Aviva Quietly Reduce MVRs

Aviva have reduced their Market Value Reduction (MVR) factors this month. I know this because it says so in the right hand column of their with-profits page: http://www.aviva.co.uk/savings-and-investments/with-profit.html. I've checked on a client's investment and it's a reasonable reduction of about 2%.

In the past this sort of "good news" has been announced with a fanfare. For example last time they reduced their MVR rates they issued this press release with a full list of rates depending on different dates of investment: http://www.aviva.com/media/news/5487/.

This time around, there's no announcement and there's no details on the website of what these reductions are or on what day in May they came into force. I've written this blog simply because I'm puzzled by the silence and lack of information. I spotted the website change Monday morning and I've waited to see if an announcement will follow but this looks like the second day of tumbleweed.

One of the great criticisms of with-profits is the lack of transparency. In the absence of clear information it's inevitable that people will speculate with conspiracy theories. And to get you started here are just a few potential theories that might explain the silence:

Conspiracy Theory 1/ The reductions are so small that everyone will criticise and give up hope of a recovery.

Conspiracy Theory 2/ The reductions are so large that everyone wonders why and questions whether it's a ploy to reduce the No-MVR carry-forward promise that they've made on Aviva (ex CGU) With Profits Bonds reaching their 10th anniversary.

Conspiracy Theory 3/ They're unsure how to communicate and justify the 4.8% MVR rate applying on the three Special Bonuses they made in January 2008, January 2009 and January 2010.

Conspiracy Theory 4/ The decision to improve rates were made when the FTSE looked steady at 5,700 but now that it is 7% lower at 5,300 the pressure's back on for a quick change back again.

Conspiracy Theory 5/ Improvements in MVRs typically signal an opportunity for people to consider divesting and they don't want people to know.

Of course the most obvious explanation is that they've not got around to it just yet. Let's hope we hear some news in the next couple of days.

Rationally Assessing your With Profits Bond

It turns out that we don’t always make rational decisions. Our brains are genetically wired for a far more simple life than we live today. When faced with sophisticated financial products we often struggle to make logical and rational choices.

Studying the way that the irrational human mind affects financial decision making is called behavioural economics. The level of debt that individuals and countries in Western economies have built up, the faulty financial instruments at the heart of the credit crisis and the spectacular failure of banks are good examples of our flawed human economic behaviours.

There are a number of biases that affect our judgment. Here are four examples of investors’ irrational behaviour which I believe are preventing With Profits Bond holders from easily making the rational decision to cash-in on their 10th anniversary guarantee;

Representativeness. People assume commonality between objects of similar appearance and investors tend to assess situations based on superficial characteristics rather than underlying probabilities. The With Profits Bond appears to be an investment that only rises, like a deposit account. This disguises the reality that the investment assets of a with-profits fund fall as well as rise.

Conservatism. In this context, conservatism means that investors cling to prior beliefs in the face of new information. This issue more than any other is critical to overcome. The false belief for With Profits Bond investors was that their investment was worth what it said on the statement. The new information is that insurance companies actually base your investment’s value on your fair share of the fund known as “asset share.” It is the difference between your asset share and the value on your statement that at the time of writing makes the 10th anniversary guarantee so valuable for so many people.

Loss Aversion. Investors are gripped more by the fear of losing money than of gaining it. As odd as it sounds, investors’ motivation for gaining the windfall from calling on the guarantee by cashing in is tempered by the fear of losing their investment by making this decision.

Frame dependence. This is where the form of presentation of information can affect the decision made. In this case the presentation of information is wrapped in insurance company jargon like “Market Value Reduction” making it hard to understand.

If you have a With Profits Bond and a 10th anniversary guarantee, you need to challenge these feelings, weigh up the facts and make an informed and rational decision.

Shareholders to Profit from the Unwind of Guarantee Costs

Aviva PLC's annual accounts don't usually interest me greatly, but the following paragraph caught my attention:

"On an ongoing basis, profits will arise from earnings on the re-attributed estate (estimated at £45 million per year on an IFRS basis), the financial unwind of guarantee costs, the movement in value in any un-hedged assets backing the guarantees, and any demographic profits /losses (e.g. lapses) resulting from policyholder action." - page 6 of Part 2 of Aviva FY 2009.

Initially I was drawn to the estimated annual profit from the reattribution of the CGNU Inherited Estate in 2009. Having paid £450M in the reattribution, £45 million a year represents a 10% annual rate of return. In approving the reattribution scheme the FSA stated that they calculated the Internal Rate of Return that Aviva might expect to enjoy in assessing whether the offer from shareholders to policyholders was fair, although they would not disclose what they considered fair (see FSA's Second Report, paragraphs 77 to 81). It seems that a 10% return is fair. Hmm, in the post credit crunch world and 0.5% per year base rates, I'm struggling to see a 10% return as fair.

But actually the point I think policyholders should really note in Aviva's paragraph is "profits [to shareholders] will arise from earnings on...the financial unwind of guarantee costs." This issue should be at the very heart of how you assess your policy. The sad reality, as evidenced by this statement, is that Aviva KNOW that on the whole, policyholders don't take advantage of their guarantees and that a large chunk of the funds reserved to pay for guarantees will eventually unwind back to shareholders.

Right now there are tens of thousands of Aviva (CGU) With Profits Bond policyholders who have passed their 10th anniversary and are eligible to claim these guarantees. Unless they act, the value will unwind and what would have been profit to policyholders will revert to profit to shareholders.

Policyholders in an Aviva CGU With Profits Bond who are in any doubt about the value of this guarantee can read our Aviva Aluminium Report. Please contact me at Fraser Heath Financial Management if you have any questions.

How to Buy a Past Performance

There are a couple of features of Prudential’s With Profits Bond which mean that if you understand how it operates, you can really work it to your advantage. I’ll write separately about the “£25,000 rule.” This article focuses on how your investment can travel back in time and effectively buy a past performance.

Firstly, every investor in a With Profits Bond needs to understand that your future returns are always based on the value you bought your investment. Sure, there’s an indicative rate of return based on the annual bonus rate, but to work out whether you are due a bit more than the annual bonus when you cash-in (due a terminal bonus) or a bit less (due a Market Value Reduction), the insurance company always refer to the growth in the with-profits fund based on the value when you bought it.

In the case of Prudential With Profits Bond, they average together all investors who buy in the same tax year*. This means that anyone who invests their money before 5th April 2010 will have the value of their investment pooled together with every other investor from 6th April 2009 to 5th April 2010.

On Friday 26th February 2010 Prudential announced a return in their With Profits life fund for 2009 of 15.7%. Based on the performance of equities and property in 2009, a year where the first quarter of 2009 was poor and where we have enjoyed strong and steady returns in the main asset classes in the with-profits fund from the second quarter of 2009 onwards, it would be reasonable to assume that this good return has mainly be enjoyed by investors in the current tax year.

By timing your investment before the end of this tax year, you should be able to benefit by aggregating the value of the assets you bought in the fund with those who bought assets when they were much cheaper. Calculating the gain you would make requires details of how much was invested each day and seeing how the asset mix was fixed on each day to work out so it’s not possible for me to do, but one might cautiously conclude that there are several percentage points head start to be had by investing now. It’s a rare case of effectively being able to buy a past performance.

*Please note that this article is not a recommendation to invest in Prudential’s With Profits Bond and we cannot be held responsible for any actions you take after reading it. The article aims to simply explain our understanding of how Prudential pool their investors for the purpose of assessing asset share for future terminal bonus (and market value reduction). We have checked our understanding with Prudential who have confirmed via email, but this description of pooling the With Profits Bond by tax years is not included within their Principles and Practice of Financial Management document. Prudential could change this practice. For a personal recommendation, please contact Fraser Heath Financial Management.

Darth Vadar - The Real Face of With-Profits

When you are assessing your with-profits policy, keep in mind that if you take off its mask, you may be surprised with what appears underneath.

The unmasked with-profits, the real value of your investment, is what matters. The shiny, black and sleek exterior is just for show, except in certain circumstances. The secret to understanding your investment lies in realising that it's what's underneath that determines your investment return. Only then will you realise your plan's growth potential and learn to evaluate whether the guarantees are valuable. Only then will the force be with you.

Owners of Aviva With Profits Bonds can unmask their with-profits plan by reading our free Aviva Aluminium Report on the value of the 10th anniversary guarantee.

How many millions will be lost before the message gets through?

It should have been a fine day today. I woke up and was delighted to discover that my expose of Aviva's questionable stance on communicating their 10th anniversary guarantee on With Profits Bonds had made the front page of Professional Adviser. I had finished my Aviva Aluminium Report the night before and was pleased with the way it explained why policyholders only gain from their 10th anniversary guarantee if they switch out or cash-in. And I was enthused at the prospect of spreading Professional Adviser's discovery to personal finance journalists - a message that could finally wake everyone up to potentially the biggest missed opportunity by policyholders, the media and financial advisers ever.

But on leaving the office after 7pm, I felt dejected that not one personal finance journalist had even acknowledged receipt. I have an image of my geography teacher a few months prior to my O Levels telling the class he felt like someone shouting at passing cars that the bridge they were heading for had collapsed. Every day there are thousands of policyholders driving past those people capable of shouting loudly to the point of no return at full speed oblivious of the thousands of pounds they are losing as a result. There's nothing we can do for the tens of thousands who have gone over the edge already but there are hundreds of thousands more that we can still save over the next year or so. But with thousands falling daily I lament every day that passes with my screaming hoarse voice unheard.

And it's not just my geography teacher haunting me tonight. I recall with great clarity a conversation ten years ago with the chief actuary of the company I worked for, explaining that the with-profits fund had to reserve for the guarantees that they had committed to even though over half of those guarantees are never taken up. I suspect that nowadays most advisers and policyholders fully appreciate the value of Guaranteed Annuity Rates, but I suspect that many still don't evaluate guaranteed sums at maturity, guaranteed bonus rates, and particularly 10th anniversary With Profits Bond guarantees and that over half are wasted.

His words haunt me because I know they were pivotal to my career change and decision to set up With Profits Health Check. Knowing that I can explain the value of policies to with-profits policyholders I felt sure I could help them avoid wasting their money. And while I've achieved that with clients who have approached me through with profits health check, I know I'm still just scratching at the surface.

What was Professional Adviser's discovery, you ask? The message that might finally get more people waving at the edge of the road and catching the eye of policyholders otherwise destined for the point of no return?

Well, like a great movie, they were the quiet words said against the backdrop of white noise and mayhem. Not the words in the headlines or the posturing, but the words tucked away near the end of the article. Spoken by Aviva's Richard Kelsall, they simply said

"...we should fully expect customers to switch out of with-profits..."

You may have grasped it but I suspect you may still be wondering why I think those words should be the catalyst for getting the media to start waving vociferously at cars heading for the edge. And it's this. When the man who is writing the cheques says he should be writing you a cheque, you probably ought to think he has a point.

Until now, all we have heard is the white noise. We hear IFAs looking like spivs with watches in the inside of their coats telling people how bad with-profits is and the 10th anniversary is a chance "to get out of jail free." If I'm reading these words as a policyholder worn down by a complete mistrust of the financial services system I would be sceptical of the story, particularly if I didn't understand what my With Profits Bond was really worth.

But finally, Professional Adviser cornered Aviva and got them to admit that even they were advising policyholders to switch out and capitalise on this 10th anniversary guarantee. Let's not underestimate that admission. If these policyholders bank their guarantees we calculate that Aviva shareholders will end up paying out over £500 million!

And Aviva CGNU was just one of 16 insurance companies offering these guarantees. The sheer size of these guarantees is difficult to comprehend. I think we're talking about about billions of pounds that are up for grabs but only if eligible policyholders ask for their money back while the guarantee still applies.

Someone surely has to help get this message over before too many more fall over the edge...

With Profits Bonds in Plain English

This week Aviva stated that they expect future With Profits Bond sales to come from direct marketing and affinity groups rather than through Independent Financial Advisers. As many IFAs have pointed out in various discussion on this news, its popularity amongst IFAs has waned for many reasons including its complexity and lack of transparency. In an effort to try and make it more transparent for someone thinking about investing in a With Profits Bond, I think that a truthful description of a With Profits Bond might read as follows;

* Your money is invested in a managed fund and what you get back depends on the performance of that managed fund.

* If you ask for a valuation when the value of your managed fund has fallen, we'll pretend it's actually risen in value so you feel better about it.

* If you actually want your money back, however, that's when we'll tell you what it's really worth.

* The pretend value assumes that you've had a nice steady return on the whole sum you invested. But when you think about it, that would be nonsense. How can we pay 7% to your salesman and your money still be worth the same you put in? It's laughable when you think about it, ha! ha! No, if you actually want your money back then obviously for you to get the pretend value not only does the managed fund have to have performed well but it's got to cover all those charges too.

* The assets in the managed fund will not be optimised to generate the best investment returns. Instead, we'll manage the fund so that when stock market values fall and we get nervous about the guarantees we've made to previous policyholders, we'll sell lots of shares because they may fall further. Only when values of shares have picked back up will we have the confidence to increase the allocation to shares at which point you'll not have fully participated in the rally like a normal managed fund would have.

* We should point out that if markets fall for a sustained period and the guarantees we've made to other policyholders are significant then the managed fund may turn into a fixed interest fund. The long term growth prospects and efficiency of this investment will be compromised for you and bare no resemblance to the investment you thought you were making, but at least all the other policyholders will be ok, that's the main thing.

* Oh, and about those guarantees. They're great if you die at a time when your managed fund is worth less than we pretended it was. Your relatives can then get the pretend value. Other than death, well, we've been stung for offering guarantees to other policyholders in the past so we're a bit stingy in that regard nowadays.

* Please also note that when we say "with profits" we also mean "with losses". The losses include things like paying fines for misselling previous policies. We know what you're thinking: if the shareholders benefitted from the misselling, why don't they pay the fines, right? Ha! Ha! Well, we can see what you're saying and the Finnacial Services Authority looked at that last year but we successfully lobbied them that this would be retrospective so we can still pay future fines for past misselling out of the fund and your return will suffer if we do.

Why don't they make a sales aid with these points on I wonder?

With Profits' Malaise: The Cause and Effect

Although with-profits has been around for 200 years it's only since the 1960s that the funds started investing in equities. At that time they could look back on high inflation and high stock market returns in the fifties and see the gain to be had. This served policyholders well right up to the mid to late 80s as inflation and investment returns stayed high. And that's ultimately the cause of its downfall.

Against this backdrop of double digit stock market returns, how were actuaries supposed to know the full extent of what was going to happen over the next twenty years? I read one high profile IFA call with-profits a rip-off last week but that implies some form of deception which I don't believe was there. (If it was a rip-off, the company he works for were not only complicit but were the major beneficiary of the con.) Insurance companies thought it was prudent to offer guaranteed annuity rates at levels that are now worth twice the open market rate. They thought it was cautious to offer a guaranteed basic sum on maturity that required an annualised return of 6% per year. They thought a guaranteed bonus rate of 4% was playing it safe.

It's these guarantees set in a time when no one dreamt of the prospects of almost 0% interest rates that have caused the problem, and not, in my opinion, reckless marketing. For sure, over-payment of terminal bonuses as a competitive tool in the 80s and 90s, using the Inherited Estate to buy group stakeholder pension business and acts like paying special bonuses to ease through a reattribution to shareholders have exacerbated its problems, but ultimately they simply promised too much at a time when they thought they were doing anything but being generous.

It's these guarantees that have led to financial strength problems and the reduction of risk assets in even the strongest with-profits funds (Prudential's with-profits fund's last stated equity exposure is just 39%). A reduction of risk assets means a reduction in reward prospects.

The critical issue that the media and financial advisers must address urgently with policyholders in with-profits funds is not the opacity, the misselling fines, or the inherent conflict of interest in the funds. It's simply to work out the value of their guarantee.

In other words, if we know that by cashing the plan in that the policyholder would need to generate an 8% per year return net of charges and tax in an alternative plan to match the guarantee promised if he stays, then it simply doesn't matter what the asset mix is or the financial strength or anything else. They are the lucky ones who bought policies that led to the problem.

But for policyholders who don't have valuable guarantees then all of these factors matter.

My fear is that the cause of with-profits' malaise, these wonderful guarantees, will unwittingly be discarded by people who hear the bad news about with-profits and assume the problem applies to all policyholders.

Notes:
I posted a version of my article above originally on www.ifalife.com.
The source for the data that I used in my graph was www.finfacts.com and www.statistics.gov.uk.

Market Value Reductions (MVRS) are NOT Penalties

Popping up in my google alerts email on With Profits Bonds this evening was an article written by Tony Hazell in Financial Adviser entitled "Tales from the Crypt". It was a gloves-off attack on with-profits (and Aviva's with-profits in particular) and I found myself agreeing with much of it.

One point in particular, however, left me wishing he and others used different language. He states "Had investors ... possessed the flexibility to move their money to better alternatives without facing horrendous penalties..." If I could change one thing about about how journalists and media-connected Financial Advisers talked about with-profits it would be to stop incorrectly referring to the Market Value Reduction as a penalty. As Arsene Wenger might say, "it was never a penalty."

Let's imagine you gave me £100 in January 2000 and I tell you I'm going to give you a return of around 4% each year. So by 2010 it's worth £150 and we'll call that your "pretend fund value". However, back in 2000, in the small print, there's a caveat or two. The main caveat is that I'm going to deduct £10 for my troubles upfront and then invest your remaining £90 in the stock market and what you'll really get back will depend on how well your £90 performs. We'll call that your "real fund value."

The good news in the brochure is that if your £90 grows well when you ask for your money back I'll give you more than the "pretend fund value" as a "terminal bonus".

Unfortunately, we've had a ten year bear market, your £90 has performed poorly and, you know, I'm not a charity, you'll just get back what it's really worth: £120. OK, that's less than your "pretend fund value" but I'll have to reduce that pretend value back to the real market value if you want your money back.

Now, you and I both know that's not how with-profits bonds were marketed, but it's as close a representation for with-profits as I can think of at this time on a Friday night / Saturday morning. But although that's not how it was marketed, this is a reasonable approximation of what was in the contract.

The fund is worth £120. it's not done what you wanted or what I lead you to believe it might have done but it is what it is. It's £120. You can keep it with me if you like and hope your £120 eventually catches up with that pretend £150 I made you think it was worth.

You might be thinking "What's in a name?". Well, for as long as you think of the Market Value Reduction as a penalty, you will be focussing on the wrong thing. You're focussing on my made-up figure of £150 when it's only worth £120. It will only ever be worth £150 if I've stipulated in the contract you can have that figure on the happening of a certain event like death or the 10th anniversary. If such a feature exists, then this guarantee could be truly valuable if exercised.

In my opinion, that's a different mindset to approaching the investment genuinely believing that that it's worth £150 and treating the £120 value as a £30 penalty. A penalty implies the policyholder is undertaking a wrong doing for which a penalty is appropriate. Who wants to commit an act that is deserving of a penalty? And who feels good about their investment that has just avoided a penalty?

If the personal finance media and financial advice profession is honest about what these policyholders have, admit that the investment is only worth the market value, policyholders will get genuinely excited about these amazing 10th anniversary guarantees that are passing thousands of investors by each week. If we don't, their golden value will be lost.

How with-profits Fund Management Can Diminsh Returns

Aviva announced on 12th January 2010 that their With-Profits Life Fund had returned 6% for the year 2009. Better than both cash and a poke in the eye. But could it have been better?

Aviva's Cautious Managed Life Fund returned 10% in 2009 and the Aviva Distribution Life Fund returned 20%. By comparison, these two funds, with an investment profile suitable for cautious to moderate investors such as those in with-profits funds, had performed so much better. How come?

When the value of the investments in a with-profits fund start to fall the liabilities don't. The comfortable gap between the value of the assets and the value of the liabilities starts to reduce. Neither the company nor the Financial Services Authority want to see the assets fall to a dangerous level where another Equitable Life is on the cards and so the insurance company starts to sell some of the investments that are most likely to see this sorry event occur. As a result, the company starts selling company shares when they are already cheap.

This risk starts to reduce when investment markets recover. At this point, the company can feel the relief and start increasing the exposure to shares again. By this time, the shares are more expensive and policyholders have missed out for good.

The fact that insurance companies worry about their liabilities in this way is fine if you have a policy with valuable guarantees. You're part of the reason they take this action to protect these guarantees. But if your policy doesn't have a valuable guarantee then you've simply missed out compared to where you might have invested.

Policyholders who are worried about their with-profits fund should seek independent financial advice and ask for an assessment of the guarantees. Any advice you receive which has not quantified the guarantees for you should be called into question.

We've produced a video to help explain this blog article at Fraser Heath Financial Advice News.

For more information about our service, please visit www.withprofitshealthcheck.com and for a with-profits health check, please contact me.