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.