With Profits Funds are no longer as important a part of pension funding than they were. However, there are so many still in force that this is an important topic. The earliest life insurance companies, such as the Equitable Life Assurance Society (established in 1762), wrote life assurance business which was necessarily priced with prudent assumptions.
These were originally ‘non-profit’ policies as far as the policyholders were concerned.
The life assurance companies found that their profits were greater than anticipated because the number of deaths were less than expected. These ‘accidental’ profits were distributed to policyholders as benefit increases.
If you have an old pension plan which is invested in a With Profits Fund then this section is for you.
With Profits Funds
With Profits funds were a mainstream retail investment until the early 1990s. They aimed to offer the inexperienced and more cautious investor significant exposure to growth assets, such as equities and property, but with returns that were ‘smoothed’ to reduce year-on-year volatility.
With Profits funds are a type of ‘pooled investment’ fund. You pay into the fund along with a number of other investors and your money is put together and invested in equities (i.e. stocks and shares), bonds (i.e. fixed interest), property (i.e. commercial property) and cash.
What distinguishes With Profits funds from other pooled funds are bonuses and ‘smoothing’.
What are bonuses?
The costs of running the insurance company’s business are deducted from the With Profits fund and what is left over (the profits) is available to be paid to the With Profits investors.
If you are an investor in a With Profits fund you do not get to see the actual value of the underlying assets. The value of the underlying fund changes daily, but your fund values grow by a steady rate, by means of a reversionary bonus, which is calculated annually. So bonuses are the way that the product provider allocates your share of the profits of the fund.
Whilst your fund value grows steadily by the addition of a reversionary bonus, it may be lower or higher than the value of the underlying assets. Generally, reversionary bonus rates are set at a level lower than the growth expected from the fund in the long run.
To make up the difference a terminal bonus is paid out at the end of the investment period. A terminal bonus is variable and is not guaranteed.
The product provider’s bonus plan aims to give you a return which reflects the earnings on the underlying investments over the period of your investment, whilst smoothing some of the extreme highs and lows of short-term investment performance.
What is smoothing?
The With Profits Fund aims to smooth some of the extreme highs and lows of short-term investment performance in order to provide you with a more stable return.
The product provider does this by holding back some of the investment returns in good years with the aim of using this to support bonus rates in the years where the investment returns are lower.
Smoothing, therefore, aims to reduce the direct impact of market changes on the fund investments and means that you are less directly exposed to rises and falls in the value of your investments over the shorter-term.
This smoothing mechanism helps restrict the variation in payout on the day that you need it – i.e. when the product matures. You can still get your money out at other times: but for smoothing to work, there needs to be a mechanism to protect the whole fund from being depleted from investors trying to exit after a market fall.
This protection is called a market value reduction (MVR) or a market value adjustment (MVA). If you wish to withdraw from the fund early at a time when the market value of the fund is reduced, you may find that your pay-out is reduced by an MVR/MVA so that the payout reflects the reduced market value of the fund in a manner which is fair to all customers.
However, to protect you from market falls just at the moment when you genuinely need the funds (as in a pension maturity), many providers guarantee that they will not apply MVRs upon certain events.
Please bear in mind, however, that smoothing will not stop the value of your plan reducing if investment returns have been low.
Conventional With Profits Funds
An initial sum assured (guaranteed minimum sum) is increased by the addition of annual bonuses and a terminal bonus.
The size of bonuses depends on fund performance, the costs of the insurance business, and the need to smooth bonuses between good and poor years.
The trend has been for bonus rates to fall in line with lower interest rates and investment returns since these funds were extremely popular in the 1970s and 1980s.
Surrender penalties would usually apply if the policy was terminated early with no reductions applied on maturity.
Unitised With Profits Funds
In the late 1980s and early 1990s most life offices replaced their conventional With Profits policies with the ‘unitised’ version, which aimed to make charges more transparent through the introduction of an annual management charge (AMC).
A unitised fund is split into units – when you pay into it you buy a certain number of units at the current price. Unit prices increase in line with bonuses declared, and do not fall. Or if additional units have been added, these are not taken away (but market value reductions can be applied).
There might be surrender penalties if you decide to surrender the policy early.
- Units may be fixed price – the price of the unit never changes so bonuses are paid as extra units to your policy.
- Or variable price – bonuses are given as an increase in the unit price, so each unit you hold is worth more.
Some funds offer a guaranteed roll-up interest rate ranging from 1.75% to 4.0%pa.
What went wrong for With Profits?
In the 1950s and 1960s traditional With Profits products were low risk with around 50% invested in equities and property, the equity backing ratio (EBR) and the balance invested in fixed interest assets and cash. In the 1970s and 1980s competition became quite fierce and in order to boost returns equity backing ratios typically moved up to between 60% and 70%.
Between 1973 and 1982 UK inflation had been in double figures and at the end of the 1980s and into the 1990s people were slow to believe that low inflation was here to stay and insurance companies were slow to reduce their bonus rates to sustainable rates. They were influenced by a competitive market and financial advisers who judged funds on past annual bonus rates.
By 2000 many With Profits funds were in a weaker financial position due to the cost of compensation payments for mis-selling personal pensions, increasing longevity, and the impact of annuity rate guarantees. It was at this point that global equity markets fell three years in a row. With Profits providers found that to meet liabilities to policyholders they had to dip into their reserves.
To maintain solvency, in terms of the regulatory requirement to hold sufficient assets to meet guarantees, many funds sold equities when prices were historically low and bought bonds, when prices were historically high, leading to significant net losses for the fund. The equity backing ratio typically fell to around 30%, while a minority of funds moved entirely into fixed interest. Annual bonuses fell, in some cases to zero.
When global stockmarkets recovered from 2003 to 2007 the funds did not significantly benefit because they had sold their shares. Even worse, as interest rates increased throughout 2004 to 2006, the prices of fixed interest investments fell, offsetting much of the gains made by the equities.
Most insurance companies now operate closed funds.
What you should check
- Principles and Practices of Financial Management (PPFM) – If you are invested in a With Profits fund it is worth your while to obtain a copy of the PPFM document which each company running a with profits fund has to provide. This contains detailed, technical information about how the fund is managed.
- Type of fund – is your With Profits fund conventional or unit linked?
- Product Provider – what is the view of the product provider and particularly their financial strength as measured by outside agencies?
- Is there a large difference between the current fund value and transfer value? If so this would indicate either a terminal bonus or an Market Value Reduction. If a terminal bonus then a transfer to a different fund or pension plan could crystallise this rather than risk losing it. If an Market Value Reduction is there an MVR free exit point?
- Does the fund offer a guaranteed roll-up interest rate?
- Timescale – How long is left before you want to take benefits from the pension fund?
- Attitude to risk – Does the asset allocation of the fund match your risk profile?
- What guarantees and options will be lost on switching out of the fund?
- Future performance potential – What are the prospects for the fund moving forward given the current asset allocation and particularly the equity backing ratio?
- What will the impact of costs and charges be if a transfer is recommended?
Links to more information about older pension contracts
- Retirement Annuity Contracts
- Section 32 Buy Out Plans
- Guaranteed Annuity Rates
- Guaranteed Investment Rates
- Pension Term Insurance
- Protected Tax Free Cash
- Hybrid Pension Schemes (or Underpins)
- Money Advice Service Pensions and Retirement
- If you need personal financial advice on With Profits Funds then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.