Investment Solutions for 'With Profits' Investors

If you bought an investment policy, such as an endowment or pension, in the 1980/90s it's possible your money was invested into a 'with profits' fund.

The concept of with profits was sound.

The idea was that your money would not be directly exposed to the stock market. Instead, your plan would earn a bonus each year. This would be largely based on the returns that your provider had achieved and the
prospects for future years.

The pension or endowment provider would attach the bonus to your plan (known as a reversionary bonus), which could not be removed. At the same time, in years of good fund growth they would retain a portion of the profits which could be used in future years to pay a bonus when performance was poor, or even negative.

This 'smoothing' effect attracted a lot of investors as it was a way in which they could benefit from investing in the stockmarket without directly taking the risks.

When the policy matured the provider would usually pay a loyalty bonus (known as a terminal bonus). Although not guaranteed, this bonus often had the effect of increasing the returns by a considerable amount, especially late in the 1980s (many endowment companies were paying annual bonuses of up to 9%, with the overall return being 13% when the terminal bonuses was included).

How does With Profits Work?

It's important to understand how the funds work. Even though the provider may pay you an annual bonus, it's highly unlikely that the fund itself will be achieving the same amount of return, as it will normally be higher or lower.

Your money is invested across different 'asset classes':

-equities (shares)
-bonds
-property
-cash

Since 2000 many companies have reduced their exposure to equities,
therefore reducing their growth prospects. The typical fund has gone from 65% equities exposure to 30%. In 2005 the equities % were (for pension funds):

-Clerical Medical 34.4%
-Friends Provident 29.1%
-Standard Life 19.3%
-Equitable Life 4%

Also let's consider the fall in the bonus rates.

We mentioned earlier the 9% bonus rates. What you also have to consider is the real rate of return. In 1990 the rate of inflation reached 9.5%, so with an overall return of 13% the real rate is the difference, being 3.5%.

With profits companies are now paying annual bonuses of 0-4%. There's also been a fall in terminal bonuses.

We believe that a number of with profits funds are not satisfying the objectives they were originally designed for. 

So, if you have money invested in with profits, what can you do?

Step 1

Find out what bonuses your provider is paying, along with the percentage exposure they have to equities. Also check what the charges are on the plan. If they are paying a bonus of 4%, but the overall annual charges are 4% (which is possible when you factor in all the charges), then you are LOSING money in real terms.

Step 2

Ask for a transfer value (for a pension) or cash in value. You also need to check if the provider will apply a 'Market Value Reduction', which is applied to protect the existing investors in the fund. If they do apply one, it will mean you will be offered a lower amount than its current value.

Step 3

Assess your attitude to risk. There's a number of tools that you can use for this. The results will help you decide what exposure to shares you will be comfortable with.

Step 4

Choose the most suitable investment portfolio in line with your attitude to risk. Let's look at some examples with their annual returns from 1988 to 2005:

-100% Fixed Interest, 7.1% pa
-20% Equity 80% FI, 8.0%
-40% Equity, 60% FI, 8.9%
-60% Equity, 40% FI, 9.6%
-80% Equity, 20% FI, 10.3%
-100% Equity, 10.8%

Source: Dimensional Matrix 2006 Year Book

The FTSE All-Share, which covers 97% of the market, has returned 10.8% pa during this period.

As you can see, increasing exposure to risk brings higher returns (and more risk), but the main benefit is that you will be benefit from the returns immediately as none of the returns will be carried forward, as is the case with 'with profits'.      

The Key Considerations

Reviewing your investments should be a priority. Many people make the mistake of thinking that the tax wrapper they have (such as a pension) is the investment. The funds your money is invested into is KEY to ensuring you achieve the returns you desire.

Take the time to go through your investment portfolio, especially if you have money in with profits funds. Don't underestimate the importance of doing this, as it will be too late when the policy matures or you are due to receive the proceeds.

NOTE: Past performance is not a guide to future performance. The value of your investments may fall as well as rise.