Up until this time, with-profits funds had been used extensively to help people fund their mortgages, with the promise of paying off the mortgage and offering a lump sum at the end of it.
But a low interest rate environment and poor performance from equities meant that many would not meet the commitments people were expecting from them, and the FSA - as was - got involved and with-profits funds fell completely out of favour.
But many organisations do still offer with-profits funds, as a more basic savings vehicle or in the form of a pension, and according to industry analysis, they still offer useful returns.
Barnett Waddingham says that as at the end of 2017, the average performance of with-profits funds for one year was 6.22 per cent, and the five-year figure is 6.85 per cent, achieving a positive return over five years.
In its fifth investigation into with-profits funds, 'UK with-profits fund: investment performance and strategy', the actuary said: "We observed a range of investment returns achieved by the funds investigated over one year.
"In general, larger funds performed better than smaller funds. Despite this general trend, a number of smaller funds have performed well compared to the best performing larger funds."
Market players
According to the Association of British Insurers (ABI), the number of with profits policies held by ABI members fell from 5.2m in 2012 to 2.5m in 2017. According to actuary AKG, the biggest player in the market is Prudential, which reported £8.2bn of premiums in 2016, and a 31 per cent market share.
Standard Life Assurance, came in at £800m, with a 7 per cent market share and a number of mutuals have a strong presence with Royal London, Wesleyan Assurance Society and NFU Mutual making it into the Top 10.
Martin Shaw, chief executive of the Association of Financial Mutuals, says: "My mother had six with-profits policies and they paid nearly double the term. For an awful lot of people that's a really positive story.
"Where they weren't relying on the with-profits to pay off the mortgage people have had really positive results."
He added that, quite often, with-profits funds can outperform the typical unit-linked balanced managed fund, "but you also find a difference between mutual-owned organisations and Plcs because you're not paying money out to shareholders."
With-profits funds are essentially invested in an array of assets, typically equities, bonds, property and cash. As such they operate in a similar way to a multi-asset fund, but the difference is that they give a form of guarantee, promising a certain return at the end of the term, and they operate a process called 'smoothing', which is when returns are held back during a good year, to add to the pot during a bad year.
Understanding the bonus
It is this process that has got with-profits funds into trouble, as it is considered something of a dark art in terms of how it is managed.
Mark Stone, financial planning director at Whitechurch Financial Consultants, says: "With-profits have been much maligned over a large number of years because a lot of companies that were pushing them reduced bonuses dramatically.
"You still have the bonus declaration. You get smoothing and regular bonuses when the overall fund outperforms. The downside is the complete opposite when it falls.
"If the market goes up 10 per cent and your bonus declaration is 5 per cent, you'll get 5 per cent, not the full market growth. But if the market goes down, you don't get the bonus being made."
What made matters worse was when people wanted to cash out of their fund, but the fund assets were less than the smoothing had allowed. This happened particularly during the time of the financial crisis of 2008.
You get smoothing and regular bonuses when the overall fund outperforms. The downside is the complete opposite when it falls.Mark StoneMr Stone observes: "When you have extreme market conditions the underlying value can be reduced. With any with-profits fund you have the value including bonuses, and you have an underlying basket of assets and the smoothed value.
"Following the 2008 correction, because values dropped dramatically, the MVRs were applied because the underlying value of assets was less than the smoothing. There's no transparency in the charges or the smoothing.
"Most will tell you what their smoothing process is, but you can't see where you are in that timeline."
Scott Eason, a partner at Barnett Waddingham, explains: "They're trying to spread the risk. Fundamentally you might not get as much if the markets go up, but if the markets fall, you might not lose so much.
"A lot of people like the smoothing element if the timing goes against them - there's a lot of reasons why people would use them.
"The problem was in the way they worked - you don't just get the investment return, you get a bonus. For example, you might have £10,000 at the start; every year the insurance company will add a bonus of 1 per cent, and your account will be £11,000, that's what the guarantee is worth.
They still liked the guarantees, they didn't like the ability to change the underlying assets.Scott Eason"Before the dotcom bubble burst in 2011, they were 70 per cent in equities and were paying high bonuses."
However, after the bursting of the dotcom bubble, a lot of insurance companies moved into bonds, and so did not achieve anything like the returns they were getting previously.
Mr Eason says: "That's what people didn't like. They still liked the guarantees, they didn't like the ability to change the underlying assets, and develop it into something that they weren't buying into at the beginning."
While the market for with-profits policies to pay off one's mortgage is over, a substantial number of organisations still offer with-profits policies in a number of formats. Prudential offers access to its Pru Fund, a large with-profits fund, and people can use with-profits policies for pension accumulation and decumulation.
Investors can also take out a with-profits as a savings policy, while many mutual organisations offer a simple tax-free saving plan, that allows savers to put aside up to £300 a year into a with-profit policy.
melanie.tringham@ft.com
