With-profits bonds, once a popular form of life insurance-based investment, have slipped in popularity over recent years. Their status tumbled as a result of a poor economic climate, when funds could not make the promised annual payments to clients.
In a with-profits bond, investors pay a lump sum into the fund for a stated number of years. The manager then invests these funds into a wide spread of assets. As the investment grows, reversionary bonuses are added on, usually on an annual basis. The amount paid out by this bonus is determined by how the fund has performed since the last payment.
The cost of running the bond is deducted from the fund as management charges, typically between 1 and 2 per cent depending on the provider. The annual management charge (AMC) may be determined by the amount invested in the fund, with the fee as a percentage often decreasing the larger the sum invested. This is the case with Aviva, LV= and Teachers Assurance. Engage Mutual was the only provider surveyed whose percentage fee increased in line with the sum invested.
One of the most appealing elements of with-profits bonds is the “smoothing” process, in which – in simple terms – some money is held back in reserves during years of strong performance so that payments can be made in years when the fund has underperformed. Investors, in theory, could rest assured knowing that even in years of economic turmoil they could rely on income from their with-profits bond.
Economic downturns
What sounds good in theory does not always work so well in practice. Years of underperformance caused reserves to dry up and investors to be denied their payments, leading many with-profits bonds to go under.
Market value reductions (MVRs) started to be imposed on with-profits bonds just over a decade ago to remedy prolonged periods of poor performance. The reductions may be applied after a lasting or particularly steep downturn in the value of the assets in which the fund is invested, as it decreased the amount investors receive should they withdraw from the bond during such times.
Fewer providers of with-profits bonds are currently imposing MVRs; they proved deeply unpopular with investors as they had no way of predicting what level of MVR would be imposed until they withdrew their funds. Details are illustrated in Table A.
