With profits back to delivering presentable returns

So why is it that investing in with-profits products is viewed so unfavourably, and does that view continue to be valid?

In essence, the with-profits concept provides investors with the potential to invest in a wide range of assets and to receive a smoothed investment return. These policies have generally been used for longer-term savings – to pay off a mortgage or for a pension, for example.

In a with-profits fund, policyholder premiums are invested in a pooled fund of assets, a significant proportion of which are usually in the form of real assets promising returns in excess of inflation. There will be smoothing of claim payments to insulate the policyholder from the extremes of market variations.

There may also be a share in the wider profits or losses of the insurer, for example those arising from mortality experience and expense levels. Finally, the with-profits policy will have certain guarantees, for example a guaranteed amount on death or maturity.

The range of investments found in each company’s with-profits fund varies considerably, and in some cases may be a simple mix of equities, property and fixed-interest securities.

In other companies the with-profits fund may include investments in infrastructure assets, emerging markets, venture capital as well as, in some cases, other forms of insurance business.

The smoothed investment returns are delivered to policyholders by means of the addition of regular bonuses, usually in guaranteed form, and a non-guaranteed final bonus at the time there is a claim on the policy.

Historically, policyholders found themselves in the happy position the final payout was higher than they had anticipated

These bonuses are at the discretion of the company, and there are now a large number of rules and regulations surrounding the use of discretion and the fair treatment of customers holding with-profits policies.

Some companies have gone to the extent of creating with-profits committees, often drawn from independent non-executives, to monitor the use of discretion and ensure fair treatment of policyholders.

If you look back far enough, the investments underlying with-profits policies, almost exclusively, used to be fixed-interest securities, and bonuses were only in regular, guaranteed form.

During the 1960s and increasingly in the 1970s, wider investment policies were adopted, and as equity performance outstripped that of fixed-interest securities, non-guaranteed final bonuses became more prevalent and steadily larger.

Also as a consequence, policyholders found themselves in the happy position that the final payout was higher, and sometimes significantly higher, than they had anticipated. Hence mortgages were paid off and there was money left over, or pensions were larger than expected.

With-profits business was extremely popular through the 1980s and into the 1990s. Investment returns from many investment classes performed strongly through this period and, when there was a downturn (such as Black Monday in October 1987, or Black Wednesday in September 1992) the smoothing concept came into its own.

In this period the payouts on with-profits endowment savings plans became a kind of symbol of the strength, expertise and talent inherent in each company. So companies vied with each other to appear in the top placings of the annual survey of with-profits payouts.

And eventually, payouts lost connection with reality and with fair returns and were used primarily for marketing purposes to promote sales of new business.

So as the 1990s ended and the 2000s began with reducing interest rates and a series of poor stock market returns, the with-profits bubble burst. Payouts had to be cut and as the table below shows – they were cut hard.

As a result with-profits savings policies and investments proved to be a major disappointment to many savers. For some investors, projected growth rates turned out to be overly ambitious and their expectations for continuing levels of unrealistic payouts could not be met.

Also over this period, policyholders have come to expect a much greater degree of transparency in their financial products. Older style with-profits products suffer from a degree of complexity and opaqueness which makes assessing the value of your product hard to understand and which today’s generation of investors does not appreciate.

Despite all this, with-profits business retains a very strong presence in the investment markets, with total assets under management of around £300bn as at the end of 2014.

With-profits business retains a very strong presence in the investment markets

Is the historic perspective obscuring the benefits of the with-profits approach?

To paraphrase Warren Buffett: “It takes 20 years to build a reputation and five minutes to ruin it.”

Something similar could be said about with-profits business; after many years as the ‘poster boy’ product it fell short of customers’ expectations and is now trying to rebuild confidence and trust.

In my view, with-profits should be seen as a cautious, long-term investment vehicle that helps smooth out the bad years by keeping aside some of gains in the good years. The product really has to be invested over a reasonably long period in order to allow it to smooth out the peaks and troughs for a few economic cycles.

The more modern with-profits products have been designed to be more transparent with clearer charging structures, similar to unit-linked products, and a clear view of the investment strategy and smoothing policy. These appeal to the current generation of investors with their desire for transparency.

Recent payouts on single premium investment bonds show that there are some with-profits funds giving quite presentable returns over a longer period. From our analysis of a survey of payouts on investment bonds surrendered in 2015, the average payout of a little over £16,000 would have produced a return of around 5 per cent a year on an investment of £10,000 in 2005.

As with all investments though, choosing which company to invest with can make a large difference.

The best and worst performers produced significantly different returns resulting in payouts in excess of £3,000 more or less than the average.

While many with-profits funds have closed to new business, there are several well-known names with significant funds which continue to attract significant volumes of new with-profits business.

Around £4bn and £5bn on new single premium with-profits business has been written each year for the past three years, with one company responsible for more than 2/3rds of those sales. The mutual sector, as would be expected from the movement that gave us the with-profits concept originally, is also well-represented here.

With-profits products retain popularity in certain areas of the market. With their access to a wide range of diverse investments, the smoothing mechanism and greater transparency, they remain very well-placed for cautious investors looking to invest over the medium to long term.

Tim Bateman is a life actuarial partner at Mazars