They were originally touted as the investment choice for the cautious, but today with-profits policies are seen as confusing , old- fashioned and poor value. There is no doubt that returns have been disappointing over the past decade and many people want to take their money and run. But after Prudential declared it paid out £2bn in bonuses to its investors last year, could they still have a place in your portfolio?
Prudential’s announcement last week certainly cemented it as a market leader for with-profits investments. Last year £700m was added in annual bonuses and £1.3bn in final bonuses and policyholders typically saw year-on-year increases of between 5 and 8 per cent. Prudential’s payouts compare favourably against rivals – with a 20-year, £200-a-month pension payout of £85,460 against Aviva at £84,921, Standard Life at £78,669, Legal & General at £78,544 and Scottish Widows £70,863.
Patrick Connolly of independent financial adviser Chase de Vere says: “While it is easy to be critical of with-profits investments, there are often good reasons why investors should retain existing policies. The financial strength of the provider, their ability to invest in growth assets and commitment to paying competitive bonuses and payouts should be important considerations. Prudential is the market leader in these respects.”
The idea behind with-profits is to smooth out the peaks and troughs of the stock market, and policies were sold in droves by life assurance providers in the Eighties and Nineties. All policyholder money is pooled together and invested in the insurer’s with-profits fund (which in turn invests in a combination of assets such as shares, bonds, property and cash). Each policyholder gets an annual bonus – as well as a potential final or terminal bonus upon maturity – but money is held back in good years so that returns are consistent regardless of performance.
Unfortunately, this theory did not play out in reality because in the early days providers were paying out overly generous bonuses in a bid to attract business. In good times, they were overpaying and shifting their investment strategies from being very conservative to being far more aggressive, which left them with nothing to pay investors when markets nosedived.
David Smith, wealth management director at the adviser Bestinvest, says: “In the good old days the stock market only seemed to go up in value and with-profits funds normally made more money than was paid in bonuses. When the market started losing money, all of a sudden what had been paid in bonuses was more than the underlying funds had made.”
After the market crashed, insurers realised they had paid out too much in previous years and had to claw back profits by slashing annual bonuses and putting market value reductions (MVRs) on funds, which in effect took bonuses away by greatly reducing the maturity payouts.
Exit costs mean some investors are still lumbered with a policy offering returns barely above cash. These “zombie funds” are closed to new business and pay the bare minimum (they are usually invested in gilts and corporate bonds instead of equities) .
The nature of with-profits funds also means it’s not always clear how much money is being held back for the smoothing process and how much is being deducted to cover management costs. With all this in mind, advisers rarely recommend new investment in with-profits, largely because there are cheaper, more flexible and more tax- efficient alternatives.
Danny Cox of the adviser Hargreaves Lansdown says: “We have probably seen the worst of the problems but we haven’t recommended with-profits since June 2002. Prudential with-profits is one of the better funds, but the sector itself has been a disaster for over ten years with investors remaining trapped in poorly performing funds with stiff exit costs.”
The problems have left investors struggling to decide whether to stay put or cut their losses. The message from the experts seems to be that not every with-profits company should be tarred with the same brush, so the decision on whether to get your money out or stay put depends largely on the strength of your provider. Look at the bonus rates paid in recent years, how actively the fund is being managed and whether it is open to new business. Then check for exit penalties, tax liabilities, the maturity date and whether there are any extra guarantees (some older plans have valuable minimum guaranteed rates).
Your policy may have an MVR-free date after which you can cash in without penalty (this is usually available on the tenth anniversary). MVR rates can change over time and some providers will cut theirs after periods of strong performance, so keep an eye onthat. It may also be the case that policies offer little or no annual bonus but are paying relatively large terminal bonuses.
If you can get your money out without a harsh penalty, there are alternatives. Multi-asset funds and absolute return funds are in some ways the natural choice if you want exposure to a diversified pool of assets with low volatility. Like with-profits, absolute return funds aim to provide positive returns regardless of market conditions. But these cannot offer a predictable income and are more likely to carry high fees.
“If you are being offered a guarantee, you must be missing out somewhere, either by overpaying on charges or getting a limited performance,” says Mr Cox.
Increasingly, advisers and DIY investors are using online platforms to build tailor-made portfolios, mixing shares, bonds, cash and equity funds rather than buying into pooled investments such as a with-profits fund. In effect, many investors are constructing their own with-profits funds without actually realising it. And the advantage of using online platforms – run by the likes of Fidelity and Hargreaves Lansdown – is that fees are generally low and investments can be sold in a heartbeat, giving much more flexibility.
An equity individual savings account is a sensible place to start as you can invest in stocks and shares free from capital gains and income tax. The entire allowance of £11,520 for this tax year can be invested (only half is allowed in cash) and you can pick your own investments and withdraw money at any time without worrying about exit penalties.