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Box clever

In the Greek myth, Pandora receives a box filled with dubious gifts from the gods and is instructed never to open to it. Curiosity gets the better of her, however, and she risks a peek inside. Out swarms Evil in myriad guises and by the time Pandora slams the lid shut, all that is left in the box is Hope.

For many financial advisers, clients who hold with-profits bonds are their Pandora clients – they are praying that these investors do not lift the lid.

You may be among those who have chosen not to tell your clients the terrible truth about with-profits bonds-at least for a while. After all, a bull market will see market value adjustment figures disappearing, won&#39t it?

Well, we analysed the average face values of with-profits bonds from nine of the leading providers and compared them with the average amount of money the investor would get back if he or she surrendered the policy.

Whether the policies were three, four or five years old on May 1, 2004, they each needed the surrender value to increase by at least 19.5 per cent for it to match the face value. The surrender value broadly equates to the fair asset share for these policies. Assuming that no bonuses are added, how long would it take for the assets in the fund to make up a 19.5 per cent shortfall? As a taxed investment with potentially a limited exposure to equities, charges increasing due to the cost of guarantees and a crab-like investment market it could be years.

What to do

If you decide it is time to offer advice to your clients holding with-profits, your challenge is to find an effective, efficient and profitable way of approaching the review. Unfortunately, the with-profits bond&#39s &#39keep it simple&#39 design belies the complexity of the investment.

In its response to the FSA&#39s consultation paper 207, Treating with-profits policyholders fairly, Sofa says it “strongly believes that there should be specialist with-profits advisers who can advise on this most complex subject”.

We agree that there is real merit in using specialist with-profits advisers to analyse a client&#39s with-profits bonds. Outsourcing to specialists is a growing trend for IFAs. That said, a qualified investment adviser should be more than capable of discussing the key issues and applying his or her clients&#39 personal circumstances to determine the best course of action. The trick is to cover every issue and to document each point clearly. Some with-profits specialists can help you with this.

The first stage of the review requires the adviser to explain to the client exactly what his or her investment is worth. We would explain that the current fund value is a misnomer. The term conditional value is closer to the mark as the value can only be accessed under certain policy conditions such as on death, a specified anniversary date or when the client&#39s fair share of the fund is broadly similar to the conditional value. If the client&#39s fair share of the fund falls above or, more likely, below this conditional value, then that is the sum she will receive from the insurance company unless said policy conditions apply.

Now that the Evil of the investment is out of the box, you can draw your client&#39s attention to Hope. The first thing to do is to assess the guaranteed policy conditions to see if there is any way in which these may be utilised.

Guaranteed policy options ensure that an investor&#39s returns are not just determined by the performance of the assets in the fund. We would analyse each guaranteed policy condition and calculate its value in monetary terms and also express these values as annualised returns.

Imagine a client whose with-profits bond has a conditional value of £20,000, whose fair share of the fund is only £17,000 and whose policy stipulates that he can take 7.5 per cent of the conditional value without a reduction applying.

In this case, the client is ent-itled to an annual withdrawal of £1,500 that will only reduce his fair share of the fund by £1,275. Every investor who takes advantage of this entitlement effectively receives a subsidy of £225. Every investor who does not, loses out. We would calculate a supportable level of spending money based on the client&#39s current fair share of the fund on the grounds that spending the full 7.5 per cent entitlement would probably erode his capital. We discuss annual savings vehicles for any excess above the supportable spending level.

To expand this example further, if this same client has a guarantee that he can access the conditional value on a specific day in five years&#39 time, we would explain that assuming no bonuses are added he can be assured of £20,000 on that date. If he were instead to surrender the investment and reinvest the £17,000, he would need to achieve an annualised return of 3.3 per cent after tax and charges for the investment to be worth £20,000.

We would also calculate the projected conditional value on the anniversary date assuming the current annual bonus rate does not change and then compare these returns with stochastic modelling projections for efficient portfolios that are appropriate to the client&#39s attitude to risk.

We would also address:

•The projected return based on the fund&#39s asset mix and the expected volatility of this asset mix compared with the client&#39s attitude to risk.

•Whether the asset mix appears to be adopting modern portfolio theory to maximise investment returns or whether its asset mix appears to be determined by matching liabilities.

•How the bonus rate compares with other with-profits bonds.

•How the conditional value and fair share payouts have compared with the average with-profits bond over each of the past five years.

•How the company has smoothed returns over the past 12 months.

•The fund&#39s financial strength.

•How the company operates its management of the fund, referring to the company&#39s Principles and Practice of Financial Management document, highlighting any interesting strengths or any skeletons in the closet.

•How the investment is taxed and whether tax savings can be made for the client.

•How partial or full surrender would impact on the client&#39s tax position.

Only after addressing all these points and eliciting the client&#39s reaction to them would we feel confident of recommending the best way forward.

It is worth bearing in mind that conducting such a review could save you £360 costs with the Financial Ombudsman. A report in the Ombudsman News (July 2004) points to a rising number of with-profits bond-related complaints. It may not be the easiest or happiest meeting you ever hold but even if your client&#39s investment is rotten to the core, if you look carefully, you are certain to find hope.


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