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.