The exact mechanism that delivers this combination of some safety with out-performance when compared to a building society account is usually a mystery to most investors.
In fact, the way with-profits fund managers achieve this is by means of quite tightly-defined asset allocation between different types of investment "class". The main types are equities, property, fixed interest securities such as bonds or gilts, and cash.
How do these various asset classes work in relation to each other? Martin Brown, operations director at the With-Profits Bond Shop, which specialises in these policies, explains: "The starting point is that equities have a tendency to out-perform other asset classes over the long term. In effect, they are there to provide the growth in the value of a bond. At the same time, there will also be a requirement for a relatively stable income stream.
"Until recently, yields from equities could have provided some of this, but they have fallen significantly of late, which partly determines the extent to which a with-profits fund might invest in fixed-interest securities."
Michael Hayden, savings and investment director at Legal & General, a leading with-profits bond provider, adds: "Fixed interest securities will provide an income stream combined with security.
"If you hold a bond to maturity you will get your money back, always assuming that the company whose bond it is stays around."
Cash is a similar type of holding to securities, delivering its own minor yield within a fund.
Property is another important asset class, says Mr Hayden. "It is a mix of the two classes in risk terms," he says. "Primarily it involves investment in commercial properties. The income stream from the property rental provides an element of security and hopefully the increase in the value of the property over time will provide additional capital returns."
Given that there is an inter-relationship between these three main asset classes, in what proportion are they held, and why?
A glance at the table on this page shows that generally equity holdings will vary between 60 and 70 per cent, with one or two exceptions. Property will vary between 10 and 12 per cent, on average, while fixed interest holdings range between 17 and 25 per cent, again on average.
What determines this mix, says Mr Hayden, is a combination of factors. One of them is whatever guarantee may have been given to the investors by the with-profits bond provider. The greater the guarantee, the more likely that company's fund manager will be required to meet it by investing in fixed-interest securities.
"We invest in assets that match our liabilities. Their nature will determine the investment strategy," he adds. "For example, if we were giving investors a certain guarantee, say of 5 per cent yield, we would invest in a greater proportion of fixed interest securities. So to some extent we are driven by investor expectations."
Aside from investors' own needs, requirements by Government regulators that a with-profits fund has enough assets to cover its own liabilities and policyholders' reasonable expectations will also determine the proportion of each asset class.
Generally, a fund with a high level of "free assets", over and above those required to meet the criteria set by regulators, will be able to invest more highly in equities.
For example, as Chris Robinson, intermediary sales director at Prudential - whose Prudence fund has sold some pounds 7bn since its launch in 1991 - says: "Our ratio is about 60 per cent in UK equities and 15.4 per cent in international ones, with 13 per cent in property and 10.1 per cent in fixed interest securities.
"We are able to invest in this way because we have a higher proportion of free assets than many other funds. The point to remember is that with- profits bonds are a smoothed managed fund. Capital growth comes from the equity element of the fund. Distribution bonds are more geared to income and they will contain a different mixture of fixed interest securities relative to equities."
How are various asset classes determined on a day-by-day basis? Michael Hayden says: "The actuaries set the guidelines. They know what the liabilities of a fund will be and they will construct a portfolio to reflect that. An actuary might say we need a core of perhaps 25 per cent in fixed interest securities, or 15 per cent in property on the basis of, perhaps, plus or minus five. The fund manager will then manage the fund on that basis.
"In practice, it is not just a question of setting parameters for an asset class. An actuary may specify that a bond must be of not less than A-plus quality (which would mean a high-quality security)."
All of Legal & General's fund managers will be involved in the investment process, selecting equity or securities on the basis of the actuaries' recommendations.
Reviews of the portfolio will be held monthly to determine whether the expectations of the policyholders are being met.
For many investors, none of this will seem important. All they want to know is how much they are likely to get and how safe their money is.
In practice, it is thanks to this carefully calculated strategy that with-profits bonds deliver the returns they do. Investment, however, means homework - and asset allocation is one part of that equation.
The Independent has produced a free 24-page Guide to With-Profits Bonds. Written by Nic Cicutti, this paper's personal finance editor, the guide examines the arguments for and against bonds. For a copy of the guide, sponsored by The With-Profits Bond Shop, call 0845 2711007.
ASSET ALLOCATION FOR WITH-PROFITS BONDS
COMPANY UK OVERSEAS TOTAL PROPERTY FIXED CASH AND
EQUITITIES EQUITIES EQUITIES INTEREST OTHER
Britannic 70 8 78 17
Clerical medical 48 14 62 10 15 13
Colonial 56 18 74 23 3
CGU 53 16 69 10 16 5
Eagle Star 55 10 65 20 15
Equitable Life 46 14 60 7 27 6
Friends Provident 44 16 60 10 28 2
Legal & General 48 12 60 16 21 3
NPI 41 10 51 9 30 10
Norwich Union 56 15 71 11 18
Prudential 64 15 79 10 9 2
Royal & Sun Alliance 51 13 64 11 25
Scottish Equitable 70 15 85 15
Scottish Mutual 54 17 71 3 20 6
Scottish Provident 68 68 11 17 4
Scottish Widows 51 16 69 7 17 9
Sun Life/AXA 63 18 81 14 5
AVERAGE 55 13 68 9 19 4
Source-The With-Profits Bond Shop, asset allocation as at 31 August 1998.Reuse content