What are with-profits investments?

With-profits investments have been central to the long term savings plans of millions of individuals and it is estimated that £39bn is currently held in with-profits mainly through pensions, endowments and bonds.

A with-profits investment is a long term investment which aims to provide a lump sum at a date in the future or in the case of a with-profits annuity, a yearly income with the possibility of investment growth over time.

The premiums paid by policyholders are pooled into a fund, which is used by an insurance company to invest in different types of assets e.g. equities, commercial property, corporate bonds, gilts and cash deposits. 

With-profits investments grow through the addition of bonuses to the policy, which take the form of regular (annual/daily) bonuses and a terminal (final) bonus.  The amount of bonus, and whether a bonus is added at all, depends on how the underlying investments in the fund perform and how the insurance company expects them to perform in the future.

Insurance companies use a process called smoothing to hold back profits in years of good investment growth to top up bonuses in years of poor investment growth.  With-profits investments have traditionally been marketed as a cautious investment to investors looking for higher returns than a bank or building society savings account but without the risks associated with investing in the stock market.

Why is there a need to review with-profits investments?

The recent performance of with-profits investments has been poor.  Many with-profits funds are suffering the effects of declaring bonuses in the 1990s which in hindsight could not be justified, and the fact that when stock markets fell between 2000 and 2003 many with-profits funds were too heavily invested in equities. 

The weaker life companies became during this period, the less able they were to hold equities, which in turn forced them to sell equities and to switch to less risky investments.

The adoption of more cautious investment strategies, partly as a response to regulatory concerns that some life companies did not have sufficient solvency capital, meant that many with-profits funds did not benefit from the stock market rally between 2003 and 2007.  The upshot of which has been that most with-profits funds are now offering very low regular/terminal bonuses or worse still no bonuses at all.

In addition to offering poor returns, many life companies have chosen to apply market value reduction penalties to ensure that policyholders do not leave the with-profits fund with more than their fair share of its assets.  This is to protect policyholders who remain in the fund, but it also means that policyholders who decide to surrender their investment or switch out of the fund will receive less than they had expected.

What can be done to improve the situation?

Depending on the type of policy you have, you may be able to switch to another fund, sell the policy, transfer to another provider or surrender the policy altogether.  Whether this is the right thing to do will depend on a number of factors and you should always seek independent financial advice before making a decision.  The main factors to consider, in addition to the current bonus rates, include:

• The financial strength of the life company managing the with-profits fund.

• The asset allocation and investment strategy of the with-profits fund.

• The remaining term to maturity.

• Are there any benefits or guarantees that will be lost if the investment is transferred, surrendered or switched into another fund?  Some pension policies have a guaranteed annuity rate, which means that the policy may provide a higher pension income at retirement than the annuity rates available in the market.

• Are there any charges or market value reduction penalties that will be levied if the investment is transferred, surrendered or switched into another fund? 

• What is the possible cost of replacing any life cover that will be lost by stopping a policy?

• Does the investment have spot guarantees?  Many with-profits investments have spot guarantees, which offer the opportunity to exit a policy early on certain dates without incurring a market value reduction penalty. Although they often apply on the tenth policy anniversary, they must be exercised within a limited time period, otherwise the opportunity is lost. 

Clearly the changing nature of with-profits funds means that with-profits investments should be regularly reviewed to ensure that they continue to meet expectations.  This is especially relevant, as huge volumes of with-profits bonds were sold between 1999 and 2001, and these policies are now approaching their spot guarantees. 

At Xentum we have been proactively reviewing the legacy with-profits investments that our clients hold, and recommending alternative investments where appropriate.

1 Comment

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  By Julian, December 18, 2009 @ 2:49 pm

  No comments yet, but probably because people quite often bury their heads in the sand, when pensions are mentioned.
  As a Trustee I think that the with-profits investment has often been the easy option for companies. As once you are in it you are more than likely to stick with it. I am currently reviewing our scheme and you have given me plenty to think about.
  Thanks David (now if you could just tell me where to switch!)

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