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Don&#39t be misled by the headlines

With-profits bonds have been one of the great success stories of the life insurance industry over the past decade. Sales have boomed, the bonds have produced good returns and, as a result, offices will rarely, if ever, have applied a market value adjustment.

The product meets a real need by offering the more cautious customer the opportunity to benefit from equity-linked returns with less vola-tility than would be experienced with a product linked directly to the markets.

Most investors in a with-profits bond, and their advisers, will be looking to select a provider with the potential to produce superior long-term returns. What are the key factors they should be considering? The simple answer is good investment performance and low expenses. With an Oeic or unit trust, we could stop there. In the case of a with-profits bond, it is necessary to have a deeper understanding of the nature of a with-profits fund.

There are two main drivers of good performance for with-profits investments. First, there is the skill of the investment managers and how well they perform relative to their chosen benchmark. Looking at the difference in performance between a top-quartile fund and a median fund over a period of 10 years suggests that superior investment management skill might deliver an excess return of around 0.75 per cent a year.

Of course, it is very difficult to predict in advance which companies will be the ones that deliver the superior performance over the next 10 years.

The second element of investment performance is the constraints imposed on the investments in the with-profits fund. These will determine the proportion of the fund invested in fixed-interest securities rather than equity-type investments which can be expected to produce higher returns over the long term. Over the past 50 years, the outperformance of equities relative to Government bonds has been on average over 6 per cent a year (source: The Millennium Book, London Business School, 2000).

For a with-profits fund with 20 per cent more assets in equities than the average fund, this would have resulted in an excess return of 1.2 per cent a year. It is, of course, important to remember that past performance is not necessarily a guide to the future.

The ability of an office to invest in equities will be driven by its financial strength which, in turn, is driven by the nature of the guarantees it offers. The higher the levels of guarantees, the greater the reserving requirements and the greater the need to invest in more secure assets.

By analysing an office&#39s financial strength and the guarantees offered under its contracts, it should be possible to make informed judgements as to the likelihood of it maintaining high levels of equity investment and good long-term returns.

High annual bonuses and guarantees on income and capital under with-profits bonds can have very significant reserving implications. All else being equal, the offices better able to deliver good long-term returns should be those with lower annual reversionary bonuses and those which do not need to hold large reserves for MVA-free guarantees.

Another area to look at is expenses or, more correctly, the deductions that will made from the contract. This is one area where generally there is relatively little to choose between the leading companies as charging structures are broadly comparable in their effect.

Mutual offices, however, will have a significant advantage over proprietaries as they will not pay a proportion of their returns to shareholders and there may be profits available from other business lines to supplement the returns. This could make a difference to the annual return of up to 0.75 per cent.

If the with-profits bond is to continue to be a success story, it will be very important for good practice to be followed by the whole industry. In selling the business, it will be essential that the true nature of contracts be spelt out to the customer. It must be emphasised that this is not a guaranteed product and the customer may, in certain circumstances, get back less than they invested.

Both adviser and product provider have a role to play at the point of sale and in the supporting literature. The industry should move away from the use of eye-catching headline rates that may not be sustainable. Instead, companies should focus on emphasising the real long-term benefits of with-profits investment.

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