Secrets of Success: Pick well and with-profits can still work

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For those of you with the stomach for getting into detailed statistical study of investment returns, there are some interesting figures to be extracted from the latest annual survey of with-profits endowment policies by the trade magazine Money Management.

For those of you with the stomach for getting into detailed statistical study of investment returns, there are some interesting figures to be extracted from the latest annual survey of with-profits endowment policies by the trade magazine Money Management. They remind us about what is good and what is bad about the whole with-profits concept.

If you go solely by the headlines in the press, you will surely believe that with-profits as a concept is dead. Bonus rates and realised values for with-profits policies have been falling for years. Each year seems to bring fresh announcements of cuts. Worse still, some providers continue to levy a surrender penalty - euphemistically called a market value adjustment - if you try to take your money out before your policy has matured. Since the Equitable scandal broke five years ago, sales of with-profits policies have plummeted. Few financial advisers have the nerve to recommend them any more.

But in practice, however, the real picture about with-profits is not quite as simple as the headlines would have you believe. Millions of investors do still have their money tied up in with-profits policies that they rightly feel unable to abandon, if only because they also recognise there is no guarantee they would do any better by switching.

And while it is true that the whole concept of with-profits has taken a critical lambasting and has now in many respects become outdated, the performance record is not as uniformly bad as popular opinion would have you believe.

Take the level of returns recorded on maturing with-profits endowments as an example. The sums realised on these policies have certainly been falling. The average 10-year with-profits endowment policy maturing in February 2005, for example, produced a pitiful annual average rate of return of 2.7 per cent, just 0.1 per cent above the rate of inflation over the same period. Until five years ago, by comparison, the annual yield on 10-year with-profits policies was consistently between 9 and 10 per cent a year. The comparable figures for the average 25-year endowment - the kind most people use to support their mortgages - are nothing like as bad. But they too have fallen from a realised annual return of 12.4 per cent on policies maturing 10 years ago to 9.1 per cent for those maturing in February this year, a decline of around 25 per cent in five years.

However, there are two important caveats. One is that these are nominal, not absolute returns. If you take inflation into account, the picture changes. As the second chart shows, the downward trend is much steeper for 10-year endowments, but much less marked for the longer 25-year policies. While the average 10-year policy's realised yield has fallen from five per cent to zero, the comparable figure for 25-year policies is actually higher (at 4.5 per cent a year) than it was 10 years ago.

The second thing to emphasise is that the average figures conceal an extraordinarily wide range of performance by individual providers. The second chart shows the best and worst inflation-adjusted returns achieved in both the 10-year and 25-year endowment sectors. You can see that the best providers have paid out consistently good returns of more than six per cent a year in real terms, while the worst have been terrible, especially for shorter term policies.

The figures provide ammunition for both critics and supporters of the with-profits concept. The performance of many with-profits policies has been bad, something that can be attributed both to their relatively high costs and the indifferent investment performance of many life companies. In reality the with-profits concept, with its aim of smoothing returns through the stock and bond market cycles, only works as a long-term investment.

In up and down markets, 10 years is simply too short a period to allow smoothing to work in a cost-effective way. That is why the figures for 10-year policies are so much more volatile and unimpressive than their 25-year equivalents. The reason so many financial advisers continued for many years to push their clients into 10-year with-profits products may not be unrelated to the handsome upfront commissions life companies pay on these policies.

On the other hand, there is nothing wrong with the impressive rates of return that the best with-profits endowments have produced over time. A realised average real return of five to six per cent a year represents a more than acceptable return, particularly for the cautious investors at whom with-profits have historically been directed. Most sensible people, if offered such a return over 25 years, should grab it with open arms.

The paradox is that the longer you set out to invest for, the more important it becomes to pick a provider that you can trust to invest your money competently and cost-effectively over such a long period. This is tough and the job is more difficult because new technology has completely outmoded the old way of doing things.

The with-profits industry has failed to demonstrate that it merits the trust of investors. This overshadows the fact that a well-run low-cost smoothed investment fund is of itself a perfectly sound investment concept that can still deliver something of value to the lucky minority who pick wisely.

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