A 'new generation' fund has emerged in the offshore market which provides an alternative to the traditional with-profits concept, but can it beat the industry's negative perception?
It is fair to say that the offshore with-profits market never reached the dizzy heights of the UK market at its peak. However, at a relative level, offshore providers did enjoy a lot of success selling their with-profits funds back into the UK and overseas.
But then came the bear market of 2000 - March 2003. Since 2000/01, the UK with-profits market has fallen by a staggering 93% (source ABI). At the same time this forced a number of wider issues surrounding with-profits, such as the lack of transparency, the application of market value reductions, falling equity exposure within the funds to name but a few, into the industry and consumer spotlight.
It was little wonder that this had a knock-on negative impact on the offshore with-profits market, ultimately reducing the number of funds available.
In recent years, however, with-profits funds have emerged in the offshore market in new guises. Some providers have opted to offer what we would recognise as traditional with-profits, complete with annual bonuses, market value reductions and some guarantees. These funds have undoubtedly had success in some areas, for example, the Channel Islands.
There may be some debate though as to how much long-term success these funds will have in the UK. The UK onshore with-profits market is still struggling with poor investment levels and widespread negative perception of the traditional with-profits concept. It is difficult to see how these offshore funds can succeed in the UK where most onshore funds have failed, and convince the industry that they are a viable alternative in today's market.
So, is there an alternative? A new option to emerge relatively recently in the offshore market is what has been labelled 'new generation' with-profits funds. These funds provide investors with a smoothed managed alternative to traditional with-profits.
Before looking at what benefits these funds can offer, it is sensible to look at how these funds operate. Between the onshore and offshore markets there are various forms of the new generation with-profits funds. However, some common traits are:
• Reversionary and terminal bonuses have been removed in favour of a fund with smoothed growth.
• More emphasis on smoothing, with any costs being disclosed. (In some cases the smoothing method is fully transparent, allowing investors and advisers to see and understand how it works on a daily basis)
• Guarantees have either been completely removed or their costs disclosed.
• Profits or losses from smoothing or guarantees are kept within the ring-fenced with-profits fund and shared among the remaining policyholders.
• More disclosure about when payouts to policyholders might be adjusted.
Typically these funds use a smoothing mechanism to reduce short-term volatility by reducing the peaks and troughs in the performance. For example, a fund may look to smooth performance around a central growth assumption (or expected growth rated, the EGR). The actual returns of the underlying assets would be calculated daily and compared to the 'EGRs'. Half of the difference between the actual and estimated growth rates would then be added to or subtracted from the actual returns to give the smoothed price. For example:
• 10 (actual) - 6 (EGR) = 4 (difference)
• 4 (difference)/2 = 2 (half of difference)
• 10 (actual) - 2 (half of difference) = 8 (smoothed unit price)
Benefits for today's investors
So why should advisers recommend new generation with-profits? Well, these funds have a number of key advantages over old-style with-profits.
• Clear smoothing formula - as mentioned earlier, smoothing reduces the peaks and troughs of performance. While smoothing has been a fundamental element of with-profits structures of the past, in the new generation funds the smoothing method is more clearly explained and one smoothing formula applies to all investors.
• Ring-fenced funds - one of the key Sandler recommendations was that 100% of all investment profits and losses should be retained within the fund and reflected in payouts to investors (known as a 100/0) fund.
• Any guarantees described and their costs explained - in some cases the new generation funds will have no guarantee, perhaps because the provider views the cost of offering a guarantee to be too prohibitive, ie the customer would not see this as value for money. Alternatively, if a new generation fund does have a guarantee then the onus is on the provider to fully explain what the guarantee covers and how much it costs. In old-style with-profits, while life companies did not charge specifically for guarantees, they were certainly not 'free' and the cost was not transparent.
• Investment reporting - typically unit prices for new generation funds will be published daily, making it easier for advisers and their clients to track the progress of their policies. Providers are also required to communicate the investment performance and the asset mix of the funds to investors on a yearly basis.
You will note that there is one common theme running through each of these advantages: transparency. This is the key differentiator for the new generation funds over old-style with-profits. It is true that investors now have access to much greater information on how old-style with-profits works, for example, the introduction of the Principles and Practices of Financial Management (PPFM) documents in 2004. However, the key thing to remember is that transparency was at the very heart of the development of new generation with-profits. These funds incorporate the principle of transparency on many levels, in line with the Sandler and FSA recommendations.
Transparency has extended into all aspects of new generation with-profits. And none more so in the area of client and adviser communication. As mentioned above, there is much more regular investment reporting than in old style funds. However, it does not just stop there. Providers are placing much more importance on making sure the pre and post-sale literature clearly describes how the funds work and in particular how the smoothing works. The amount of information on the new funds and what goes on 'behind the scenes' is far more than was ever available for old style funds. This transparency will be crucial in widening the acceptance of the funds.
Ideal for the cautious investor
These funds were designed specifically for more cautious investors looking for the potentially higher returns of equity investment but with an element of smoothing to reduce volatility. During the past five or six years there has been definite shift in the risk profile of a typical investor to a more cautious stance. This has greatly increased the potential market that new generation with-profits funds are relevant for. Previously, these investors may have looked to predominantly equity-based investments to provide their returns. However, these investors are now more wary of the stock market and are keen to avoid nasty surprises. This is where the smoothing mechanism of the new generation with-profits funds comes to the fore. Essentially, smoothing reduces the short-term volatility of the funds by smoothing out the peaks and troughs normally associated with unit-linked funds.
Looking beyond the name
There is definitely a growing acceptance within the market of the benefits new generation with-profits funds can offer. However, it would also be fair to say that the name 'with-profits' has a poor perception among many investors and advisers and has hampered wider acceptance of the benefits these funds can undoubtedly offer. For some, 'with-profits' carries automatic associations of low bonuses, high MVRs and costly guarantees. There is no widespread awareness that the new generation funds carry none of this baggage.
So how can providers get the message out to the wider market? Existing funds need a consistent track record of demonstrating that they have done exactly what they set out to do, in other words, delivering smoothed performance. The ongoing challenge facing providers is to how best communicate this message and how to get advisers to look beyond the name 'with-profits'. And, of course, continued positive press coverage is always beneficial.
There is a clear opportunity here for providers and advisers alike. The market conditions are right, there is a growing number of cautious investors and the funds are performing. If we as providers can get the education right on the benefits of these offshore new generation with-profits funds then there is every chance the market will go from strength to strength.
UK with-profits market has fallen by 93% since 2000/01.
New generation products effectively smoothed managed funds without reversionary or terminal bonuses.
Latest with-profits products are transparent.
Subset of fintech
Just one-fifth not in favour
Member of PRA's practitioner panel
Risk to retail investors