Don't knock Equitable. The move to gilts proved profitable

'Only the most starry-eyed investors could expect holdings to keep growing in that market'

The wholesale collapse of equity markets in the past three years has produced bizarre anomalies and consequences, particularly in institutional investment. Who would have predicted 18 months ago that policyholders in Equitable Life's now-infamous with-profits fund would have achieved one of the best investment returns in its class in 2003?

The wholesale collapse of equity markets in the past three years has produced bizarre anomalies and consequences, particularly in institutional investment. Who would have predicted 18 months ago that policyholders in Equitable Life's now-infamous with-profits fund would have achieved one of the best investment returns in its class in 2003?

Thanks to its enforced move out of equities (which tanked again last year) into gilts (which produced yet another year of positive returns), the fund did better than almost all other funds of its kind last year. It is true that because of the swingeing exit penalty imposed on early leavers, you cannot get your hands on the money, and the fund still fell in value, but since when has the primary objective of a pension fund been to cash it in, rather than to leave it to grow to maturity?

The irony is that the Boots pension fund, which moved smartly and voluntarily out of equities into gilts shortly before Equitable was forced to do the same, has been basking in critical acclaim. But our old friends at the Equitable remain the chief whipping boys for a generation of aggrieved savers, many of whom still do not realise how fortunate they have been to have earned higher long-term returns – even after all their trials and tribulations – than most previous generations.

We do not know yet whether the Equitable can survive the bleeding of cash from its with-profits fund, or the baying pack of lawyers snapping at its heels, and it will be many years before we can finally assess the fate of those who did and did not jump ship at the height of its troubles. But a good number of those who have left may turn out eventually to be worse off than many who, for whatever reason (stubbornness, apathy, lack of choice), decided to stay.

The argument for taking the hit of the exit penalty, and incurring the costs of moving to another provider after the adverse House of Lords judgment, was that such a move would give the investor time to benefit from the superior long-term returns available to investors in less financially constrained pension providers. So far, that has not proved such a good call, given what has happened to stock markets.

Nearly every big pension fund provider has since had to cut its equity holdings to meet solvency requirements in their with-profits funds. Those so disillusioned by the experience of "with-profits" saving at the Equitable they opted to transfer into a unit-linked policy will probably have taken an even bigger bath unless they managed to steer clear of funds with a large equity component. You can almost hear the cries of, "We were misadvised to move" already.

It is ironic how bad a press the with-profits concept has had. There are many things wrong with the way the policies have been sold. All the usual criticisms, they are too complex, not transparent enough and so on, are valid to a degree. It does not help that people are confused between with-profits endowments, with-profits bonds and with-profits pension policies, all of which have different charging structures and different strengths and weaknesses.

If there is a surprise it is how well, rather than how poorly, the with-profits concept has survived the trauma of the bear market. The surprising fact is not that so many providers have cut their bonus rates on with-profits policies sharply, but that so many continue to pay positive bonuses, despite the 50 per cent fall over the past three years in the global equity markets.

It is true that the whole point of with profits is to smooth returns through good times and bad, and true also that there were pundits who pointed out the risks many funds were taking by keeping such a high proportion in equities at the height of the bull market. But only the most hopelessly starry-eyed of investors can seriously have expected their funds to continue to grow as if nothing had happened through a market correction of such depth and severity.

Just as many of those who retired before 2000 remain splendidly unaware of how fortunate they have been, a similar kind of money illusion afflicts those who now expect pension providers to go on defying the underlying behaviour of the markets on whose returns their pensions ultimately depend. You only have to look at the share prices of many of the life companies to see that the cost of sustaining even modest smoothing in their with-profits funds is inflicting real pain on their shareholders.

Mortgage endowment policies, many of which are also linked to with-profits funds, are another case. A survey last year by the trade magazine Money Management showed that the average 25-year endowment maturing last year produced a compound annual growth rate of 11.7 per cent. In real terms (after inflation), the return was 6.5 per cent. This was a record outcome. For 10-year policies, the average real return was 4.3 per cent, down on previous years but still a creditable result.

As Barry O'Dwyer, marketing director of Standard Life, told a pensions conference organised by Taxbriefs last week, each generation expects to do better than earlier ones, regardless of the prevailing investment climate. This in no way exempts the pensions industry from the criticisms rightly levelled at the way it operates, but it does underline the point that managing expectations down to realistic levels is the biggest challenge facing the Government and the industry on the pension front. Judging by the fudges in the Green Paper by Andrew Smith, the pensions minister, before Christmas, the Government has a long way to go. If anything, its proposals have increased the incentive against saving through a pension.

davisbiz@aol.com