Investment: With-profits endowments could be your loss

IS THERE any future for the with-profits type of endowment policy, a staple offering of the life insurance business for many years? The question is hardly new, but it is worth asking again, given the current state of the investment markets and the rapid recent changes in the sophistication of the financial markets.

As most people know, with- profits policies are designed to cater to the needs of relatively low- risk investors. What they aim to do is to smooth out the annual ups and downs of the financial markets through a system of annual and final bonuses. If you buy a with-profits policy, you are in effect backing the tortoise over the hare, judging that a slow but steady approach will come out ahead over the long haul.

If you want a full exposure to the markets, and are wedded to insurance company products, then you always have the option of a unitised policy instead, whose value rises and falls broadly (but after costs) in line with the behaviour of the markets. Alternatively you can opt for a unit trust or investment trust to do the job instead. There are a sufficient variety around these days to allow you to match your risk profile to that of an appropriate fund.

With-profits policies are something of a throwback to another era: they conjure up inevitable images of dour Scottish actuaries grimly shepherding your money behind closed doors. One of the most striking features of the traditional with-profits policy is that your money is taken away and invested without your ever having much say about what happens to it. The discretion of the investment manager is almost total. The annual bonuses are declared by fiat. So too is the final bonus, which these days amounts to an increasingly large proportion of the final value of the policy - anything from 20 per cent for an average 10-year policy to 57 per cent for an average 25-year policy, according to the latest survey of performance figures by Money Management magazine.

In most cases, as thousands of mortgage holders have learnt to their cost, you will also be penalised heavily if you stop making your premium payments for whatever reason before the end of your term. In the case of 20 or 25-year endowment policies, the risk of surrender penalties means that you may be tied in for at least half your working life to the same manager with very little you can do about it if he fails to do a good job. (This does not stop around one in five endowment policies being surrendered within four years, according to the Personal Investment Authority.)

Flexibility in other words is not the name of the game with with-profits endowments. This would not matter so much if the performance of the funds was better than it has been. However, if you have opted for a low-risk investment, you can hardly complain if the performance is not as good as if you had invested your money 100 per cent in the stock market during what has been one of the greatest bull markets of the century.

Taking Money Management's figures, the average return on a 10-year with-profits policy maturing in 1990 was 14.1 per cent, or 7.9 per cent in real terms. For the past five years the equivalent real return on maturing policies has been between 5 per cent and 6 per cent. On my reckoning this is somewhere between 30 per cent and 50 per cent below the real 10-year return on the stock market during that period - which in part reflects the fact that shares account for between 50 per cent and 80 per cent of an endowment policy's assets (the rest is in bonds and property).

What has always dragged down with-profits policies' performance has been their costs. The average "reduction on yield" on a 10-year with-profits endowment policy today is 1.5 per cent for a 25-year policy; 1.7 per cent for a 20-year policy: 2.2 per cent for a 15-year policy and a horrific 3.3 per cent for a 10-year policy (and this is just an average figure: the highest cost polices go up to 4.0 per cent; the lowest, Equitable Life, is 1.6 per cent). Any investment with that kind of cost burden to carry is always going to be struggling to earn its corn, not least because you would normally expect lower risk funds to have lower costs than higher risk ones.

With the proliferation of competing products now around, it certainly seems inevitable that unless insurance companies attack their costs and make more disclosure about what their investment policies are, then the days of the with-profits fund will indeed be numbered.

But there is nothing wrong with the concept of a fund that "smooths" the risks of financial markets over time. One final statistic caught my eye from the Money Management survey. For 25-year policies, the average real return has doubled from less than 2.5 per cent for policies maturing in 1990 to 5.3 per cent for those maturing this year. Is that good or bad? Well, it all depends. If you had been offered a 5 per cent real return 25 years ago most people would have said yes: 5 per cent for a low-risk investment is a very good outcome, when set against the stock market's long run 6-7 per cent. But if it had been 2.5 per cent, you could do better with most alternatives.

The real question that insurers have to answer now with endowments is: how does anyone know what they are buying any more? There doesn't seem to be much "smoothing" going on when a 25-year-investment can produce a real return of 2.5 per cent one year and more than twice that return just nine years later. (To be fair, there are some honourable exceptions.) Add to that the fact that you don't know until very late in the day how big the terminal bonus is going to be, except that it will be more than half the value of the fund, and one has to ask whether the with-profits fund is really such a low-risk investment after all.