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Chris Gilchrist: The FCA will struggle to kill off the zombies


In my last column I said that old-style regular premium contracts with initial charging could be better value than lower-cost contracts with an up-front adviser fee. This is so counter-intuitive that younger advisers may need some history to make sense of it.

The bulk of ‘zombie’ contracts were written in the 1980s when the typical regular premium contract incorporated 100 per cent allocation, but for the first few years all premiums went to ‘capital units’ which typically embodied an annual charge of 3 per cent in addition to the normal contract charge (itself typically 1 per cent).

These contracts replaced older contracts of the 1960s and 1970s where the life company kept the first X months’ premiums and often no actual investment was made until after month 9. The loss of compounding returns on those lost early premiums was a huge handicap, and on typical growth assumptions the ‘capunits’ style contracts produced significantly higher payouts at maturity.

The capunits contracts required additional life company financing as compared with older ‘nil allocation’ policies. Often the life company would only move into profit between years five and 10. Penalties for early encashment became higher with capunit contracts because lifecompanies had to recover the cost of sales of early lapses that they had previously recouped through the nil allocation period.

So, in summary: policyholders with capunit contracts who held to maturity did better than those holding older nil-allocation policies, but those who surrendered capunit policies early did worse.

The wheel turns. We now have lower-cost regular saving contracts but the advice fee is separate. Follow the same logic as the 1980s: if you could invest that adviser fee on the same contract terms, you would be better off with a capunit contract held to maturity than with a low-charge contract and paying an adviser fee.

Of course this depends on the exact terms of the contract, but you get the idea. We’ve gone back to the future (again).

The real issue with the capunits contracts is that the early encashment penalties did not tail off, as they should have done. Once lifecos had recouped their costs of sales (including costs of lapses) any increase in penalties was unfair profit at policyholders’ expense. You can argue – they certainly will – that lifecos did not know how many policies would lapse before they had gone into profit, so they had to build in extra margin.

That just shows how hard it was (and is) to design a long-term savings contract incorporating sales/advice costs with equitable charges. But you would think that it also gives the FCA scope for some arm-twisting, since lifecos will struggle to defend hefty penalties after 20 or 30 years.

The real zombie scandal is this: if the bulk of live contracts were run by living lifecos, they would respond to pressure from advisers, policyholders and regulators and cut the penalties. But because the zombies are providing the profits for financially-engineered zombie accumulators, they won’t until the FCA beats them to death.

As we all know, that is almost impossible with zombies, and in this case they can also afford the best lawyers.

I am sure we will hear a lot about sanctity of contract and the dangers of retrospection as the FCA review proceeds. Meanwhile the policyholders get nil service for which they are paying an annual 1 per cent or more. There are times when US-style class action suits look very appealing.

Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits The IRS Report



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There are 5 comments at the moment, we would love to hear your opinion too.

  1. The obvious conundrum is that these zombie life companies could simply ignore any directives from the FCA such as to remove unreasonably penal early exit terms from these old contracts and invest in decent fund managers. Forcing closure of the entire operation isn’t an option, as it would only make the situation worse.

    Perhaps, in the face of non-compliance, the FCA’s only options would be to:-

    1. Order them to offer all policyholders 100% exit terms and recommend that said policyholders seek outside advice on where best to reinvest (a huge programme but not impossible) and, if they fail to comply with that

    2. Impose fines on the directors personally.

    It would be a bold strategy but, if nothing less would sort out the problem, what other option is there and does the FCA have the bottle to do it?

  2. I really dont know whose side to be on for this one. We all know that our business is long term planning and the FCA is trying to regulate the industry on this one with a view that those who who do not run the course should not be penalised in any way. I am sorry but those who stick to their plans should not be short changed in favour those who want to get out early. In my view that is just ludicrous.

    However some of the penalties on these funds are ridiculous. I have come across a case where One provider who will remain nameless still has MVR at nearly 27% of the value of the clients holding in their WP fund on a clients bond that is 20 years old tomorrow. The only MVR free date the provider has is on death of the policyholder. The situation is worse in that they have not declared bonuses for 7 years now and this compounds matters

    I dont imagine the FCA will not be able force providers to remove exit charges as that will close some of them down. That will not do anyone any good. Not the providers, not the thousands who lose their jobs, not the investors, not pension funds and especially not the policyholders. They will have to find some type of reasonable solution but the providers will fight this tooth and nail

    There does need to be some kind of line drawn but where it is to be drawn is a very had one to call. I think this will drag on for many many years

  3. goodness gracious 25th April 2014 at 2:04 pm

    Chris, So the stakeholder contract with lower charges, no exit fees but limited fund choices were better for individuals, as long as the fund chosen performed.
    I feel that if the provider has sold the contract to someone else, or has been taken over, then early exit penalties are unfair after 10 years. If the original writer of the contract is still the same, not merged or taken over by someone else, transfer penalties should be allowed for 15 years. That’s fair and does not commit someone to a lifetime of underachieving investments or just rank profiteering.

  4. Chris I know the topic is Zombies, but taking the point about capunits and the charges in the 80’s. Where clients are now further disadvantaged is if in those days one charged fees then if you look at single premiums instead of regulars the allocation rate was often as high at 105%. So for (say) £100k you got £105k invested. If the fee was £3k the client was quids in and we were all happy. Even if the allocation was 103% the client was in for free. It certainly eased the path of fee charging!
    This is one instance where the RDR has definitely disadvantaged clients.

  5. I hope we do hear a lot about “the sanctity of contract and the dangers of retrospection”. The position you appear to be taking is similar to those who argue for freedom of speech – so long as you agree with me.
    Freedom of speech means nothing unless you are prepared to allow people to say things with which you do not agree. Similarly the fact that zombie contracts are so poor is NOT a valid reason for retrospection or ignoring existing contracts. If you weaken on this point then all is lost. The only correct way to deal with the zombie is to draw a line and to move on – to accept that it is part of history and that we no longer allow such bad contracts. To attempt to change history here will only end in disaster.

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