With-profits investors hit on the way out

Once hailed as the safest way to get in on stock market returns without the volatility, millions of us have piled our money into with-profits funds over the past few decades, sometimes via mortgage endowments, pensions and bonds. But today, they have a reputation for poor returns, complexity and even secrecy. And last week two insurers announced plans to penalise investors who withdraw their cash.

In a U-turn on a decision taken just over a year ago to remove exit charges, Norwich Union will levy a withdrawal fee of between 13 and 22 per cent on policies opened between 1992 and 2008, and Friends Provident will inflict a charge of 5 to 14 per cent on some 250,000 policies, mostly from 1999 and 2000. The consensus is that the other with-profits providers are poised to follow suit.

These funds work by placing policyholders' money in one big pot and investing it mainly in shares, corporate bonds and property for several years. Their main selling point has been that, in a technique called "smoothing", some of the returns made during good years for stock markets are held back to pay for the bad times so that the investments aren't ravaged.

With-profits policies run for a specific period, usually between 15 and 25 years. Investors receive annual bonus payments as well as a lump sum, the "terminal bonus", when the investment has run its course. The bonus levels are set by the provider, and this arrangement has led to charges that the products lack transparency and that investors are not sure upfront what they are getting for their cash.

But providers rebut these claims. "We believe with-profits funds continue to be a suitable investment option for those who are looking to do better than a bank account over the long term while being cushioned from daily stock market volatility," says Shaun Cooper, with-profits actuary at The Co-operative Investments.

Along with a number of other providers, however, the Co-op reacted earlier this month to the global financial crisis by cutting the terminal bonuses paid on maturing policies. "Despite smoothing investment returns, difficult market conditions have resulted in the need to reduce policyholder payouts," says Mr Cooper. "This enables us to better protect those customers who remain in the fund."

But investors could be forgiven a sense of déjà vu, in terms not just of reduced bonuses but also "market value adjusters" (MVAs) – the exit charges that are imposed on policyholders who want to pull their money out during rough or volatile times when the pot is down.

"In October 2001, with-profits holders were faced with mass MVAs of as much as 25 per cent," says Danny Cox of independent financial adviser (IFA) Hargreaves Lansdown. "By 2007, Norwich Union had lifted its MVAs, but the insurance companies will tell you that these charges are measured on a case-by-case basis, so although blanket exit fees had been removed, MVAs have never gone away."

And quite how these bonuses and penalties are calculated seems an inexact science – dreamt up by insurance companies, suggest critics, including consumer group Which?. With-profits funds are accused of breaking normal investment convention by taking customers' money without providing the information generally supplied by other investment vehicles. "It is also difficult to find out what the fundamental mix of investments is," says Mr Cox.

If you want to get out, there may be an MVA-free window if the maturity date for your mortgage or pension is approaching, or your policy is close, say, to a 10-year anniversary. Alterna-tively, gradual withdrawal, up to a value of 7.5 per cent a year of the original capital, doesn't incur MVAs – although tax on the profits may apply.

But even if you feel stuck, Andy Cowan of IFA Towry Law believes it could be worth accepting the penalties and pulling out early. "People tend to freeze when these penalties are inflicted – as providers anticipate. But you have to decide if you are prepared to have your money badly managed for another 10 years or whether you take the cash, minus the penalty, and reinvest it in a better opportunity."

But finding a new home for your money could be tricky. "With 20 million policies active at one stage, there is no real equivalent to with-profits in that space," says Mr Cox. "You need to make a decision about the risk you are prepared to take. If you're happy to get into shares in anticipation of a rally, fine. But if you're risk averse, stick your money in a savings account."

Compare top offers on 0% balance transfer credit cards at Independent Compare