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