Despite all the caveats on policy projections, such as “the returns are not guaranteed” and “you could get back more or less than this”, clients are heavily influenced by the figures provided. They will often quote the figures, particularly the highest one, and regard them as their minimum expectation at maturity.
It is clearly very important not to raise false expectations. At Liverpool Victoria, we are concerned that not all companies are taking sufficient notice of the link between assets held and the projections issued.
The FSA handbook contains clear rules and guidance on the projections provided to clients. In particular, guidance in COBS rule 6.6.2 of the handbook states: “A projection needs to be carried out on a basis of uniform and consistent rates of investment return so that firms do not seek to compete on the basis of wholly speculative forecasts as to the potential value of future benefits.
This should ensure that private customers purchasing a life policy receive information about possible future returns from their investment which is fair and not misleading.”
The FSA specifies a lower, intermediate and higher rate of return to be used in projections but note in COBS rule 6.6.49(2) that “reduced rates of return must be used if the firm expects the rates in the tables to overstate the investment potential of a contract”. The standard annual rates of return are 4, 6 and 8 per cent for taxed business and 5, 7 and 9 per cent for gross business.
The investment potential of a contract is obviously determined by the assets in which it is assumed the policy is invested. The table below gives examples of potential returns for different hypothetical asset mixes based on assumptions about future investment returns. The assumed rates of investment return are 7.5 per cent for equities, 6.5 per cent for property and 4.5 per cent for fixed interest.
The table suggests that to achieve a gross return of 7 per cent, a fund would need at least 83 per cent in equities if the balance was in fixed-interest investments. An assumption of 7 per cent could also be justified using 70 per cent equities, 20 per cent property and 10 per cent fixed interest.
The average with-profits fund in August had just 43 per cent in equities, 11 per cent in property and 46 per cent in fixed interest. This would only justify an intermediate projection rate of 6 per cent.
Although the gap between 6 and 7 per cent does not seem that great, over 10 years an investment of £10,000 produces £19,670 at 7 per cent, yet only £17,900 at 6 per cent.
Companies are starting to promote with-profits bonds that are designed to produce income rather than growth. These tend to be invested in funds with a lower equity content and a higher fixed-interest or property content. The table below demonstrates that these asset mixes will tend to produce lower overall expected investment returns.
At Liverpool Victoria, we consider that it is very important not to overestimate the potential returns from with-profits contracts. To do so is likely to result in policyholder disappointment and potential complaints at a later stage.
Our with-profits fund has one of the highest equity and property backing ratios in the market. However, for our new with-profits income bond, we have decided to use lower rates of return for projections. This is because the new bond will have a lower EBR and a greater focus on income-producing assets. We have decided to use rates of 4, 5 and 6 per cent rather than 4, 6 and 8 per cent as we believe this is the only way not to create unrealistic expectations.
The FSA wrote to CEOs in June asking them to consider whether their assumed rates of return on with-profits funds remain appropriate given their asset mixes. Although particular emphasis was placed on mortgage endowments, the letter also referred to their use for other purposes.
Perhaps IFAs should ask providers to justify their use of the FSA projection rates when these seem difficult to justify based on their asset mix. IFAs should also consider seeking information from providers to help explain to clients the potential risks associated with different types of asset, particularly the volatility in anticipated returns.
Ian Blanchard is group actuary at Liverpool Victoria