With-profit funds have had a rough ride since the turn of the century, and their demise has been well documented. But the market environment has changed. Christopher Salih asks if 2006 will see with-profits attracting investors once more, or will the flaws exposed over the past few years prove to be fatal?
The story of with-profits has been well told. The principal was fine, but the reality lacked transparency, performed badly and ended up ill-serving investors. Regulators intervened after the event and - some would argue - have made the situation worse by forcing insurance companies to buy corporate bonds for asset-liability matching at a time when they were fully valued. Throw market value adjustors (MVAs) into the mix and it is understandable why the tale of with-profits is such a sorry one.
The souring of the market in 2000 started a chain reaction for with-profits. Poor returns led to solvency problems, which led to clients heading for the exit, which led to market value adjustors, some as high as 25%. Funds began to close to new business.
This was set against the backdrop of the Equitable Life scandal. They sold policies with guarantees in their contracts, and after a series of court cases the company was forced to meet those guarantees, leading to a reduction of the value of all the policies issued by the company. The regulator intervened, saying that with-profits providers needed to match assets with future liabilities, which for the most part meant buying corporate bonds. As with-profits policies had often been sold with high commission payments, the debacle did little for the image of the advice industry either.
Now in 2006, the situation has changed once again. With-profits funds have moved a long way towards matching assets and liabilities and the stronger ones have been taking greater exposure to equity as the markets have moved up. The picture no longer looks as desperate as it did. But has the bear market revealed terminal flaws in both the structure and implementation of with-profits? Can with-profits ever attract investors again? Or - with portfolios running into billions - would they want to?
What has changed in 2006? Martin Brookes, director of portfolio management at Prudential, says: "From our point of view we are still strongly committed to with-profits. There is now more competition in the market following the emergence of both cautious managed and distribution funds, but we believe there is more scope for diversification in with-profits because of the size of our fund, and consequently more value than through a linked value fund because of the smoothing."
With-profits now have lots of baggage as the industry has not done well with them. However some unit trusts have done badly in the past. Is it the structure or the investment policy that is at fault? Brookes adds: "The Prudential fund has been relatively strong and largely avoided the problems in the market. We have managed to hold equities despite the sell-up, while holding some good fixed interest and property solutions."
Nick McBreen, adviser at Worldwide Financial Planning, believes the problems are terminal regardless of market conditions. He says: "It is almost a without profits contract. It is a completely unfair investment option for a client due to the opacity of the product. The returns are completely out of our hands as they are dependant on a company actuary, which is ludicrous."
This view is common among financial advisers. But providers are clearly still finding some willing buyers. The gradual movement towards a larger equity holding in these funds will endear them to some, though others will say it is too late. In 2003, figures by Cazalet Consulting showed that the average equity/property exposure of with-profits companies was 56%. By the end of 2005, that had only moved up to 59%, despite two decent years of market returns. Some still have minimal equity exposure. As might be expected, Equitable Life's exposure to equities is just 18%. Standard Life's with-profits fund, in the midst of demutualisation, holds 45% in equities.
David Aaron, marketing manager for investment products at Scottish Equitable, says: "Equities were as high as 60% to 70% in 2000. Now - even though markets have improved in the past three years - the majority of life companies remain cautious. All these companies who have with-profits funds are focused solely on meeting guarantees and are cautiously remaining in fixed interest to do so."
Considering most asset classes have made progress over the past few years, the problems of with-profits go further than market turbulence. John Enos, managing director at The Hartford, says: "The issue of asset allocation is key to the whole debacle that is with-profits and its failings both in structure and implementation. Control of both risk diversification and asset allocation has been taken away from the client and the adviser. Returns are also overseen by the companies' actuary. It is case of giving away complete control of an investment."
And clearly some with-profits were very bad indeed. Around 22% of all with-profits investments are now closed, with the majority of these funds stuck in fixed interest products with restricted upside potential. Managers of these funds are even more focused on meeting guarantees like deaths and maturity dates, purely to avoid penalties of their own.
McBreen says: "What is the point of leaving money in a closed fund? Clients have to look at the possibility of a penalty on encashment and ask is that a good enough reason to stay? If I were a client I would go back to square one and analyse the cost and consequences of my actions."
MVAs levels have improved. The level of the MVA should theoretically follow the stock market, but this has happened little in practice. Justin Modray, head of communications at Best Invest, says: "On a general scale MVAs have actually been falling, but they remain in place for lots of clients who might be thinking now is the time to make a move. They still cause lots of frustration in the market. Standard Life for example reduced its with-profit MVAs at a slower rate than others to protect it in the wake of demutualisation."
Indeed with the majority of life companies dropping MVAs in the wake of stronger long-term performance, Aaron says the emphasis has switched from MVAs to issues on fairness. "To a large extent, the whole question of MVAs has gone away, despite smaller ones remaining attached to some policies, that story is not really there. The main driver for advisers and clients has switched to the FSA's 10 questions of fairness," he adds.
The FSA is now pushing advisers to look through the quandary of with-profits for their clients, and decide whether to move their investment regardless of whether their fund is open or closed to new business. The FSA has now posted 10 questions on the issue of with-profits in the hope that they will offer advisers a suitable guide for what they should do with a client's with-profits investment (see box-out below). The questions tackle the key issues of existing policyholder guarantees and bonuses.
Aaron says: "The 10 questions present challenges but also opportunities for advisers. The FSA is forcing everyone's hand by making sure that advisers address the issue of with-profits now, and that those who ignore it are doing so at their own peril."
Another part of the FSA clampdown on with-profits has been the release of the Principals and Practices of Financial Management (PPFM). This document means all with-profits insurers (including those that have closed their with-profits funds to new business) must produce and describe how they run their with-profits business. Insurers must make their PPFM publicly available. Once a year, each with-profits firm must tell its with-profits policyholders whether, and to what extent, it has complied with its PPFM. That report must be made available to policyholders.
Modray: "It helps to destroy the problems of lack of transparency as it lets advisers know precisely what a life insurer has been doing with its with-profits fund. It lets you know how the fund has performed and whether MVAs are attached."
Life companies have tried to address the issues of opacity with the launch of new series with-profits funds. Brookes says: "These funds offer more transparency to advisers, and importantly the actuary is not setting the bonus."
Enos adds: "These groups had to do something to get sales up. They offer something to new policyholders, but importantly the unlucky ones are still stuck in the older models, which have failed. They may offer more transparency and freedom but is that really enough?"
All this information means a difficult decision for advisers. Most will have a majority of their clients holding some kind of with-profits fund. The FSA's clampdown has made information more readily accessible to advisers, which makes a decision on a client's with-profits portfolios more pressing. Add to that the growth of alternative investments to with-profits - unit-linked product providers like The Hartford, or cautious/distribution funds, or multi-manager funds and it is unlikely with-profits will ever regain their reputation.
Enos believes the future is bleak. He says: "If you look at the three main sectors of with-profits of endowments, bonds and pensions, all are under massive pressure. The only justifiable cause to stay in these funds is the penalties incurred if you leave, as many of these closed "zombie" funds have high MVAs attached that kick in the moment a policy is moved.
"These funds have had their day. They started in the 1960s and 1970s when information and technology was secondary to how the product was packaged. Nowadays both technology and knowledge are at the forefront of the industry and these life companies are still trying to sell these 40-year-old cars with lots of mileage and dodgy performance, while there are up-to-date, Ferrari-like models on the market. It is purely illogical."
McBreen says: "Get out now. There is no justifiable cause for staying in a with-profits fund. The market is as strong as it's going to be and these funds are still defending themselves from their errors in the past. I've never sold one in my life. They are lousy by comparison to unit-linked funds that offer the transparency needed.
"You have all these imponderables that you just can't answer and that is topped off by you getting only a fifth of the fund's growth. The majority of these funds are just treading water, and from the client and adviser point of view the risk and return case is not clear. The bottom line is that you are not in control of what you're investing in."
Brookes says that although with-profits have been stereotyped as a poor investment, not all funds have suffered. He says: "It is unfair that all funds have been tarred with the same brush. Our fund has performed well and has met expectations. We don't expect to get back to the heady days of the 1990s, but sales have been up in the past year or so.
"We've gone out and explained to advisers the multi-asset nature of this fund and the reaction has been positive across the board. It is a case of people stripping back the noise and looking at what is actually there. Unfortunately not every fund has been as well managed and the likelihood is that the market will consolidate in the near future."
Despite changes in both market environment and regulation, advisers are stuck with a difficult decision over the future of their with-profits policyholders. Markets have arguably peaked for the time being, which offers a good time to get out. There are also plenty of other products on offer. At the same time the FSA has tried to force advisers' hands by making them address with-profits now. It is a difficult decision, most funds still have penalties attached for early withdrawals regardless of whether they are open or closed, meaning a hard conversation with clients. But after a turbulent few years, advisers should be used to that by now.
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