Payouts on with-profits have fallen in recent years and this is a trend that is expected to continue. This article explains why this is the case and that it affects all types of investment, and not just with-profits.
Returns relate to the period of investment
It is important to realise that, where long-term savings are concerned, final payouts do not just depend on investment returns in the last few years.
How an investment grows year by year throughout its term can have an enormous impact on its final value.
Comparing historic payouts could give investors, particularly those whose plans still have many years to run, a very misleading impression of what their policy could be worth when it matures.
In order to see why this is the case, consider the results of plotting month-by-month growth for three 25-year £50 per month savings plans which are each started exactly one year apart. For simplicity, charges have been ignored and investment has been taken to be entirely in UK shares.
The difference in final payouts is very significant. A plan started in 1976 and ending in 2001 grew to a total of £164,707.
A plan which started just a year later in 1977 and ran until 2002 grew to £113,590, some 31 per cent less than the plan started a year earlier.
However, the return on UK shares in its final year was only -14.8 per cent, which does not fully explain the difference in payouts.
A plan started in 1978 and running for 25 years until 2003 returned a total of £85,907, nearly half of the amount for the 1976 plan.
The same issue as previously noted can be seen when the payout on the 1977 plan is compared with the outcome of the policy started one year later. The 1978 plan's payout is 24 per cent less than the payout a year earlier, yet the investment return in its final year was only9.7 per cent.
Points to note from this are:
The investment performance in the final year, while very important, does not fully explain the difference in payouts. The investment return over the whole period and the timing of the premiums is what matters. The more premiums that have been paid, the more significant is the investment performance in any year.
The above examples relate to UK equity investments but the same principle is true for with-profits and regular savings plans invested in other investment classes, such as managed funds, bonds and even cash.
For with-profits investments, smoothing aims to reduce investment return volatility, particularly in the final year of a savings plan. Since the final year's return can be the most significant influence on the final payout value, smoothing can be a very valuable benefit to with-profits investors.
What about future payouts?
Future with-profits payouts will reflect the underlying investment performance for the period in which the policy is invested.
The investment performance for all asset classes is expected to be lower in the future than it was in the past.
This is due to the fact that we are now in a low-inflation, low-interest-rate environment.
Therefore, future with-profits payouts can be expected to be lower than they were in the past. However, this is not something that only affects with-profits. It is true for all investment plans.
Of course, the prospect of lower investment returns does not have to mean that it is not worth saving.
The important thing to consider is how much an investment plan has grown when compared to the growth in prices. An investment return of 10 per cent a year during a period when inflation averages 8 per cent a year is not as valuable as, say, a 6 per cent a year return when inflation is 2 per cent.
The attraction of with-profits
The UK's low-inflation environment is affecting the returns on all forms of investment.
In making long-term investment choices, investors need to look beyond historic payout comparisons. For many investors, the attractions of smoothing and the potential benefits of mutuality make withprofits a very attractive investment option.