Beware the media criticism of with-profits bonds ' compared with most equity and bond investments they will perform better and give peace of mind, writes David Aaron
Recent newspaper articles have misled investors about the merits of with-profits bonds because of the difference between the amount companies earn on their with-profits fund and the amount they pay out.
The Prudential's with-profits Bond Fund made a gross investment return of 86.6% over the past five years. Out of this, it had to pay 15.2% in tax giving a net investment return of 71.5%. From this, the deduction over the five-year period was 12.8% for charges and the cost of 'smoothing', giving a net bonus return of 58.7%. The equivalent annual reduction in yield is 1.7% a year, which is very much in line with the charges on a unit trust (source: Prudential).
Furthermore, over the last five years, with-profits bonds have given average returns of about 60% net of basic rate tax. This compares well against the average UK All Companies unit trust, with returns of 56.5%, and the average Global Growth unit trust, with average returns of 39% (after basic rate tax but before capital gains tax). With insurance bonds, higher rate taxpayers only have a liability of 18% tax on gains from bonds as opposed to 40% tax on any grossed up income from a unit trust, because the life company has already paid tax at a reduced rate.
with-profits bonds pay bonuses each year, which, once allocated, cannot be taken away on death, although companies reserve the right to apply an MVA penalty for those who cash in early. This is perfectly fair as insurance companies must protect the interests of their long-term investors.
While the national press is quite right to criticise with-profits bonds for their lack of transparency, but some of the leading companies are now changing their stance on this and are quite rightly pointing out how much money is earned on their fund.
The smoothing effect
There have, of course, been times when the stock market has performed better over a five-year period than the bonuses paid on with-profits bonds but the situation has also been the other way around, as is currently the case. The smoothing effect gives investors confidence as well as enabling them to sleep at night when there are huge falls on the stock market. Investors are buying a fund that deliberately does not pay out what has been earned and choose to receive a little less than the actual returns in rising markets so they can receive a little more than the actual returns in falling markets, such as in the past year.
This protects their investments from the volatility of the stock markets. Most with-profits bonds also allow investors the ability to withdraw up to 7.5% net of basic rate tax without any penalty. At present, this is in excess of what most with-profits companies are paying in annual bonuses but could be very valuable again if interest rates go up or stock market returns increase to the levels reached over the last ten years or so.
While with-profits bonds are not the answer to every investors' needs, they should form part of a core portfolio for most investors and a large part of portfolios for elderly investors who wish to supplement their income tax efficiently.
The other criticism of with-profits bonds is the high commissions they pay to intermediaries and the life companies' sales staff. My view is that advisers should be paid for the amount of work and time they spend when advising their clients and also for the quality of investment and tax planning advice they provide. In some cases, only a small commission is warranted and here charges should be reduced. In other cases, where a lot of time is spent sorting out clients' affairs, setting up trusts and re-arranging a client's investments for example, a slightly higher level of commission is fully justified. Commissions can also more cost effective for the client in comparison to fees, which have to be paid out of after taxed income and are subject to VAT. On the other hand, it would be sensible if commissions on with-profits bonds were to be standardised so that there is little temptation for intermediaries or other agents to choose one company over another. So, whether the adviser takes a commission and rebates some, or charges a fee and rebates all, of the commission, it is important to be fair when dealing with a client by making the investment cost effective.
Equitable Life has done the industry a great disservice by paying out higher profits than its free asset ratio justified and by its historic mismanagement over the guaranteed annuities affair. But even so, the returns on its with-profits funds are still likely to be higher than those from building societies or bank deposits.
Shadow over integrity
Another development that cast a shadow over the integrity of some of the with-profits bonds funds is the High Court ruling on the distribution of 'orphan' assets that have been built up within the with-profits funds of two companies taken over by AXA, Equity & Law and Sun Life. As a result, the Consumers Association believed that insurance companies have not given fair returns over the years but have built up around £30bn of orphan assets through the underpayment of returns to policyholders.
AXA will only distribute £225m of the orphan assets to with-profits policyholders as re-organisation bonuses, out of a total of £1.7bn. This will increase the value of their policies by about 3% when they mature. In addition, AXA has proposed that one-off payments averaging £400 would be paid to policyholders, costing £300m in total from its own resources, in return for people waiving any interest in possible future distribution of surpluses from the orphan assets. This claim was accepted by over 500,000 members, representing about 79% of policyholders by value.
AXA argued that it had identified only £250m out of the £1.7bn as being surplus. The balance has been needed as reserves to provide investment flexibility and financial strength to safeguard all policyholders. There is some justification for this as there is little doubt that as a result former Equity in Law & Sun Life policyholders will continue to receive competitive bonuses.
Push for transparency
The Faculty and Institute of Actuaries has published a paper containing recommendations on how transparency for with-profits bonds funds might be achieved and argue that such funds offer an attractive, medium to low-risk savings vehicle. If their proposals are accepted, this should give investors confidence and be helpful to intermediaries.
The FIA paper also suggests a specific reporting model for with-profits policies to show all groups that policyholders are treated fairly. There is a separate reporting policy for any category of business to which a distinct bonus policy applies. It also recommends that detailed written records are kept of how such funds are managed and that clear and comparable information is provided to policyholders on the management and performance of funds.
Howard Davies, Chairman of the FSA, describes with-profits funds as 'opaque'. The FSA is now reviewing such funds and will concentrate on the extent of the discretion that is available to management over and how this discretion is exercised. It is also looking at the transparency of published information about the funds and how better information can be provided to policyholders, by describing investment strategies and the way in which terminal bonuses are determined.
Even though, as a result of low interest rates and possibly lower stock market returns, with-profits bonds may not give such high returns as in the past, I still believe that, compared with most other fixed interest and equity investments, they will perform better and give investors peace of mind.
The smoothing effect on a with-profits fund gives investors confidence.
With-profits protects investments from the volatility of the stock market.
With-profits should form part of most investment portfolios.
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