Units show edge over with-profits: Andrew Warwick-Thompson says guarantees could hamper pensions linked to bonuses

THE current round of pension bonus reductions should give with-profits policyholders further cause for thought.

The tide has already turned against with-profits pensions. Since 1992, my company has advised private clients to invest all new pension contributions in unit-linked funds.

The main difference between the two types of fund is that unit-linked investment is more volatile. Under a unit- linked policy, the return is directly related to the value of the assets held within the fund. The return therefore rises and falls in line with market conditions.

Under a with-profits policy the return is 'smoothed' by bonus declarations. These cannot usually be taken away or reduced. The terminal bonus reflects how much the investments have increased in value (if at all) during the term of the policy, and is paid at the policy's maturity.

Returns on conventional with-profits policies are subject to a number of factors that do not apply to unit-linked funds:

With-profits investment managers are constrained by the need to hold assets to cover their liabilities, including declared bonuses, and by the need to maintain future bonuses at a competitive rate.

The proportion of the with-profits investment return provided in the form of bonuses is largely at the discretion of the insurer. A relatively low rate of return may be guaranteed, the remainder of a good return being held back to make up any shortfall in the bad years.

Expense charges are not explicitly stated. Under the terms of policies, insurers can adjust deductions without constraint.

To make matters more complicated, many modern with-profits policies are 'unitised', so they combine elements of both conventional with-profits policies and unit-linked policies.

Every contribution buys a number of with-profits units, the value of which is guaranteed by some insurers to increase at a low level until retirement. Each year the insurer declares a bonus, which further increases the price of the units - they are valued daily. When a policy matures (or if investment is switched into a unit-linked fund or transferred) the price may be increased further by a terminal bonus.

Unlike conventional with-profits policies, the low guaranteed rate of return (if any) that applies at the outset of a unitised with-profits policy may be reduced at any time. The insurer does not need to hold as much in reserve, allowing a more adventurous investment policy. From the policyholder's point of view, however, such a policy suffers from disadvantages of conventional with- profits policies and has few of the compensating guarantees.

In recent years, competitive pressures have made insurers reluctant to reduce bonuses in the face of falling investment returns. But now bonus rates have started to fall and this trend is likely to continue in the near future.

With-profits investment gives the comfort of guarantees, but the deductions are a high price to pay for this security.

The large element of terminal bonuses in maturity proceeds makes modern with- profits policies similar to unit- linked policies, except that the with-profits return is at the discretion of the insurer.

In the face of adverse publicity, insurers have improved the terms for policies that do not reach maturity. This means that the bonuses allocated to policies that do will be reduced.

In the medium- to long-term, a good unit-linked managed fund should outperform a good with-profits fund as the investment strategy can be more weighted towards equities.

When considering how to invest your pension you should seek professional advice. Bacon & Woodrow gives the following general guidance to private clients on unit-linked policies:

Invest in 'managed' unit-linked funds rather than specialised unit-linked funds: investment allocation of pension portfolios is entirely made by investment professionals.

Diversify between several managed funds as the investment grows.

The investment should be switched into more secure gilt- and cash-based funds as retirement approaches.

For clients who already have with-profits policies:

Don't switch existing with- profits investments to unit- linked, because the terms are unlikely to be attractive.

Don't make regular premium with-profits policies paid-up, because the penalties imposed are likely to be high, but do not increase the regular premium.

Andrew Warwick-Thompson is head of the partnership pensions section of Bacon & Woodrow, consulting actuaries.