Martyn Ingram of The Investors Partnership suggests some alternatives to the with-profit endowment investment
The recent market setback has served as a reminder to many investors that long-term investment strategies need to be robust if capital losses are to be minimised in the shorter term.
In the past, retail investors who needed permanent capital security would consider investing in endowment with-profits funds. They left the day-to-day investment responsibilities to professionals and were expecting a capital guarantee and the prospect of additional secure profits via an annual reversionary bonus. In addition, at the end of the investment period they were expecting a one-off payment in the form of a maturity bonus. This bonus would be calculated after taking account of investment conditions over the full period that the retail investor had been invested.
During uncertain times, an endowment with-profits investment was a sure winner in terms of sales to new investors. Cautious retail investors liked the idea of a guarantee. With unitised with-profits investments, they were seduced by the offer of a guaranteed bonus at the time of investing, as well as by the offer of enhanced allocation rates, both of which made endowment investment appealing compared with the alternatives available.
The fact that enhanced allocation had to be paid for somewhere along the line was something to which most investors didn't pay much attention. They also didn't pay much attention to the fact that the initial guaranteed bonus wasn't certain to be paid year-after-year for the full investment term, but most probably assumed that it would. Both the bonus and the enhancement were upfront and artificial, but they made retail investors feel that they were securing a higher return than that available from a high interest building society account.
Of course, once maturing endowment investments failed to produce the investment returns that investors had hoped for, those retail investors started looking for alternatives, such as distribution funds, cautious managed funds and structured products.
All of these alternatives to with-profits were selected with the aim of generating returns that would be better than cash deposits. And - surprise, surprise - during favourable market conditions most of them did so. Simply collecting a portfolio of investments that comprise holdings that are targeted to produce modest returns in favourable market conditions is not the answer for everyone. While these types of investments can have merit for those investors looking for an alternative to with-profits, there are better investment alternatives available.
The original with-profits concept was excellent. The problem wasn't the concept - the problem was over-inflated investor expectations, and the willingness of product manufacturers to support sales teams who would drive the writing of new business without consideration for the fact that the endowment was overly reliant on healthy returns from the stock market.
Today, the same attitude prevails. For example, when advisers supply potential customers with projections of future returns from products that invest in bonds, equities and commercial property, the potential customers are usually led to believe that they will make returns that are superior to those achievable from holding their investment in cash.
It might not help the sales process, but perhaps potential customers should be provided with an illustration of what they might get back if the investment is unsuccessful. The difference between a loss of 3% per annum and a gain of 3% per annum can be significant after the effects of compounding are taken into account.
For investors who want to be more 'hands on', a do-it-yourself with-profits portfolio could be a solution. Because of risks to capital, especially over the shorter term, a do-it-yourself endowment with-profits portfolio needs to have a strategy that provides guarantees. Below I provide an example using a single premium approach and a 10-year time horizon.
On day one, a guarantee that needs to be fulfilled in 10 years' time could be provided by investing in cash deposits and structured products. The split between the two would be decided after taking account of expected investment opportunities over the 10-year time horizon.
If a better structured product is likely to be available in the near future, it would be better to leave the guaranteed element in cash and term deposits (near-cash) in the shorter term. Individual structured products should make up only a small proportion of the overall portfolio, and they should not be reliant on the same market events to produce good returns. The quality and reliability of any guarantees also needs to be carefully analysed and monitored.
Also on day one, the non-guaranteed part of the portfolio can be established. This can invest in anything from protected investments to speculative investments, and the overall aim is for this portion of the portfolio to provide the bonuses. A do-it-yourself portfolio needs to be reviewed on an ongoing basis, and an annual portfolio realignment is advised to lock in guarantees.
Imagine for a moment that the portfolio had been created three years ago. The original investment would have been made in July 2003, and excess profits could have been taken from the non-guaranteed part of the portfolio and transferred to the guaranteed part in July 2004. In July 2005, the same would have occurred again, increasing the level of guarantee; even in July 2006, after the recent market setback, a further transfer could be made.
Each year, a decision is made on what proportion of profits should be taken from the non-guaranteed element and transferred to provide a guarantee. Not all profits should be transferred, as some should be held back for transfer in future years. It is important to make transfers even if losses have been made by the non-guaranteed portfolio. This portfolio should hold investments that will go up in value when most other investments are going down. One such investment is cash, but more complex investments can be included to do the job if required.
The overall aim is to run these two main portfolios side by side. In addition, there would be a third portfolio that would have a nil balance at inception and would fund any maturity bonus. In summary, portfolio one provides the guarantees required, and surplus profits made by this portfolio are either held in reserve to meet future bonuses or transferred to portfolio two. Portfolio two is there to create profits to enhance the guarantees in portfolio one. The profits from portfolio two should be targeted at a level at least equal to prevailing cash deposit rates. Portfolio three is the icing on the cake - the reward at maturity for a job well done.
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