The with-profit wagon keeps on rolling along

Millions of savers are stuck on board this rickety old investment vehicle. Is it time to jump free?
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Try out this piece of wizardry from the UK financial services industry.

"The amount of the bonus, and even whether there is a bonus at all, depends on... returns earned on the investments," warns a guide, updated only last month, by City regulator the Financial Services Authority (FSA) .

Now take a £27bn pension fund run by Norwich Union that, last year, swelled in value by 10.7 per cent.

In previous years, the returns from the fund had been battered by the poor performance of the stock markets. So policyholders could have been forgiven for thinking that, at last, the insurer would pay an annual bonus that reflected this good fortune. But it's not to be. The "bonus" is to be slashed by a third from 3 to 2 per cent, as Norwich Union tries to keep enough money in the pot to honour generous payouts promised on maturing policies years before.

Now turn to a personal pension fund run by Friends Provident, which produced a healthy 8 per cent return in 2006. Policyholders hoping for a suitably generous annual bonus to shore up their savings have instead been left empty-handed.

Welcome to the weird world of "with profits" investments. Despite a reputation that's been shredded by tumbling stock markets, high charges and stiff exit penalties, this rickety wagon keeps rolling along.

Part of the industry's endurance is down to the generous commissions it continues to pay to the independent financial advisers (IFAs) and salesmen who flog the policies. Last year, for example, Norwich Union launched a with-profits "inflation protection guarantee" bond paying advisers 6 per cent upfront. Many insurers pay commissions at higher levels than this.

The woes of the with-profits sector are well documented, from endowment policies that now look unlikely to clear the mortgages held by millions of borrowers, to the pension annuities (or incomes for life) that brought the near collapse of Equitable Life.

For decades,beginning in the 1960s, these funds were sold as a low-risk way for UK savers to generate heftier returns than those available on building society accounts, but without direct exposure to the volatility of shares. Life companies would achieve this by "smoothing" returns - keeping back surpluses generated in the good times to keep the returns coming even when the markets turned down.

The popularity of with-profits carried on in the 1990s with the sale of investment bonds that, for higher earners, offered 5 per cent tax perks.

But once UK markets began falling in 2000, the performance and bonuses of all with-profits products - annuities, bonds and endowments - fell away too, and those with life savings in these poorly performing funds began to suffer.

The smoothed reserves kept back for the bad times weren't adequate as it emerged that life companies had over-estimated the returns they would make.

In a panic, insurers slapped "market value adjusters" of up to 20 per cent on the funds to stop investors fleeing: on an £8,000 investment, they would have to pay a £1,600 penalty to escape. That was enough of a deterrent.

Meanwhile, new solvency rules for life firms limited their ability to invest in shares. So when the markets began to turn up in 2003, they missed out on the growth.

As the 2007 with-profits "bonus season" begins - Prudential and Standard Life are among those unveiling results in the next three weeks - millions of savers may be asking what they're doing in these policies. "I cannot see any possible situation now where with-profits is the right thing for a client," says Patrick Connolly of wealth manager JS&P Towry Law. "Go back 20 years, or even 10, and it did its job. But today it is not the answer."

JS&P doesn't recommend any with-profits products, and nor do many others, including independent financial adviser(IFA) Bestinvest.

For anyone holding a with-profits policy that they're unsure about, now is as good a time as any to re-examine the options. That's especially true for those in policies closed to new savers, often called "zombie funds", where managers have little incentive to do anything spectacular with your money.

Check the projected payout for your policy, says Justin Modray of Bestinvest, and if it's way off target and you're unhappy at its performance, consider an exit to a more simple product, such as a unit trust.

Watch out for penalty clauses, though: bonds usually have a five-year "get out" but many pensions suffer onerous transfer penalties of up to 5 per cent.

Even if there's a penalty, it can still be worth switching. However, Mr Modray stresses: "You need to work out how much you need to generate [in extra returns] in the time you have left]to make this [penalty] back."

In particular, a pensions transfer can be very tricky and it will be worth speaking to a specialist.

Any change will involve a lot of research, but the FSA, consumer body Which? and IFA websites such as that run by Har-greaves Lansdown are a mine of information.

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