If you're looking for a way out ...

Investors cashing in with-profits policies early face soaring penalties. Is that fair? asks Simon Hildrey

Last Monday, policyholders in Standard Life's unitised with-profits pensions heard the bad news that they would lose 25 per cent of their savings if they wanted to withdraw from their scheme. Investors in the mutual's conventional with-profits policy fared little better: they were told that 20 per cent of their money would be retained if they jumped ship. So what has caused this sudden hike from the 10 per cent exit penalty that was imposed only last November?

According to Standard Life and other insurers, exit penalties, known as market value adjusters (MVAs), have been applied over the past couple of years to bring surrender values closer to the underlying value of the with-profits funds.

But some independent financial advisers (IFAs) and industry insiders argue that MVAs have had to be applied because of "mismanagement", as many with-profits funds retained a high exposure to equities (70 to 80 per cent) long after stock markets started falling.

MVAs are not a new concept. They were applied occasionally in the 1980s and 1990s, but over the past two years virtually every insurer has used them.

If you want to get out before your policy matures, some insurers do offer penalty-free days – for example, on the 10th anniversary of the day the policy was taken out. But to offset this, insurers can reduce the bonus rates on policies with MVA-free days. Patrick Connolly, associate director at IFA Chartwell Investment Management, says Scottish Widows has cut the annual bonus on such policies from 5 to 1.5 per cent, compared to a reduction to 4 per cent for policies without MVA-free days.

MVAs are usually applied when stock market falls lead to a large number of policyholders wanting to cash in their investment. Insurers argue that policyholders quitting at this point receive a higher proportion of the with-profits fund than they are entitled to. This is because the surrender price, which reflects the value of all the bonuses paid during the life of the policy, is higher than the plummeting value of the underlying with-profits fund. So an MVA is applied to redress the balance.

"MVAs are only used in extreme circumstances such as those seen in the past three years," says David Riddington, senior actuary at Norwich Union. "If we were to pay out the unit value, it would be unfair to those staying in the policy."

In theory, this argument appears to make perfect sense. But, examined more closely, it has a number of flaws.

For a start, with-profits policies are designed to be low risk, giving smoothed returns, yet MVAs create volatile returns. Also, policyholders could legitimately ask why the unit value of their with-profits policy is so much higher than the value of the underlying fund that penalties of up to 25 or 30 per cent have to be applied. Surely, "smoothing" should ensure the surrender price and the underlying fund value move broadly together? So are high exit penalties a sign that life companies have not reacted to current market conditions and become over-exposed to equities?

Another problem is the lack of transparency. How can policyholders determine whether an MVA is set at a fair value for those quitting or staying in a with-profits fund if they are not told by insurers what the underlying value is?

"There needs to be more clarity about why insurance companies are imposing exit penalties and what the impact will be on their money if policyholders remain in the fund or leave," says Delroy Carinaldi at the Consumers' Association.

Alan Steel, managing director of IFA Alan Steel Asset Management, goes further in his criticism. "With-profits are meant to be fairly safe investments. But they have suffered because insurers have paid out higher bonuses to policyholders and provided greater guarantees than they could afford, in order to attract greater volumes of new business. This was OK while stock markets kept rising, but when markets turned downwards, insurers found they didn't have the reserves to cover their guarantees. This is why MVAs are being applied."

And unfortunately, the situation shows no signs of improving.

If leading IFAs like Hargreaves Lansdown and Alan Steel are correct and reserves have been reduced substantially, it could take years rather than months before bonus rates can rise significantly and MVAs disappear.