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Fine line on with-profits

The latest stock-market turmoil has inevitably led to the introduction of market value reductions on surrender of with- profits policies and that has equally inevitably led to ill-informed consumer press comment about investors being penalised by insurance companies.

No one welcomes MVRs but in many ways they highlight the benefits rather than the drawbacks of with-profits investment.

With-profits offers two key elements of security for investors – smoothing and guarantees.

Smoothing provides protection against short-term market fluctuations close to the date when payouts are due while guarantees give a floor on the amount of the payouts.

However, the guarantees only apply at a specified date or range of dates (and generally also on death), allowing the insurance company to invest widely but ensure it has appropriate assets to meet the guarantees if they bite.

When guarantees do bite, policyholders are effectively getting higher payouts than their contributions have earned. The cost of the guarantees has to be met and it comes from the with-profits fund, meaning there is less left there for other investors. All else being equal, their bonuses, and so their payouts, are likely to be lower than they otherwise would be.

This process is normal and accepted at times when guarantees apply but if payouts are effectively at the guaranteed level when the policyholder decides to cash in early or move out of with-profits, it will unfairly disadvantage those who remain. MVRs are designed to ensure that does not happen.

MVRs only apply to unitised with-profits arrangements. Under the old “conventional” version, cash-in values at times when guarantees do not apply are determined by the insurer and the calculation method is generally not public, although the same principles apply – providing fair values on surrender while protecting the benefits of those who remain. With unitised policies, the process is more explicit, which is why it attracts publicity.

Policy mechanics vary but most unitised with-profits plans have a unit price which is guaranteed not to fall and which will rise in line with a regular bonus rate. In some arrangements, the unit price is always £1 and bonuses increase the number of units but the effect is similar.

On top of the face value of units (number of units multiplied by unit price), there may be a final or terminal bonus, which is not guaranteed. Adding this in gives the total value of each unit at a time when guarantees apply.

If this is more than the underlying value, then the insurance company may choose to apply an MVR on encashment when guarantees do not apply. There may also be an explicit deduction on surrender but that is related to the recovery of initial costs, not to investment returns.

It is possible to have a final bonus and an MVR applying at the same time to the same units. This is largely because smoothing of investment returns can mean that the final bonus can take payouts above the underlying values. The MVR brings the two closer.

Although MVRs are often presented as arbitrary penalties by the consumer press, their use is strictly controlled. Circumstances when they will apply and an outline of how they are calculated will be in each company’s principles and practices of financial management and in the shorter customer-friendly summaries.

The protections offered to those who cash in early are weaker than for those who take their benefits when guarantees apply but with-profits investment still offers greater protection against short-term market movements than unit-linked.

The balance between offering this protection and being fair to those who remain with their investments is one that requires fine judgements but with-profits continues to serve many customers very well.

Ian Naismith is head of pensions market development at Scottish Widows

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