The with-profits market has changed dramatically over the past few years. Not so long ago it was booming, there was an abundance of providers and investment performance was delivering stronger returns than we currently experience. Advisers and consumers alike were attracted to the benefits of with-profits.
This changed when the markets headed south in 2000 and stayed there for the next three years. Like other equity-based investments, with-profits bonds suffered from stockmarket difficulties, although it has to be said that the diversification and smoothing inherent in with-profits meant they tended to fare better than pure equity funds.
In response to the stockmarket decline, with-profits bonus rates were duly cut, but bonus rates alone could not bring into line the fund values policyholders expected and the value of the underlying assets.
For investors that remained invested, providers could gradually bring the two values into line. For investors wanting to cash in their policies, market value reductions (MRVs) were applied. The MVRs ensured that policyholders leaving a fund did not take more than they were entitled to, or more than their fair share.
MVRs were understandably unpopular, causing distress and exposing a lack of product understanding on the part of investors and, in some cases, advisers.
Another legacy of the bear market was to weaken with-profits funds. Unfortunately, some people understood “weaken” to mean “weak”. Some funds remain strong in spite of being weaker than they were a few years ago.
As a result of the weakening, some bonds have been surrendered. What is most worrying about this trend is the apparent failure to differentiate between strong and weak funds. There is anecdotal evidence to suggest that some advisers are recommending that their clients leave strong funds because MVRs are lower.
At first sight, and from an MVR-avoidance point of view, that might appear to make sense. Upon further inspection, however, the recommended action could be quite different. Advisers, like policyholders, have to take a considered, longer term view and avoid making panic decisions.
Strong funds have more investment freedom than weak funds. Weak funds may have to invest predominantly in lower risk investments, for example fixed interest investments, which ultimately limits the upside potential of the fund. To distinguish between strong and weak funds, advisers can refer to third party rating agencies to assess fund strength for them. Standard & Poor's and AKG are two that provide this type of service.
Fund closures have added to the confusion in the with-profits bond marketplace. Fund closures are nothing new but some people mistakenly believe that a closed fund must be weak, which is not necessarily the case. Open funds don't always outperform closed funds.
The FSA is at great pains to emphasise that funds close to new business for reasons other than fund weakness, such as a change in business strategy and changes in the economic and regulatory environment. A total of 66 out of 110 with-profits funds in the UK are now closed to new business for a variety of reasons.
So what does the future hold for with-profits?
The FSA anticipates that there will be some activity on the sale and restructuring of closed books of business. To date, there has been “more talk than transactions” but the FSA says “there are signs of this beginning to change”.
Providers will continue to take steps to protect their existing books of business. Strong providers in particular will be keen to ensure that advisers and policyholders differentiate between strong and weak funds and the implications this has on investments.
The remaining strong with-profit bond providers will continue to urge advisers not to lump all with-profit providers together. Strong funds can offer investors good prospects for future growth and the merits of with-profits still hold true.
Prudential has recently launched the PruFund Investment Plan, a with-profits bond which, instead of using bonus rates to distribute investment returns and implementing an MVR to correct divergencies, publishes an expected growth rate for the forthcoming quarter and uses a formula for adjustments.
This is a much more transparent approach which has been the subject of much debate in the industry and press.