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TEPs: With-profits hits target

It has not been a great time to retire in the last two years as the value of some funds have fallen by over 30 per cent during this time. Even if retirement can be deferred, how long will it take for these funds to recover to levels of only a couple of years ago?

The traditional approach has been to move more assets into cash as retirement approaches. However, the continuing fall in interest rates has made this option less attractive despite the downward volatility of the alternatives.

In the past, this gap has been filled by with-profits funds but the number of options for pension trustees looking to provide a route to growth with security continues to dwindle.

The first problem trustees face is that the current generation of with-profits funds are not really with-profits at all.

Take a unitised with-profits fund. The guarantees provided do not apply through the lifetime of a policy as with “traditional” or “real” with-profits funds.

Accrued reversionary bonuses are guaranteed not to fall, yet there is no element of guarantee to take into the future. This differs from a “real” with-profits fund where on day one of the policy after payment of just one premium you get a guaranteed sum assured which is used as the platform to add all future bonuses.

The second problem is that while “real” with-profits funds are clearly a better option, there are very few companies still offering this valuable option. It is this market demand that has led to the rapid growth in investment funds which invest in traditional with-profits policies via the Tep market.

SSASs and Sipps have been buying individual policies for many years. However, as pension funds have grown and the desire for with-profits increased, managing individual policies could become an admin burden.

The first question many will ask is, why on earth would anyone want to invest in withprofits? You only have to glance at the Sunday newspapers to see that endowments are not exactly flavour of the month.

Pension schemes buying with-profits endowment funds have already spotted one key point. A mortgage endowment policy has to hit a fixed target on a fixed date.

If it does not hit the target, then the policy has “underperformed”. As a result, a policy that might have delivered an annualised return of around 12.5 per cent over 25 years is branded a failure.

Take away the need for a policy to hit the fixed target on a set date and the policy suddenly becomes a different product and the return rather than being a failure is now very acceptable.

Teps are not just about performance, though. Virtually every policy sold in the Tep market has guarantees which exceed not just the purchase price but also the purchase price and all future premiums.

It is this level of guarantee that proves particular attractive to SSASs and Sipps, where there may be significant exposure to risk through investment into own-company shares and assets.

An integral feature of this combination of performance and protection is the concept of smoothing, which insulates investors from the extremes of investment volatility. Pension schemes in particular find this unique facet of a with-profits fund attractive in helping executives plan their retirement.

This high level of security makes certain Tep funds suitable for gearing. The high level of guarantees make lending an attractive proposition to a bank and the opportunity to make pension investments work harder is proving increasingly attractive.

There are around 300 with-profits funds where policies could be traded although this presents a challenge to anyone managing a pension fund.

At first sight, it would appear that the obvious answer is to focus on the top 10 performing offices which are most familiar to pension schemes and their IFAs. This approach ignores the many opportunities offered by funds which are available at a more significant discount to their real value.

In addition, there are a number of opportunities to add value to a portfolio from funds which are closed to new business. As a with-profits fund approaches the end of its life, it is usual for bonus rates to increase noticeably in the final years to avoid the situation where the last policyholder gets everything.

These areas of hidden value can only really be exploited by pension schemes when the investment is made through an investment fund. Scheme trustees and their advisers may prefer to invest in a fund run by an endowment market-maker to take advantage of their specialised knowledge.

This level of diversification typically spreads risk across 25 different with-profits funds and, when the range of maturity dates is included, pension scheme trustees are offered a true two-dimensional diversification strategy.

Potential investors might also prefer the attractions of an actively managed fund. I have described how active management can be used to add value when policies are being bought. However, this approach can be extended to the management of policies once they have been bought.

Rather than hold every policy to maturity, the latest generation of Tep funds recognises that every policy has an optimum holding period. After this critical point, the yield curve starts to flatten and in many cases the fund will enhance returns by selling a policy and reinvesting in a younger policy which still has its maximum growth years ahead of it. This type of analysis is incredibly complex and requires bespoke software that provides the fund manager with a hold or sell recommendation on each policy each month.

Pension scheme trustees looking to balance the seemingly contradictory aims of security and growth should take a look at the inherent strengths of with-profits policies held by traded endowment funds. The secure growth prospects offered by these funds provide opportunities at all stages of retirement planning.

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