In general capital guarantees tend to apply to products with a fixed term, or to be applied on set anniversary dates (for example, the 10th anniversary of opening a product and subsequent five-year anniversaries), or upon the death of the policyholder.
Smoothing
Performance smoothing is carried out by adding bonuses to members’ funds.
These fall into two main categories: regular ‘reversionary’ bonuses added to members’ pots every year and ‘terminal’ or ‘final’ bonuses added when an investment matures or is cashed in.
On occasions a market value adjustment could also be applied when a member voluntarily cashes in an investment following a sustained period of falling markets. This helps ensure no member benefits or suffers disproportionately.
Reversionary bonuses are, once declared, guaranteed and cannot be reduced or taken away in future unless the policyholder stops paying premiums before a policy with a fixed term matures.
Interim bonuses, which can later be reviewed, can also be applied when a member cashes in an investment part-way through the year.
During the first year of a policy, the reversionary bonus added to that policy would be pro-rated.
So if, for example, a reversionary bonus of 2 per cent were to be declared for a given year, then a customer with a policy valued at £10,000 would lock in a bonus of £200 for the year.
If, however, they were to have made their investment three months into the year, then the bonus would be based on the nine months the policy had been in force.
So, in the case of a £10,000 investment, nine-months’ entitlement to a 2 per cent full-year reversionary bonus would equate to £150.
Calculating bonuses and MVAs
The unpredictability of market performance and the way liabilities change as members of different ages and life expectancies join and leave make it neither practical nor desirable to calculate bonuses based on a fixed, inflexible formula.
Nonetheless, a clear process and set of rules apply when deciding the extent to which returns are smoothed.
The rules that govern smoothing are set out in the fund’s Principles and Practices of Financial Management.
Bonuses and MVAs are agreed by the provider’s board after receiving actuarial advice about the fund’s liabilities.
They are calculated based on what is known as an ‘asset share’ – the proportion of the fund’s returns, net of costs, attributable to each member based on the contributions they have paid.
The precise bonus that is paid is decided within a range on either side of the asset share value.
In years of strong performance the reversionary bonus may be set at, for example, 80 per cent of the asset share.
