When President Gorbachev launched glasnost in the Soviet Union in 1985, his policy of openness revealed the flaws in a system strangled by the arcane rules of an unaccountable bureaucracy and ultimately this led to its downfall.
The FSA's investigation of misselling of endowment policies, coupled with a severe and prolonged equity bear market, has brought glasnost to bear on the practices of the UK investment industry and revealed the fundamental contradiction behind the incomprehensible actuarial terminology of with-profits.
This sets the scene for the replacement of with-profits products by the transparent alternative, cautious managed funds.
Some might feel that with-profits will be sorely missed as they offered:
1: A headline rate of growth (the reversionary bonus rate).
2: The prospect of a terminal bonus on top.
3: Guarantees – for example, market value adjustment holiday periods or a fixed high-level reversionary bonus in year one.
4: Smoothed investment growth, with none of the ups and downs associated with investing in the stockmarket.
On the face of it, with-profits were the perfect investment product. They seemed to offer, via the reversionary bonus,a risk-free rate of return and, in addition, the potential of a healthy (terminal) bonus on top.
Equity-style returns with cash-like risk – the proverbial free lunch. When put like that it is patently obvious that the numbers cannot add up.
But during the long bull market of the 1980s and 1990s, it was forgotten that equity markets could go down as well as up.
How could it be that actuaries' tried and tested methods did not work? The problem is that, at the heart of with-profits and the features mentioned above, is a requirement that the actuary correctly forecast the long-term returns to investments. But, as Niels Bohr, the eminent physicist and Nobel prizewinner pointed out, “prediction is very difficult, especially about the future”.
The graph on page 54 shows the rate of growth of the FTSE All Share index over different fiveyear periods.
For the five years from January 1, 1987, the market grew at 11 per cent a year. It managed 15 per cent a year for the five years after January 1, 1993 but it shrank by 1 per cent a year for the most recent five-year period. Is the correct long-term return -1 per cent, 11 per cent or 15 per cent or some combination of them? The simple fact is that nobody knows.
There would be no problem with an incorrect long-term forecast if all with-profits investors held their policies to maturity and, at maturity, the terminal bonus could be negative as well as positive.
This would mean that all policyholders got back what they invested plus the growth on their investment; no more, no less. But, in the real world, many investors do cash in early and terminal bonuses cannot be negative.
In these situations, if the life company has been working on an assumption about long-term investment growth that is too high, it will pay out more than was actually earned on a given policyholder's investments, leaving a gaping hole in the with-profits fund.
The maths are simple. Pay out too much to one investor and what is left in the pot is less than the remaining investors have themselves earned.
Hence, with-profits introduces a new risk – actuarial misestimation risk. If the actuary overestimates investment growth and sets too high levels of reversionary bonus, there is a risk that maturing investors and those cashing out will be paid too much (smoothed up) and the remainder will be left in a shrinking pot (smoothed down).
Fine if you are in luck but not a risk that can easily be controlled or understood, so why take it? Especially when there is an increasingly popular alternative, more in tune with the modern world, that offers transparency, daily valuations, easy access and tax efficiency.
This alternative, a cautious managed fund, builds on the true strength of with-profits – their investment mix. We can learn a lot from how life companies constructed their with-profits funds. After all, they had an economic interest in the performance of the fund, so they had a powerful incentive to manage it well.
We see that the underlying funds were always mixed asset, including UK equities, fixed interest, international equities, property and cash. This combination is astute and consistent with basic investment theory – that a port-folio of dissimilar assets offers the best trade-off between risk and return.
Of course, some life companies would hold more in equities, and some would hold more in bonds but the principle of a mix of assets was unshakeable. As bonds often rally when equities decline and vice versa, holding both in the portfolio meant that, in aggregate, risk was reduced. This is real smoothing without any guesswork about the future or transfers of wealth between investors.
Hence, as Sandler concluded in his review, a fund with a mix of assets is the best method for delivering lower risk returns over the long-term, suitable for the greater mass of investors. As the impossible promises made on behalf of with-profits are revealed, and reversionary bonus rates fall to less than cash returns, it makes sense to strip away the risky bets taken by the actuary and simply invest directly in a fund managed in this fashion.
Cautious managed funds are restricted to a maximum of 60 per cent in equities, a portion of which may be international, and are consequently consistent with maintaining enough of a balance between bonds and equities to benefit from the smoothing effect of uncorrelated investments.
Some funds in the sector, for tax reasons, restrict themselves to a maximum of 40 per cent in equities. While giving up some growth potential, these distribution funds should still benefit from the smoothing effect of holding both bonds and equities in one portfolio.
Investment funds cannot invest directly in property but there are plenty of opportunities to invest in stocks that are exposed to the property cycle – certain investment trusts, property companies and housebuilders, for example – so that, in practice, funds in the cautious managed sector are free to emulate the best of the with-profits asset allocation mix.
A further important advantage of cautious managed funds over with-profits is their freedom to make the most of investment opportunities, whereas with-profits funds, from time to time, could get tied up with liability matching obligations.
Thus we witnessed, at the low point of the equity market, with-profits funds being forced sellers of equities while investment funds could pick up the bargains.
As Standard Life chairman Sir Brian Stewart, considering the demutualisation of his firm, recently said: “We have to recognise that the world is changing.” Indeed, just as glasnost changed the Soviet Union, so it is a theme changing the demands of informed and aware post-internet western consumers. The transparency of cautious managed funds can meet these needs while opaque with-profits cannot.