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Smoothed operator

The advantages and disadvantages of with-profits have been discussed thoroughly in recent years although I have often found the debate being diluted by the financial and marketing self-interest of those taking part.

There is little doubting the appeal of investment that provides the potential to outperform cash while offering a capital guarantee. This is compounded as the investment can be expected to grow each year by the addition of a bonus payment that, once added, cannot be taken away and that effectively smooths out the peaks and troughs of the market.

All very good so far. But how realistic is this proposition in today&#39s market environment? I would contest that while this product des-cription remains the perceived notion of, say, a with-profits bond, the products available in the market fall some way short of matching this analysis.

There are three main claims made in the product description. One that all-udes to investment performance, one relating to the “shape” of the return and an implied point that leads investors to believe that the value of their investment can not fall from year to year.

Considering each of these in turn raises some fundamental questions regarding the sustainability of the product type.

In investment performance, if I may first assume that long-term equity-linked returns are simply the sum of long-term bond returns plus equity risk premium.

This premium reflects the uncertainty associated with the return and is also considered to take account of inflation. This basis is widely used and with long bond yields at about 5.2 per cent, the expected long-term return on equities may be about 7-7.5 per cent, imp-lying an equity risk premium of about 2 per cent.

If a typical with-profits fund is broadly invested 60/40 in equities and bonds, this means that the outperformance is likely to fall by around 1 per cent before taking any account of charges.

Once one factors in the additional cost of managing equities over bonds on 60 per cent of the portfolio, the potential for greater returns shrinks further still.

So it seems already that a balanced portfolio of equities and bonds has only a modest chance of outperforming a bond portfolio in the current climate.

Now for smoothing. Perceived as a strong benefit of with-profits, this product feature also has costs. To understand this point, it is vital to understand how a typical smoothing mechanism operates, at least in headline terms. In principle, money is held back from years of strong performance to make up the shortfall in years of poorer returns.

That is fine but whose capital is used to fund this process and what is the cost of capital for that source? For other policyholders, the cost of capital is arguably a perfect reflection of policyholders&#39 reasonable expectations – a figure that in all reality will be based on past performance and the information provided at the point of sale.

It will certainly be a figure greater than the returns from cash or else they would have invested there. If the capital is shareholder capital, its cost is likely to be even greater. I am not aware of a single UK life office that operates on a target return on capital less than about 12 per cent.

Therefore, if, say, 10 per cent of the fund at any time is smoothing capital, the performance of the fund may dip by a further 0.25 or 0.5 per cent. In theoretical terms, the portfolio return is now precariously close to the long bond ret-urns discussed earlier.

What about the cost of guarantees and solvency? My preference is always to consider the cost of a commercial guarantee. To protect the initial value of a balanced portfolio at the end of 10 years can cost about 1 per cent of the fund value each year. Even if you divide this figure in half, the implication is that the with-profits portfolio will underperform a bond portfolio over the long term and that is before you consider the considerable additional costs of ensuring that the guarantee is in place every year at the previous year&#39s closing level.

Of course, many companies have come to appreciate these costs and have withdrawn market value reduction free periods from their products. A vital imp-act on the long-term ret urns can be expected alth-ough I do not feel that this has been reflected in the sales process.

It is quite simply not possible to provide a smoothed, fully guaranteed equity-linked product on straight commercial terms that can be strongly expected to outperform bonds. Something has to give. I would suggest expectation.

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