash deposits in recent years.
5 That is, before inflation is taken into account. In the long-term, investment growth rates are linked to inflation.
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Market value reductions
reductions (MVRs)
These negative bonuses used to be called Market Value Adjusters until it was pointed out they were
only ever used to reduce policy values. The MVR reflects the true performance of the fund’s
underlying assets. For example, a policy fund value may be £10,000 – this is the value of the policy
with annual bonuses attached. However, the surrender value may be £9,000 reflecting the ‘fair’ value
of the underlying assets. This is an MVR of 10%.
MVRs are seen as an additional surrender penalty by investors who want to encash their bonds. But
MVRs also protect investors who stay invested and are applied so investors who encash their bonds
are not disadvantaging remaining investors by taking more from their fund than they are entitled to.
Value
Example of when an MVR will apply at encashment
MVR
Time
Market return
Underlying asset return
With Profit policy value
MVRs are policy specific and depend on how much is being encashed and how long the policy has been
in force. The insurance company will take into consideration investment and bonus histories in the
MVR. The MVR will fluctuate depending on the underlying value of the fund. So investors will never
know the exact MVR applied until they switch out of the with-profits fund or encash the investment.
Early encashment (or exit) charges
Many people get MVRs and early encashment (or exit) penalties confused. This is not difficult when
surrender values include both, normally without an explanation of the split between them.
An MVR is applied at the level of the with-profits fund. An early exit penalty is applied at the level of
the contract itself. For example, if the investor switched from the with-profits to the cash fund within
an insurance bond, a MVR might apply but the exit penalty would not. But if the investor encashes the
insurance bond in its entirety, both charges may be applied.
Life insurance companies are good at giving with one hand and then taking away with another. This is
true of the relationship between insurance bond allocation rates6 and early penalties. A high
allocation rate is normally accompanied by high exit penalty in the early years.
Terminal bonuses
A terminal bonus is an amount added to your policy to reflect the positive performance of the
underlying assets, when you take your money from the fund. Terminal bonuses are not guaranteed.
They can be added and taken away at the life companies’ discretion.
6 For example if £100,000 was invested in an insurance bond with an allocation rate of 105%, the fund value (but not transfer
value) would be £105,000 on day 1.
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Example of when terminal bonuses will apply at encashment
Value
Terminal bonus
Time
Market return
Underlying asset return
With Profit policy value
MVRMVR-free dates
MVR free clauses allow investors to access their funds without an MVR applying on specified dates.
You should check your policy documents, or contact the life company directly to check this.
E xa m p le o f a n M V R fre e g u a ra n te e
M V R f re e d ate = gu a ra n te ed p a yo u t of W ith P rofit p olicy v alu e
Value
X
MVR
T im e
M a rk e t retu rn
U n d e rly ing a sse t re tu rn
W ith P rofit p olicy v alu e
‘Conditional’ and ‘fair’ values
Much commentary on with-profits is about people suffering ‘losses’ because of the MVR levied on
surrender. When MVRs are high it is felt that this ‘traps’ investors into poor performing investments.
This will feel like a loss, because expectations have not been met. But the assets needed to pay the
fund value are not there in the underlying fund. The quoted ‘fund value’ is no longer a valid measure.
It is just a promise the provider may or may not deliver in the future. The term conditional value7 is
more appropriate as the value can only be accessed under certain conditions such as death or when
the client’s fair share is broadly similar to the conditional value.
The ‘fair’ value of the investment is the fund value less the MVR, excluding any separate encashment
penalty. There are legitimate concerns about whether or not MVRs are set at a fair level. The FSA
implemented measures to make this process fairer.
7
Miles Hendy of Thornbury Financial; “Box Clever”; Money Marketing; 21st October 2004
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Insurance and other complications
With-profits funds are at heart are insurance contracts. This introduces more complication when
deciding if a with-profits fund is a suitable investment.
With-profits policyholders exchange money for a contractual promise of benefits. The assets in the
fund belong to the insurer, not the policyholder. The legal position of a policyholder is similar to a
deposit account, where legal ownership of the money passes to a bank in exchange for a contractual
promise. For a deposit account, the contract is very clearly defined with the provider retaining very
little discretion and the payout is closely related to the amount invested. In contrast, the “promise”
contained in a with-profits contract is generally vague and not well defined. The return to the
policyholder can be heavily influenced by the company’s internal decisions and exercise of discretion8.
Most with-profits funds are either directly or indirectly subject to additional business risks of the
insurance company in addition to the investment risk of the fund itself:
•
Mis-selling compensation is normally borne by the insurer’s reserve fund and not policyholder
funds. But this affects policyholders indirectly. Pensions mis-selling compensation helped deplete
insurers’ reserves just as they were needed to counter the effects of the share market down turn.
•
Some companies write insurance polices from within their with-profits funds. If they make losses
as a result of people living too long (with annuities), or being too ill (for critical illness insurance);
the with-profits policyholders will bear a proportion of the losses.
•
Insurance company reserves are used as working capital for new ventures. For example, most
insurance companies have made a massive loss to date on stakeholder pensions, depriving withprofits policyholders the potential benefit of valuable reserves for the future.
Guaranteed Annuity Rates
Some old with profit pension policies contain Guaranteed Annuity Rates (GARs) which give the
policyholder the right to buy an annuity at a guaranteed rate. The rates are typically much higher than
those available on the open market today, so GARs can be a valuable benefit. PageRussell strongly
recommend you get independent financial advice before considering switch from a policy with GARs.
What went wrong with withwith-profits?
profits? CockCock-up; not conspiracy
There is no such thing as a free lunch in investment; but there is a relationship between risk and
reward. To generate returns greater than cash in the long term, with-profits funds have invested in a
combination of company shares (or equities), fixed interest investments, property as well as cash.
In the 1990s people were slow to believe low inflation was here to stay. Insurance companies were
slow to reduce their bonus rates to sustainable rates. They were influenced by a competitive market
for with-profits funds where investors and financial advisers judged funds on past annual bonus rates.
To deliver these high real returns9 with-profits funds invested greater proportions of their funds in
company shares. By 2000 a with-profits fund would typically consist of 60% company shares, 25%
fixed interest, 10 % property and 5% cash. This was a very different asset allocation from the1980s.
From 2000 worldwide company share markets fell three years in a row. With-profits providers found
that to meet liabilities to policyholders, such as MVR-free dates and declared annual bonuses, they had
to dip into their reserves. By late-2002 they were digging into their reserves to sustain returns.
Eventually many companies were forced to sell the equities within the funds and move more of the
funds’ assets into fixed interest in order to meet the funds’ liabilities10.
Sandler Review, July 2002
A real return is the growth rate after inflation is taken into account.
10 Insurance companies have to maintain a minimum solvency level and with-profits bonuses are part of the calculations.
8
9
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When company share markets recovered from 2003 to 2007 the funds did not significantly benefit
because they had sold their shares. Even worse, as interest rates increased throughout 2004 to 2006,
the prices of fixed interest investments fell, offsetting much of the gains made by the equities.
The next step some life companies were forced to take was to close their funds to new business. Doing
this meant they did not have the costs of writing new business (such as advertising and commissions),
or declaring competitive annual bonus rates.
Most insurance companies now operate closed funds, adding more complication to the advice process.
Additional complications for closed withwith-profits funds
Most with profits funds are closed to new business. The Financial Services Authority have been poor
at providing guidance on this subject, saying: “It is clear that the position of policyholders in closed
funds is much more complicated than first appears, making it extremely difficult, and in some respects
misleading, to generalise.”11 We think this is a cop-out.
A small number of with-profits funds have closed for reasons other than financial weakness and are
being run like normal open funds12. It is these funds that muddy the waters slightly.
It is possible to identify if a closed fund is being run out of strength for the benefit of the policyholders,
or out of weakness for the benefit of the insurance company’s solvency margin.13
The decision to close a with-profits fund is typically made to avoid the costs of taking on new business
and the extra liabilities of declaring competitive bonuses. The conclusions about closed with-profits
funds in the rest of this section refer to funds closed as a result of financial weakness.
Investment mix in closed funds
funds
Many closed funds are “de-risked”. They hold a low proportion of company shares and a high
proportion of fixed interest investments. The usual investment mix of a closed with-profits fund is
25% equities, 55% fixed interest, 15% property and 5% cash. This compares with roughly 45%
equities, 35% fixed interest, 15% property and 5% cash for a healthy fund open to new business.
Over the long term we can expect the returns from open with-profits funds to be greater than that of
closed funds. This is because, over the long-term, we expect equities to provide a greater return
(albeit with greater short-term volatility). This expectation is confirmed in the following table
showing the relative performance of open and closed funds14:
Proportion of funds in
top 25%
Proportion of funds in
bottom 25%
Open
Closed
(up to 1 year
ago)
Closed
(between 1 and
5 years ago)
Closed
(over 5
years ago)
33%
12%
16%
25%
15%
38%
35%
46%
Not all closed funds produce poor returns - but the odds aren’t good. We believe the results shown
here would be worse for closed funds if funds not closed out of financial weakness were excluded.
Financial Services Authority, ibid, page 3
The old Scottish Amicable mutual fund is an example: When Prudential bought Scottish Amicable in 1997 the old fund was
ring-fenced and a new fund opened for new business. While it is technically closed, the old fund is run like an open fund with
a similar investment mix and investment returns to the main Prudential with-profits fund. (Source: Prudential, PPFM, 2004).
13 The information contained in the Principles and Practices of Financial Management document published by each withprofits fund provider should be sufficient to identify this.
14 Financial Services Authority, ibid, page 12 (Original source, FSA annual with-profits payout survey).
11
12
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Running costs
The running costs and expenses charged to a with-profits fund can significantly affect the investment
growth that the policyholder enjoys.
The investment costs of ‘de-risked’ closed funds tend to be lower than an open fund, because it costs
more to trade equities than fixed interest securities. Also, some firms have reduced costs by outsourcing administration and investment management. However, over time the value of closed funds
declines as policyholders’ benefits run-off. At some point the fixed costs in running the fund are likely
to become a significant drag on the investment growth enjoyed by the policyholders.
On balance we suspect that, as closed funds are subject to less scrutiny, they are likely to have higher
charges, to the long-term detriment of their policyholders.15
Are the spoils shared fairly?
Because closed funds are not trying to attract new business, they have not been open about how they
are run. It is difficult to work out whether policyholders have been treated fairly or not. The Financial
Services Authority is active, but the providers have the advantage.
Tax
Studies have shown that closed with-profits funds suffer more tax than open funds.16
Consolidators
Consolidators
The life assurance sector has experience massive consolidation in the last 10 years and there is more
to come. This has seen most closed with-profits funds hovered up and merged. The Financial Services
Authority claims to look carefully at these deals to ensure policyholders are treated fairly.17 The
companies claim that combining several old funds will create greater efficiencies and financial
solvency leading to better returns for policyholders.
We are sceptical. These firms need to make significant returns.18 They see the future revenue stream
from the policy charges of their ‘captured’ policyholders19 as ‘embedded value’ for them to farm as
efficiently as possible. The odds are against policyholders receiving a fair return.
Customer service
Our firm’s experience is that it is harder to deal with closed rather than open life offices. Whilst, this is
not a direct cost to the policyholder, this needs to be born in mind.
Conclusion
There can be good reasons for staying invested in a closed with-profits fund such as tax, valuable
guarantees, or if the fund operates like an open fund. But, closed funds rarely re-open to new business
after they have been closed. If a fund closes, it is likely to be invested in low-risk low-return
investments during the run-off; and it will decrease in size so that fixed costs will become a drag on
returns. We believe these factors and others discussed above mean that if a with-profits fund closes
due to financial weakness future returns to policyholders will be lower than in open funds.
15 O’Brien, C; Nottingham University Business School; “Closed life funds: causes, consequences and issues”; December 2006;
showed the Maintenance Expense Rate is significantly higher in closed funds.
16 O’Brien, C; ibid; page 10.
17 Financial Services Authority, ibid, page 25
18 O’Brien, C; ibid; page 40; Resolution Life looks to achieve a 12% internal return of return after tax (which compares with
6% for the life assurances companies in general).
19 O’Brien, C; ibid; showed that, after an initial spike, the surrender rates from closed funds are very low.
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Is there any reliable way of choosing a future withwith-profits winner?
The quick answer is: No. This section helps explain why and what we do instead.
Past performance of the underlying fund
Despite all the advertising by the investment industry implying the contrary, the small print is correct:
past performance is not a guide to future investment returns. There is a lot of research to show this.20
Financial strength
‘Financial strength’ is a short hand term for the proportion of reserves a life assurance company has.
It’s commonly used to distinguish between different with-profits providers. In theory financially
stronger companies are able to invest more of their with-profits funds in higher-risk higher-return
investments. Over the long term we would expect stronger companies to provide greater benefits to
their with-profits policyholders. The problem is there is no hard evidence to back this theory up.21 22
Other indicators
There also appears to be no link between with-profits returns and past payouts, underlying
investment mix or costs.23
The problem is the only person who really knows what is going on in a with-profits fund is the actuary
who runs it. With-profits actuaries have so much discretion they can manipulate short-term payouts
to negate any of the effects that these indicators may have.
Conclusion: future prospects
By investing in with profits fund you are saying “Here’s my money, don’t tell me where it’s going, or
how it’s performing, and don’t tell me about all the costs.” In return you hope you’ve picked a winner
and when you need money, you will get the invested capital plus a reasonable amount of growth back.
The system has worked well for many people over the years. And to many people’s eyes all
investments have these characteristics. So why pick on with-profits? We have three main reasons:
WithWith-profits funds have changed
With-profits funds have changed. They are now very different investments to the with-profits funds of
the 1970s and 1980s.
WithWith-profits reforms may
may make things worse not better
There are currently a number of reforms to with-profits, and other factors affecting insurance
companies that, in our view will make the smoothing of benefits (which is the unique selling point of
with-profits) harder to deliver.
There are
are better alternatives
You don’t have to ‘invest and hope’. It is possible to deliver a more efficient investment experience
where the volatility of your portfolio can be largely controlled by the investor and linked to their
attitude to investment risk or their required rate of return.
20 Financial Services Authority, “OP9: Past Imperfect? The Performance of UK equity managed funds”; August 2000 is a good
summary of the various evidence.
21 Money Management magazine asked Chris O’Brien, director of the Centre for Risk and Insurance Studies at Nottingham
University Business School, to study the relationship between financial strength of the insurance company at the start of a
policy and overall returns. He found that there is no link. (Source: Hinnings, J.; “Is it all a façade?”, Money Management,
August 2003).
22 The business consultant Stuart Fowler carried out a similar study and found no link. (Source: Fowler, S.; “No Monkey
Business”; Prentice Hall; 2002; pp 141-2).
23 Fowler, S.; ibid.
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