The Sandler Review highlights the need for with-profits providers to improve the performance information they provide to advisers and ensure policyholders are less exposed to business risk in the future
It seems long-term investors with a low tolerance to market volatility will continue to demand a product that offers a substantial exposure to real assets to ensure a return above that available on deposits that at the same time manages the short-to-medium term volatility associated with equities and, to a lesser extent, property.
Given the inherent contradiction in such a demand, any product that aims to meet these requirements will be flawed, as was recognised by the Financial Services Authority (FSA) in its review of with-profits, and by the Sandler Review. In its feedback statement on the with-profits review, the FSA pointed out the very features that manage volatility are also the chief cause for concern over lack of transparency and poor consumer understanding.
Despite the criticisms of with-profits, the industry has yet to come up with anything better for the mass market. As the cautious investor has recently learned, managed unit-linked funds can suffer from extreme volatility, while black box guaranteed products tend to be expensive in relation to the returns they deliver due to costly insurance or derivative contracts. Hedge funds are the most recent contender for the ultimate compromise but, with their peripatetic star managers, lack of communication to investors and extraordinarily high fees, arguably represent a regression from the with-profits concept, not progress.
As regulators and the Government ponder how they can improve the design of with-profits policies, one hopes they will consider the way providers have run their funds, as much as the structure itself.
While market conditions are undeniably grim, it is hard to see how a prudent smoothing process could lead providers to impose the high level of market value adjusters (MVAs) we are currently seeing.
Surely this indicates not so much that the smoothing process has failed as the fact that during the late 1980s and 1990s, providers distributed too much profit in the form of annual bonuses in order to maintain a top-quartile league table position.
There are two aspects of the Sandler Review on which providers might focus. The first is to develop a much more transparent bonus allocation policy so advisers and consumers can see to which factors the return is attributable. There are four different elements here:
l The underlying investment return.
l Smoothing of this return, either up or down.
l The contribution from participation in the provider's other lines of business.
l The costs.
Companies are notoriously touchy about disclosing the actual performance of their with-profits funds, although both Watson Wyatt and Hewitt, Bacon & Woodrow, in their 2002 Additional Voluntary Contribution (AVC) surveys, report an increasing number are now prepared to provide this information.
This should not be optional. It is an anachronism that advisers are unable to assess whether a good overall return for their clients was achieved through superior asset management skills or through imprudent use of the smoothing mechanism.
The days of actuarial shyness over smoothing are surely numbered.
The Sandler Review also suggested one of the main problems with the with-profits structure is that policyholders are exposed to the business risks of the provider. It is important to remember Sandler's recommendation to ring-fence with-profits funds was directed at proprietary companies not mutuals.
David Hare, head of with-profits communication at Standard Life, says: 'Sandler's concern is that PLCs could rip people off without their knowing it if, for example, they use the with-profits fund to make strategic investments that favour shareholders rather than policyholders.'
While the recommendation on ring-fencing has generally been welcomed, it would be misleading to suggest this is necessarily in policyholders' interests. Much depends on the provider, which is why it will always be difficult for the consumer to choose a with-profits policy without advice.
Until comparatively recently, the exposure of policyholders to business risk was generally considered a good thing and, as mentioned above, provided an important element of the overall return.
So, is Sandler suggesting only ring-fenced funds can be safe in future? If so, this puts unfair pressure on mutuals and provides rivals with unwarranted ammunition.
Will proprietary life offices suggest their funds are inherently safer than those of mutuals? They almost certainly will, which is a shame because this will confuse the public even further on how mutuals work and may put another nail in their coffin.
In the case of a mutual, the with-profits fund forms part of the balance sheet and new generations of with-profits policyholders effectively provide the necessary share capital.
Mike Wadsworth, a partner with consultant Watson Wyatt, says: 'In a sense, mutuals cannot abandon their traditional with-profits fund. Even if they do ring-fence a fund for a particular product, it is still their capital. For this reason, when you buy a with-profits policy, it is more like buying a single company share or becoming a member of Lloyds than buying a smoothed asset investment.'
Unfortunately, this is a tough point to explain successfully to consumers, particularly if they are seeking a low-risk environment. The difference between the potential risks of with-profits and the likely risks is vast. Having said that, post-Equitable, it is hard to argue that the worst scenario never happens.
If the with-profits funds sold within Sandler's suggested suite of regulated products are ring-fenced, it will result in a wider range of with-profits structures from which advisers can make their selection.
'With a strong, successful company, the returns are likely to be lower on this special type of fund than the main with-profits fund but it will be less risky,' Wadsworth says.
Whichever structure is chosen as most suitable for a client, the selection process will still need to focus on the strength of the company in terms of its asset management function and commitment to the market. Where advisers believe a mutual is strong and well financed, they may decide the returns will be significantly greater on the traditional with-profits fund and that the risk of being exposed to costly mistakes on other lines of business is minimal.
To make an informed choice, advisers should demand from providers more information about the asset management function and the actual performance of the fund. Financial strength is relevant here because the company must be able to afford to hire and retain top-quality fund managers. Weaker companies simply cannot do so and, no matter how safe the fund appears, it is likely to offer only mediocre returns.
Tom McPhail, pensions development manager of Hargreaves Lansdown, says: 'If Equitable Life offered a ring-fenced, with-profits fund, would you buy it?'
Before Sandler's recommendation on ring-fencing is pushed through, it would be interesting to study the structure and performance of the stakeholder with-profits funds run by CIS, Norwich Union and Standard Life. One of the requirements for an office to launch a with-profits fund as part of its stakeholder range is that the fund should be ring-fenced, although, unlike Sandler's model, the smoothing mechanism of the fund does not have to be set up separately.
But perhaps the most salient point derived from the stakeholder experience is the low number of providers willing to operate a with-profits fund in a 1% environment. If Sandler's regulated with-profits funds are required to offer guarantees, the number may dwindle rather than increase.
Russell Brady, head of corporate affairs at CIS, said: 'The 1% charge cap makes guarantees impractical, if not impossible. For this reason, our fund does not offer guarantees.'
Ring-fencing the with profits fund may reduce returns where the company is financially strong and profitable.
With profits providers should be required to disclose much more information on the performance of the fund.
It is unclear whether providers will be able to operate with profit guarantees in a 1% environment.
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