Sam Dunn: With-profits funds aren't carrion just yet

The decline of a once great institution is always a spectacle to behold. As the wounded beast crawls towards the horizon, vultures begin to wheel overhead, waiting for the final collapse.

The with-profits sector has long been viewed with such grim relish, its imminent demise predicted by sharp-taloned observers in the financial services industry.

It's a far cry from the golden age when with-profits funds were the bedrock for pensions, endowment mortgages and investments held by millions of Britons.

The rather clever selling point of these funds was that, as markets rose, managers would withhold some of the profit so that, when things turned tricky at a later date, they could smooth investors' returns. Annual bonuses were locked into the funds, protecting savers' gains.

Endowment mortgages - often sold with a with-profits policy from a life insurer - counted for eight out of 10 home loans in the late 1980s.

The gravy train rolled on in the 1990s through the sale of with-profits investment bonds but, as the decade drew to a close, a crisis began to loom.

Generous growth projections made in the previous go-ahead years became a huge drain on funds, as life companies were forced to pay out wads of cash each time a policy matured.

Projections of with-profits policy growth were exposed as over-stretched, with too little money being paid in by savers.

So when stock markets began to falter in 2000, the smoothing reserves were run ragged, precipitating a crisis.

The bursting of the dot-com bubble, the New York and Washington terror attacks, a global slowdown and the Iraq war all contributed to three years of poor returns. With-profits funds, heavily invested in shares, took a battering.

To protect themselves as fund values plunged, they slashed bonus rates and imposed punitive charges - often as high as 20 per cent of the investment - on any savers who pulled out.

To shore up their positions, providers sold shares and shifted investors' money into the comparative safety of bonds to guarantee that they could cover existing liabilities.

By early 2004, the with-profits industry, like the funds themselves, was a shadow of its former self. But it is not carrion yet: recent events have begun to nurse it back to health and offer a possible path to recovery.

The Financial Services Authority has introduced new rules to force with-profits companies with assets of more than £500m to control their approach to risk more tightly.

This has helped to bolster the financial strength of the funds and restore their war chests. Growth, although modest, is starting again.

And steadier insurers, though still weak on their feet, have begun to reduce the exit penalties on funds and ease back on the bonus rate cuts. Indeed, bonus increases are making a tentative comeback.

Norwich Union said two weeks ago that it would award a higher bonus to 600,000 with-profits policyholders in its mid-year review.

Other big companies have yet to declare their hands, but it is hoped that Norwich Union's decision signals an end to much with-profits misery.

But before the industry arrives at the oasis, it is worth remembering that with-profits policies - in any form - are still not being recommended by financial advisers.

Ned Cazalet, an insurance analyst, suggested last week that anybody saving pension cash in a with-profits fund should consider moving it into a multi-manager fund (where their money would be spread across lots of investments).

A particularly uncertain future lies ahead for savers in with-profits funds that are closed to new business. Without performance incentives, these zombie funds are set to stagger along until they are wound up.

Any with-profits customer - whether in a strong company such as Norwich Union or a closed counterpart such as Swiss Life - who is uncertain about its future should see a financial adviser.

Rather than leaving their investment to the vultures, they may find that there's some life left in it yet.

s.dunn@independent.co.uk