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Appliance of science

During a chat with a few IFAs after a recent seminar, I was a little taken aback by the lack of awareness of the true nature and likely future investment behaviour of with-profits and managed funds. There was general consensus (although, I have to say, not necessarily including myself) that with-profits funds have had their day but this consensus carried over to an enthusiasm for managed funds as a method of reducing client risk within a single fund.

My attempts to insert some logic into this conversation with an analysis of asset allocation met with little response. But without such an analysis, advisers risk projecting inaccurate or inappropriate investment returns and likely volatility. Therefore, this and my next article will assess the outlook for with-profits and managed funds.

A good starting point is Equitable Life – not to rub salt into wounds but as an example of how to assess likely future returns under with-profits contracts. The demise of Equitable is well documented but of some interest to this article is the decision by a small number of advisers, including my firm, right from the start to actively seek out Equitable with-profits investors and (for most, at least) recommend a transfer.

In those early years, this recommendation was largely based on a subjective assessment of the situation which led many to believe that Equitable could not “pull it round” sufficiently to merit continued investment in the with-profits fund. As we now know, this proved to be a correct, if at least a little fortunate, assessment.

Until a little over a year ago, Equitable&#39s with-profits fund was invested mostly in equities, with smaller proportions of government bonds and commercial investment property. If equities had started to perform well and commercial property continued to produce solid returns (8 to 10 per cent or thereabouts), overall returns on the fund would have been high. This would have allowed it to pay a respectable level of ongoing bonuses, with even a contribution to reserves and/or a reduction in penalties to investors seeking a transfer.

Around a year ago, however, Equitable divested the fund of almost all its equities, so that around 4 per cent remained in equities, as of the last known declaration. The proceeds were all directed towards government bonds, the returns from which are much less volatile than equities. Fundamentally, this protected the fund and bonuses from the potential for total collapse in the event of falling equity markets, which subsequently occurred.

Equitable&#39s equity sales were apparently made when the FTSE was around 4,800 compared with its current level of around 4,100, having fallen 1,000 points in the interim period while gilts have enjoyed a reasonable year. Thus, its decision was very well planned.

Whereas, prior to this move away from equities, it was impossible to even begin to estimate the returns likely to accrue to the fund in the near term, predictions can now be more accurately made. Redemption yields on mediumand long-dated government bonds average around 4 per cent a year, with shorter-dated issues a half point or so below this. Thus, we know that returns on 80 per cent of Equitable&#39s fund are running very close to 4 per cent a year, before tax and expenses.

Can I stress again that this article uses Equitable more as a prime example of principles applying to an increasing number of other with-profits funds rather than as any kind of negative comment on Equitable.

So, with 80 per cent of Equitable&#39s portfolio earning 4 per cent a year gross, what about the other 20 per cent? With the exception of a tiny residual equity holding (are these shares which Equitable found it difficult to sell with the rest of the equity portfolio last year?), the remaining part of the with-profits fund is invested in commercial property. Total returns from this asset class have been averaging between 8 and 10 per cent over the last few years but returns have been falling steadily over the last 18 months or so and commercial property now appears to be producing annualised total returns of around 7 per cent (source: Investment Property Databank Index monthly returns).

Typically, we could estimate that the remaining 20 per cent of the with-profits fund has been producing returns of 7 per cent, giving the following overall assessment (see below).

This would indicate total returns of 4.6 per cent which, after allowing for expenses of, say, 2 per cent a year, would indicate a maximum possible annual bonus of no more than 2.5 per cent. It is crucial to realise that this assessment is not based on some global view of possible future returns on all with-profits funds and especially not based on past performance. It is based on a scientific appraisal of likely future returns to this particular fund based on an understanding of the asset allocation and a knowledge that money out (in bonus declarations) now cannot exceed money in (returns on the underlying assets).

Staying with Equitable, a couple of months ago it announced it is starting to sell off its remaining property holdings in favour of gilts, thereby eventually turning its with-profits fund into a gilt fund. When this is complete, we will be able to estimate the with-profits fund&#39s investment returns with even more certainty and precision – 4 per cent a year in today&#39s market conditions, indicating a maximum sustainable bonus rate of 2 per cent a year.

Now it becomes easier to predict whether an Equitable policyholder should effect a transfer, as the following example should illustrate. A client has a pension policy with Equitable invested in the with-profits fund. His notional fund value is £100,000 with a transfer value of £75,000. Maturity at his expected retirement age is in 15 years. If he stays with Equitable, we can estimate that his £100,000 is likely to grow by 2 per cent a year, indicating an eventual fund of £134,570. If he effects a transfer and we assume future returns net of 1 per cent reduction in yield of, say, 5 per cent a year, his projected fund would be £155,850 – an increase of around 15 per cent notwithstanding the initial hit of the transfer penalty.

I would strongly suggest that 5 per cent could be easily justified from an asset allocation of equities, property and mid-range corporate bonds.

In my next article, I will move on to assess the uses and myths behind managed funds.

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