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Test of strength

In a previous article on wrap accounts, I mentioned the importance of the asset allocation process when advising clients. 7IM marketing director Justin Urquhart Stewart was quoted earlier this month as stating that it was so important that it was “not negotiable”.

What, then, are we to make of with-profits investment as an asset class?

As an investment medium, the public is certainly familiar with with-profits as it has been around for generations but in the last three or four years, it has come under increasing attack from the financial press. This has centred on the opaqueness of with-profits funds and has been accentuated by the problems faced by Equitable Life and AMP NPI.

The question we must ask is whether the with-profits concept has any role to play in today&#39s investment markets. If you told the average potential investor that you have put them into an investment which protected them against market falls by reserving some of the returns in good times, do you think they would find this concept attractive for long-term savings? I think the answer is still a resounding yes. It is clear that Ron Sandler came to the same conclusion.

Having started his review of the savings market by confirming that he was cynical as to whether with-profits inv-estment had any role to play in the future, when promoting his suite of investment products, Sandler made the comment that with-profits investment should be one of the investment options on offer, albeit that it should have less opaque characteristics in the future.

So, conceptually, with-profits remains attractive but has it delivered historically? Has it done what it said on the tin? Clearly, in some areas, notably mortgage endowments, this is questionable, particularly in the low-cost endowment area, where high assumptions were made about future bonus levels when setting premium rates.

Of course, if lower assumptions had been made, then higher premiums would have been paid at the outset and the principal problems have arisen for policies taken out in the late 1980s and early 1990s at a time when inflation was still high and when investment returns were high.

An assumption which seemed entirely reasonable at the time may look considerably less so today in our low-inflation, lower-return market.

Putting this to one side, over the years, clients of mine who have had maturing with-profits policies have in the main been delighted with the level of payouts which have been significantly higher than they could ever have anticipated when they started the policies.

However, with-profits funds cannot defy gravity. As a result, as investment returns have fallen, bonus rates have also fallen but the overall returns have fallen by rather less than the reduction in equity markets.

So smoothing has worked although there have been cuts in both annual and terminal bonuses so insurance companies may now be forecasting lower returns on maturity.

In this context, the timing of when the with-profits investment started can also have a major effect on the final return as, in assessing the maturity value, the actuary will be looking at the actual return achieved on investments over the period.

To illustrate this point, if you had started a 25-year, £50 a month savings plan investing in the UK stockmarket in three separate plans, each started exactly one year apart from July 1976 through to July 1978, they would have produced the following amounts 25 years later:

July 1976 plan – £164,707

July 1977 plan – £113,590

July 1978 plan – £85,907 (Figures based on data from Datastream and the FTSE All-Share index).

The figures are stark and if the actuary looks at performance over a given period, payments will vary considerably.

Why should we be surp-rised that payouts are falling? The principal question we should be asking is whether the investment has produced good real rates of return and maturity values have in the main met this criteria.

People investing in the with-profits funds of mutuals also benefit from the potential enhancement to returns from profits made on other parts of the mutual&#39s business. Of course, this could have a negative effect as well if the mutual loses money in other activities but, with many of the withprofits funds now subject to the stakeholder cap on charges, this is not an issue.

To summarise, we have a situation where most with-profits funds, and certainly those from the stronger offices, have delivered and where we believe the concept still finds favour among investors. However, has all the negative publicity mortally wounded with-profits funds to the extent that they should no longer be considered in the asset allocation process?

This is the $64,000 question and the answer relies on how quickly investor confidence can be regained.

As part of this process, with-profits funds must be less opaque in the way in which they operate, with clearly stated charges. However, I would argue that the smoothing process can only work if the actuary has sufficient discretion.

These are testing times for those running with-profits funds and, if they are in terminal decline, there would be little reason for those remaining mutuals not to demutualise.

At a time when the Government is trying to encourage all to save, particularly the lower-paid, the demise of with-profits funds which have particularly satisfied the needs of such savers in the past would be a tragedy.

Advisers who continue to consider them an asset class need to look at the new style of with-profits funds emerging. The basic premise must be to invest with the financially strong and at the moment I only need the fingers of one hand to count those companies which I feel fall into this category.

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