The Compensation Game

The Financial Services Authority has announced its intention to stop insurance companies using the slush funds ("the inherited estate") of With Profits funds to compensate policyholders, but only from the summer onwards. The slush fund consists of money earned on policyholders' investments that have not yet been added to their policies, and works as a buffer to protect the money already added when asset values fall. This means that where it is found that a policyholder was missold a policy in the past, the company can say "sorry about that" and pay-out compensation by raiding the slush fund.

Honestly, in what other world could this happen? If an IFA has been found to have missold a policy there's an expensive insurance policy with a large excess to call upon, but ultimately it impacts on the IFA's profitability. What insurance companies are doing here is effectively taking money from those policyholders who weren't missold to give to those who were. Where's the fairness in that, and where's the incentive for companies to ensure they abide by good practice?

It's simply staggering that this practice has been allowed to carry on for so long and reflects poorly on the industry and the regulator. In the case of the regulator this is a case of better late than never, but how disheartening to read the whimpering complaints and straw-clutching of insurance companies who submitted responses to the last Consultation Paper.

The FSA's announcement that this practice "may not lead to the fair treatment of policyholders" is Great British understating at its finest. Where the slush fund is raided it invariably leads to the fund having to invest in safer investments with lower expected returns. Ultimately, where it leads to the whole slush fund running dry, the fund effectively becomes a gilt fund with a risk and reward profile vastly different to the one that the policyholder thought he was buying at outset.


Two interesting points were raised in the Consultation Paper:

"Conflicts of Interest and Risk of Unfair Treatment of Policyholders"

"With-profits business differs from other types of long-term business, in that the interests of different parties in a with-profits fund and the wide discretions exercised by firms in the management of with-profits funds, can give rise to conflicts of interest and risks of unfair treatment of policyholders that do not arise in the same way or to the same extent elsewhere."

This sentence should see alarm bells going off in the heads of policyholders. Why invest your money in a fund where conflicts of interest could lead to you being unfairly treated?


Hard for Policyholders and Advisers to Understand

"The complexity inherent in with-profits makes it hard for policyholders (the principals), and in some instances their advisers, to understand elements of their funds' performance."

As an IFA with a background of educating advisers in With Profits over many years, I know this statement to be true. It's good to see the regulator recognising this fact. I hope policyholders start to realise that their With Profits policies need to be reviewed by a knowledgeable IFA.

Norwich Union With Profits Bond 10th Anniversary Guarantee Explained

Like many providers, Norwich Union guaranteed to not apply a Market Value Reduction on the 10th anniversary of investing in their With Profits Bond. This guarantee could be worth thousands of pounds to savers who invested in 1999, but I suspect that many are failing to take advantage simply because they don't appreciate its value.

If you have a 10th anniversary guarantee date coming up, the seven minutes spent watching this video explanation could prove seven minutes well spent.

A Tale of Two Opacities

Two into One Won’t Go

In April 2004, the management of Aviva puzzled over what to do with their two large With Profits funds.

One of the funds, the fund which contained business written as the old Commercial Union and General Accident (the CGNU fund), was healthy and robust. The slush fund (called the inherited estate) it had built up through keeping guarantees and bonuses low was larger than the management felt was necessary. Shareholder value could surely be enhanced if they could only find a way of accessing this excess, as it could if they could merge the fund with its sister fund and enjoy economies of scale.

Unfortunately the other With Profits fund, made up of business written as the old Norwich Union, was coughing and wheezing. Back in 2004 the markets were some way off their 1999 peak and all the promises the Norwich Union fund had made to policyholders were in jeopardy of not being met unless the company took some action. This weakness was a barrier to their desire to merge the two funds because policyholders in the strong CGNU fund would never agree to merge with such a weak fund and jeopardise future returns.

They were not the only insurance company with a threadbare slush fund. Most With Profits companies in the same position decided that the best way to be sure that they could honour their guarantees was to get out of risky investments and invest in assets, such as government gilts, that they could have confidence would deliver the required returns.

But Aviva knew that a retrenchment to safe investments would rule out the possibility of the two funds merging in the future. It would be better if they could find a way to get the slush fund big again and the best way to do this was to generate strong investment returns.

The Gamble

A unilateral decision to increase the charges with effect from 1^st May 2004 was made with a view to the extra charge boosting the slush fund. An extra 0.75% per year would be deducted from every policyholder’s investment which would give the fund the extra security it needed to stay invested in shares and commercial property.

This 2004 charge implementation was in stark contrast to the much heralded ‘choice’ for clients in their 2008 reattribution offer. The charge effectively resulted in a change to the contract terms and passed the onus for meeting the guarantees away from the shareholders and back firmly on policyholders.

By November 2006, the “gamble” that policyholders in the Norwich Union fund had underwritten was coming good. Two and a half strong years for stock markets and commercial property meant that the 0.75% per year charge had been worth paying for those with policies maturing at that time.

The Norwich Union fund policyholders weren’t the only winners. If the CGNU fund was healthy and robust in 2004, just imagine its strength at the end of 2006! It was ripe and bursting at the seams.

It was time to make progress with a fund merger. To get the CGNU slush fund in the same proportion as the Norwich Union fund they needed to skim off the excess. £2.1bn of the slush fund was distributed to CGNU policyholders as Special Distributions in 2008, 2009 and 2010, with 10% of the Special Distribution going to shareholders.

The plan to merge the two funds came as part of a reattribution offer, where CGNU fund policyholders would be allowed to deny themselves any potential future Special Distributions if they accept an offer from the shareholders to buy them out of any potential windfall. In the summer of 2008, shareholders were willing to pay £1bn for the right to future windfalls from policyholders.

Well, everything was going to plan until October 2008 when the management heard a little sniffle from the CGNU fund and it started complaining about a sore throat. Those Special Distributions had a double whammy effect of £2.1bn less slush fund for tough times like these, and £2.1bn more liabilities. Oh dear. Too many liabilities and not enough slush fund was the problem the Norwich Union fund had!

At the end of 2007 the CGNU fund had 71.5% in shares and commercial property but by the end of 2008 this had dropped to 55.7%. In my opinion the reduction of risky assets was a direct result of falling asset values relative to the size of liabilities, combined with a much reduced slush fund.

So it looks like the CGNU fund can now match the Norwich Union fund for the size of its inherited estate. How long before they join policyholders in the Norwich Union fund by paying an extra 0.75% per year? After all, they continued to charge 0.75% to Norwich Union policyholders even before the severe market correction.

It’s hardly surprising that the 2008 reattribution offering was taken off the table last week. £1bn is a lot to pay for the now remote prospect of future Special Distributions and for increasing the risk to shareholders in the process.

Right Here, Right Now

And right here, right now, how pleased and rewarded do the Norwich Union With Profits fund policyholders feel about the extra 3.75% they’ve paid over the past five years in charges they hadn’t bargained on when they took out their plans?

If the fund had matched its guarantees and invested fully in UK Gilts like some of its competitors instead of applying the extra charge and taking investment risks, investors might have enjoyed a return similar to the Norwich Union Gilt (S4) Life Fund which has grown by 25.1% over the past 5 years. Instead the fund they are in, after the extra 0.75% charge, has grown by 19.5% over the past five years. In others words, for policyholders with plans maturing today, the strategy has backfired.

Five years on and gilts would have seen a better return that that achieved due to the extra 0.75% charge:

NU Gilt Life (S4) data taken from Trustnet on 5^th Feb 2009. With Profits data taken from Norwich Union Information Sheet to Accompany PPFM January 2009 with 0.75% per year deducted from returns.

While I’m sure these policyholders don’t blame Aviva for the global financial crisis, they have every right to feel aggrieved about the risk and reward strategy adopted for them. Was the extra charge a method to increase returns for those policyholders or was it part of a strategy for improving efficiencies and therefore profits to shareholders through fund merger while also attempting to release some of the surplus in the CGNU fund for the benefit of shareholders?

Maybe the CGNU policyholders should be thanking the Norwich Union policyholders for creating the position where they can enjoy ‘Special Distributions’? Or maybe they should be cursing the outcome of reducing their slush fund as it seems that their fund is now not the healthy and robust fund it once was.

Whatever your opinion on the motives and actions taken, the whole process raises important questions about the attractiveness of With Profits as an investment. The extra charges that can be applied at will, the lack of control over how your fund is invested, the fact that shareholders can take 10% of the profit on your investment without seemingly ever bearing the brunt of financial risk because they simply increase charges, all adds up to With Profits being a deeply questionable investment vehicle for many savers.

For some, the guarantees make up for the disadvantages but if the guarantees on your own plan are negligible, is it really worth the shenanigans?

Be a Smooth Operator

Investors in With Profits Bonds should consider becoming ‘Smooth Operators’ and take advantage of the generous values being paid out to investors who ask for their money back.

“Our analysis shows that when markets are strong With Profits Bonds hold back returns so that when times are bad they can pay out more than they are actually worth” explained Miles Hendy, a Chartered Financial Planner at withprofitshealthcheck.com.

“This ‘smoothing’ primarily benefits those investors who cash-in their investment and the windfall they receive ultimately means less profits to share amongst those investors who stay invested and who have effectively subsidised the extra payout. It may feel counter-intuitive, but in the world of With Profits Bonds, a strong market downturn is a good time to take profits”

Fraser Heath Financial Management, the Bristol based Independent Financial Adviser that operates the withprofitshealthcheck.com website, analysed the past performance of five of the UK’s leading providers of With Profits Bonds and Distribution Bonds. When they averaged the overall mix of shares, property, bonds and cash held in the companies’ funds it was clear that there was little difference between the two types of investment product. With the same mix of assets and the same fund managers, this seemed to be a fair way to see exactly how well the With Profits Bonds were smoothing returns.

On 1^st November 2007, despite the onset of the credit crunch, investments had been enjoying strong returns for over four years. The average return of the Distribution Bonds was higher than the With Profits Bonds over 1 year (by 5%), 3 years (by 7%), 5 years (by 11%) and 10 years (by 19.5%).

However, by 1^st November 2008 investments had taken an almighty hammering and this turned the results upside down. This time the average return of the With Profits Bonds was higher than the Distribution Bonds over 1 year (by 6%), 3 years (by 9%), 5 years (by 16%) and 10 years (by 4%).

While the design of With Profits Bonds means that they should continue to hold back some returns in periods of strong growth and subsidise returns after a market correction, please note that the figures above refer to the past and that past performance is not a reliable indicator of future results.

“A ‘Smooth Operator’ could get the benefit of the extra payout available for surrendering their With Profits Bond when markets are low, re-invest in an alternative investment with a similar asset mix, and might consider buying another With Profits Bond when investment markets have recovered.” Miles explained.

Fraser Heath advise investors who are considering asking for their money back to consult an Independent Financial Adviser before doing so and would like to stress that this press release should in no way be considered a recommendation to sell.

Our withprofitshealthcheck.com website has a 32 page on-line guide to help investors make a decision about how to take full advantage of their With Profits Bond. We would be pleased to offer Independent Financial Advice to clients who contact us.

Markets were strong in November 2007 and Distribution Bonds pay back more to investors than those in With Profits Bonds:

But times are bad in November 2008 when the value of With Profits Bonds fall but protect investors more than those in Distribution Bonds:

For more details please visit www.withprofitshealthcheck.com

With Profits Prophets

Personal finance commentators seem to have the same problem analysing With Profits as football pundits have understanding Rafa Benitez's decisions. While football commentators struggle to understand why Rafa attacked Sir Alex, why he paid so much for Robbie Keane or why he substituted Gerrard mid-week, it seems some Independent Financial Advisers seem to equally stumble over the thoughts behind 0% bonus rates and Market Value Reductions.

There were two comments I read in the press over the past week from IFAs that left me questioning whether they had grasped some of the fundamentals of With Profits. Perhaps in providing soundbites to journalists some of the details were lost? The two comments were;


1/ A 0% bonus rate is even lower than cash

Well, yes, if you compare a With Profits bonus rate to a cash savings account then clearly 0% is lower, but the two can't be compared. That's because a With Profits policy usually has a guaranteed investment return already built in and the bonus rate is the icing on top.

For example, a With Profits endowment promises at outset to pay a Guaranteed Basic Sum plus all bonuses added at a future date. Back in the 80s when interest rates were double digit the insurance company might have set the Guaranteed Basic Sum with effectively a guaranteed rate of return of 6% per year. The extra bonuses then added on have might increased this guaranteed rate to around 9% per year. However, the performance of the With Profits fund, the shares, property, bonds and cash the fund owns, may have generated a return of only 7% per year for the time you've been saving in the fund. In order for the company to give you back a return that reflects your fair share of the growth it would be wrong to add more bonuses.

If you have a With Profits policy with a 0% bonus rate it may well be because you have some really good guarantees that you will benefit from when your saving plan ends. On the other hand, it may be that the rate is 0% because other policyholders have amazing guarantees and your low return is helping to pay these guarantees for others. You really need to check the guarantees if you have a bonus rate below 2%, and a good IFA can help you here.


2/ The current economic conditions have caused many insurers to place market value reductions (MVRs) on their funds, meaning it is not in the best interests of most clients to take action at present.

Just because there's a Market Value Reduction applying, it doesn't mean that you shouldn't ask for your money back. Even with a Market Value Reduction it could be that your savings plan is getting the benefit of smoothing that With Profits companies apply to protect savers who need their cash back after a severe market downturn. The Market Value Reduction is just the mechanism the company uses to make sure you get back your fair share of the fund rather than the conditional value that appears on your statement.

The conditions that may apply for you to get the higher conditional value usually include maturity, retirement, death, or in the case of a bond, a specified anniversary date. If you're close to being able to claim on any of those conditions then that's a good reason to hold firm. Otherwise, a Market Value Reduction is a valid reason to give your With Profits plan a health check.

For more details about checking the health of your policy, please visit www.withprofitshealthcheck.com.