With ProfitsJan 17 2019

How with-profits funds work

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How with-profits funds work

With-profits funds work by using guarantees, which are set at the start of the fund, and are the minimum sum assured.

Quite often, this will simply be the return of one's premiums. 

Then the actuaries will decide how to add bonuses each year, which, once allocated cannot be deducted, and will reflect how well the fund is doing, and whether the company wants to hold back returns in a good year to tide people over in a bad year.

This is the process of 'smoothing'. Then at the end of the policy the idea is to add a terminal bonus, following the final returns gained on the overall fund. 

If it looks like the assets and the premiums are going to be bigger than what we've guaranteed to pay we will look to pay a bonus.Andrew Burke

Andrew Burke, a with-profits actuary of Phoenix, which runs 13 closed with-profits funds, says: "We get the premiums from the customer to invest and we invest them in different asset types and hopefully, over time, they will grow.

"If it looks like the assets and the premiums are going to be bigger than what we've guaranteed to pay we will look to pay a bonus."

The annual bonus is allocated to the fund, and is not taken away again once allocated. The life company will also allocate a final bonus based on how well the fund has performed compared to the guarantees made at the outset.

Kevin Arnott, also a with-profits actuary of Phoenix, says: "I think one of the things that has got to be borne in mind about closed life funds, they're obviously closed for a reason. Sometimes the reason is they're in some kind of financial difficulty.

"That comes to what sort of asset mix you have. Not all of our funds have the same asset mix; if they only have enough money to cover their guarantees, they won't invest much in volatile assets like equities, which could go down, and you won't have enough money. 

"Some funds are invested in fixed interest assets because they're not very strong.

"The funds that are financially stronger are 50 per cent in equities and growth assets, and the balance in fixed interest."

Bonuses

When it comes to working out the bonuses, Phoenix looks at the asset performance, and the expenses it has to deduct, and compares it to what it has guaranteed at the end of the term.

Mr Arnott says: "Once you've made them, you can't take them away."

The final or terminal bonuses are reviewed every six months.

Mr Burke explains: "Say someone decided 25 years ago to pay £100 monthly and we guaranteed they couldn't get less than £30,000; say these premiums with investment returns and expenses, it's grown to £40,000, you come to the end of the policy and we can see you've built a pot of £40,000, we will make a 33 per cent final bonus which will lift it to £40,000."

With-profits funds work similarly to a balanced fund, in that they invest in a variety of assets - typically the usual equities, bonds, property and cash mix.

They were conventionally invested in equities, and produced strong returns until the dotcom bubble burst and they were forced to invest more heavily in bonds, which meant the returns were not so healthy.

Performance

In Barnett Waddingham's with-profits survey of 2018, researchers found a wide variety of asset classes, "although most could be described as balanced funds, with a mix of all major asset classes.

"On average, larger funds have larger holdings of equities and property, and these proportions have increased over the five-year horizon."

It found investment performance was dependent on two factors.

"The first is the high level asset allocation between the different asset classes, and the second is the stock selection within each asset class. Stock selection contains two sources of difference - the breadth of assets invested in within a class and the actual names held.

"Equities were the strongest performing asset class [in 2017], followed by property. Both performed significantly better than bonds. The bigger funds have the largest allocation to equities and property and hence benefited from this increased exposure," the survey states.

The Prudential With-Profits Fund is 18 per cent invested in UK equities, 33 per cent invested in overseas equities, 14 per cent in property and 26 per cent in fixed interest.

There are good with-profits funds that have a proven track record.Mark Stone

The balance is invested in alternative assets and cash. At the end of 2017, it had returned 10 per cent over one year and 56 per cent cumulative over five years, although this is before charges and the effects of smoothing.

Not everyone likes with-profits, because of the basic way they are constructed. The problem is the way that bonuses are determined each year, and the final bonus.

Some of the with-profits funds' critics claim that it is not clear how these are calculated and how much a policyholder's policy is truly worth.

It is basically up to the actuaries to decide how much can be allocated to the fund each year, and how much to hold back; sometimes they get this wrong and apply Market Value Reductions to adjust to the new realities.

Mark Stone, financial planning director at Whitechurch Financial Consultants, says: "They're not something that we use regularly but they are looked at. There are good with-profits funds that have a proven track record. 

"There are the customers who have held them for a number of years and the value has gone up every year."

However, many advisers are reluctant to use them because they can get more clarity on a unitised fund.

melanie.tringham@ft.com