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Taking heed of the warning signs

Last week, Hargreaves Lansdown issued a newsletter advising that it had taken a group decision to cease promoting with-profits bonds. This decision was taken in the full knowledge that we are denying ourselves some new business opportunities and that, in some cases, commission income which would have come to ourselves will now be picked up by our competitors.

So why have we done it? Well, for a number of reasons. We are now two-and-a-half years into a bear market of grizzly proportions. Reserves have been dipped into repeatedly to support bonuses.

If the market rises, then much of the early growth will be used to rebuild reserves. If the market falls further or simply tracks sideways, then reserves and bonuses will come under further pressure.

Market falls over the last 30 months of up to 35 per cent, coupled with bonuses paid out of around 10 per cent, leave a substantial deficit to be made good. Either way, it is naive to suppose that with-profits funds can deliver better returns than a fund which is not carrying the baggage of the losses of the past few years.

There are credible arguments to suggest that markets can fall a lot further before bouncing. If this does happen, then not only will short-term bonuses come under greater pressure but it is entirely conceivable that more fundamental problems will emerge. Equitable Life does not have a monopoly on running its reserves down to zero.

Insurance companies are also subject to wider market pressures. The stakeholder comic opera is proving damaging to short-term profits, margins have been squeezed, regulatory costs have increased and evolutionary competition is threatening all but the very fittest. Financial strength is a key issue both for assessing future returns and when considering a provider&#39s ability to survive in the long term.

It is extremely difficult to get a clear, unambiguous and up-to-date picture of any particular insurer&#39s financial position. The FSA does not publish any financial information of this nature on its website, even though insurers are required to report to it every year. Free-asset ratios are imprecise and subject to ready manipulation through such contrivances as including future profits before they have been earned.

We believe that the blind acceptance of with-profits bonds as still being suitable products, for the sake of marketing expediency and short-term commission earnings, is simply not an appropriate course in the present climate.

Income investors buy with-profits bonds because they want maximum income for minimum risk. As highlighted above, the risks have increased and income levels are falling. Crucially, bonus rates are dropping towards and past the 5 per cent mark. When this happens, investors taking standard withdrawals find themselves eating into their capital to meet income demands.

For many people, this is not an acceptable outcome and we should recognise the duty of care that we have to investors to ensure that they understand and accept those risks before committing their money to these products.

It is important also to take into account the regulatory position. The FSA is taking a keen interest in the nature of with-profits investments and bonds, in particular. The products will become more transparent, the sales and advisory process will be reviewed, investment authorisation will become more onerous and that is the good news.

If the market does go pear-shaped, then clients and the regulator will want to know why we failed to take account of the warning signs. The indiscriminate sale of products which are not suitable for client needs and which deliver poor value is a familiar and unwelcome storyline which should not be repeated.

So, for the immediate future, we have suspended the promotion of with-profits bonds. We will continue to monitor the situation and, where we are satisfied that a product and its provider are suitable, we will be happy to promote them again.

Tom McPhail is pensions research manager at Hargreaves Lansdown

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