With ProfitsJan 3 2019

A new challenge for with-profits funds

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A new challenge for with-profits funds

For more than a decade, the with-profits story has stuck to a similar theme: dogged survival despite accusations that the funds are outmoded and archaic and suggestions that modern multi-asset solutions are a better fit for investors.

Jeremy Askew, managing director at Town Close Financial Planning, sums up the sentiment for many intermediaries. “I don’t see much of a future for with-profits [funds] and I don’t think the providers do either. Returns are generally moribund, costs opaque and it’s an odd concept to explain to clients,” he says.

New approach

Table 2 of Money Management’s 2018 with-profits bonds survey shows interest remains muted. But the concept – or a version of it, at least – is still finding favour in some quarters. Newer approaches that aim to offer smoothed growth while ironing out investors’ bugbears with traditional with-profits, such as widely fluctuating final bonuses and market value reductions, have gained traction.

This year the popularity of these products has shown no sign of abating, with Prudential’s PruFund range seeing £6.6bn of net inflows during the first nine months of 2018 alone. But other developments show that parallels can still be drawn with the traditional with-profits ethos. In late October, one of the PruFund range implemented a downward unit adjustment of 2.5 per cent in response to worsening market conditions, its first drop since 2013. 

In a similar vein, one of the plans we have surveyed this year, by Healthy Investment, is applying a 2.5 per cent MVR on traditional with-profits bonds taken out in the past year.

Any product investing in equities will have struggled during 2018, and with-profits is no exception. Previous performance was healthier. A report by Barnett Waddingham, published earlier this year and analysing 52 funds from 20 providers, found the average with-profits fund grew 6.2 per cent over the year to December 31 2017. The five-year figure was healthier still, increasing by an average 6.85 per cent a year.

Critics will undoubtedly point to stellar growth in equity markets over the same periods, and perhaps rightly so. But as Barnett Waddingham states, with-profits funds are often promoted as an alternative to cash, and those returns exceed cash rates and inflation.

The past 12 months, however, have proved a different story for both equities and subsequently with-profits portfolios.

Table 3 shows the average fund grew 2.5 per cent in the first 11 months of 2018, barely beating October’s consumer price index reading of 2.2 per cent. The instability of markets has only continued since then – the FTSE 100 dropping to a two-year low in early December being a case in point – meaning year-end figures are unlikely to be any better.

But with markets exhibiting their first sustained wobble for quite some time, the question is: could advisers cater for nervous and cautious investors by leaning towards with-profits to provide the required security without sacrificing equities for cash?

Tony Catt, compliance officer at TC Compliance Services, believes so. He still sees advisers using with-profits as part of a wider portfolio of investments.

He says: “The attraction is not so much the underlying investment, but the presence of the smoothing and any guarantees of minimum annual returns. With the current market uncertainty, the guaranteed minimum returns have become increasingly attractive.”

However, he concurs with Mr Askew that the outlook for traditional with-profits structures is less than favourable. “They would seem to be pointless now that there are so many multi-asset or multi-manager funds available that will do largely the same job,” he says.

Providers still hold out hope. Helen Jones, commercial actuary at NFU Mutual, says: “With-profits are still really popular with our advisers and policyholders. They are attracted by the consistently strong returns we have seen over the past five, 10 and 20-year periods, and value the additional benefits of smoothing and guarantees, especially in times when markets seem uncertain as they do currently.”

Similar to with-profits, investment bonds too are struggling to hold on to their former appeal. With all gains taxed at 20 per cent, their tax position is unfavourable when compared with similar products. Mr Askew explains: “I rarely recommend investment bonds, and when I do it’s offshore only, to be held in trusts, or where it’s completely clear the investor won’t remain in the UK.”

Reasons to be cheerful?

In spite of these challenges, our 2018 survey shows with-profit bond providers still have things to smile about. The market as a whole continues to shrink, but Table 1 shows there are three new plans included this year, albeit all from one firm. LV has released the third series of its Flexible Guarantee Bond for cautious, balanced and adventurous risk appetites. 

This is not a regular occurrence: 2012 was the last year a new bond was launched by the company, and the majority of plans surveyed no longer accept new money.

Despite the tax issue mentioned above, investment bonds do offer the facility to withdraw up to 5 per cent of the investment every year without incurring any additional tax liability, which can be useful when a bond is used for inheritance tax planning via the likes of a discounted gift trust. Therefore it makes sense that most plans allow income to be drawn on a monthly, quarterly, half-yearly and yearly basis.

With exception of NFU Mutual, all plans set a maximum investment limit, which varies from £100,000 to £1m.

Performance

Individual plan performance can be found in Table 3. As stated previously, the average fund grew by 2.7 per cent in the past 12 months to November 1 2018, and the average cash-in value is substantially lower at -0.3 per cent. This discrepancy is a likely result of early surrender penalties and MVRs. However, when compared with other mixed funds and the UK market, the figures, although still lower than investors would have hoped, take on a different complexion. 

The Investment Association Mixed Investment 40-85% Shares sector, the FTSE 100 and FTSE All-Share indices also all fell in value over the past year, strengthening the case for with-profits to smooth out returns during rough periods. The story over two years is similar, as average with-profits performance again trumps the aforementioned mixed-asset sector, and across five years it is only marginally worse.

But over a decade the limitations of with-profits are laid bare. Average annual growth of 4.7 per cent is far below the 8.2 per cent achieved by the average mixed investment fund, and less than half the 9.9 per cent yearly growth attained by the FTSE All-Share index. Table 4 outlines how cash-in values have changed over the past decade.

There are some impressive individual performances. The Teachers Assurance Anniversary Bond, administered by LV, has averaged 9.4 per cent a year over 10 years, turning a £10,000 initial investment into £24,474. 

NFU Mutual’s Flexibond is another solid performer, mustering average annual growth of 6.7 per cent over the past decade, with Aberdeen Standard also delivering a yearly return exceeding 6 per cent.

The importance of selecting the right with-profits bond is highlighted by performance at the other end of the scale. Both of Healthy Investment’s products have struggled to produce an inflation-beating return with an annual growth rate at just 2.4 per cent a year.

According to Alistair Cunningham, financial planner at Wingate FP, performance such as this could be as a result of the guarantees on offer.

He says: “I do not like the lack of transparency and control you get with with-profits funds; they only really make sense for behavioural reasons, and the downsides generally outweigh any benefits. 

“This is probably true of most funds offering guarantees of any sort.”

Paying the penalty

Whether with-profits bonds rise or fall is determined by two factors: bonuses and MVRs. Bonuses are split into types – annual and final. It is important for advisers to play close attention to how individual plans add bonuses, because once annual bonuses have been added they cannot be taken away. 

However, final bonuses are regularly reviewed to reflect the performance of the underlying fund. This often means that funds adding low annual bonuses and larger final ones are more prone to sharp fluctuations in value. Details of final bonuses are shown in Table A and highlight the divergence between providers’ approaches. 

On the whole, plans tend to offer some type of final bonus, and this is largely dependent on the year in which the policy commenced. For example, Phoenix Life’s former Scottish Mutual V bond has terminal bonuses ranging from 18.5 per cent to more than 140 per cent, with the earliest plans having a higher probability of a large bonus. 

Others, particularly some of the larger providers such as Aberdeen Standard and LV, prefer not to use final bonuses and instead opt to smooth out growth annually.

In general, there is little change on this front compared with last year’s survey, but the same cannot be said about MVRs, as detailed in Table B.

In recognition of the dip in stock market values, the number of bonds applying MVRs has jumped to five from two. 

The application of an MVR is not permanent, and an uptick in markets should result in their removal. But it does offer a useful reminder to investors that funds aiming to offer smoothed investment growth can still fall victim to stock market slides. The highest MVR currently applied is by Prudential, and in some cases this exceeds 5 per cent.

Managers of with-profits funds have few constraints on their investment powers, but most still prefer a conventional mixture of equities, bonds and property. That said, the proportions of how these are allocated can vary wildly from manager to manager. See Table C.

Last year there was a clear trend of managers shifting money away from domestic to global stocks, in reaction to the uncertainty caused by the Brexit vote. This year the average allocations to each asset class have remained largely static, with only a small movement away from bonds into equities. 

The cautious approach taken by managers is highlighted by the similarity between average equity (42 per cent) and bond (41 per cent) weightings. Individually, some take a more aggressive approach than others. Phoenix Life’s Socially Responsible Bond and Wesleyan invest 73 per cent and 62 per cent in equities, respectively.

Years of strong returns for risk assets mean that the added aggression has paid off until now, as the link between equity allocations and performance reveals. 

The four top-performing funds as shown in Table 3 – Aberdeen Standard, NFU Mutual, Teachers Assurance and Wesleyan – all hold more 50 per cent in equities, far exceeding the average. Notably, despite the wider market’s pessimistic view of domestic stocks, both Wesleyan and NFU Mutual continue to have more than 40 per cent allocated to the UK.

For the coming 12 months, both Prudential and Aviva will hope for sales volumes for their newer with-profits ranges to continue on the same trajectory. 

But it’s debatable whether even the solid returns produced by some firms at a time of macroeconomic uncertainty will be enough to halt the exodus from with-profits to multi-asset.