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The gilt complex

In my last article, I started to look at the importance, for advisers and their clients, of identifying asset allocation within with-profits funds to help estimate likely future sustainable rates of bonus.

I looked specifically at the important example of Equitable Life, whose with-profits fund, at least until recently, consisted of around 80 per cent Government bonds (gilts) and 20 per cent commercial property. I suggested that this asset allocation could be expected to yield the fund investment gross returns (that is, before expenses and tax) of around 4.6 per cent, made up of redemption yields of around 4 per cent on the gilts and 7 per cent on the property holdings.

As Equitable Life has recently announced the sale of its remaining property holdings to move all of the fund into gilts, this projected return could be expected to fall to 4 per cent per annum.

This, of course, is the total return to the fund and the level of bonuses paid to investors will be much lower, primarily after allowing for expenses.

Here, I will extend the scope of this look at with-profits asset allocation to other insurers and look also at similar issues and considerations relating to managed funds.

The main issue that I considered with regard to Equitable Life&#39s with-profits fund is the predominance of gilts. It is widely known that almost exactly the same investment strategy has recently been adopted by the main insurance companies owned by AMP – NPI, Pearl and London Life.

In all these cases, the with-profits fund is apparently entirely (or almost entirely) invested in gilts. With average redemption yields on medium to long-dated gilts currently running at around 4 per cent, it is easy to see that these insurance companies simply cannot pay a sustainable reversionary bonus rate higher than 4 per cent less expenses.

You can check the exact figures for yourself from time to time but I believe the expense loading is likely to remain steady at around 2 per cent per annum, indicating distributable investment returns of only around 2 per cent per annum.

There are, of course, huge numbers of people invested in the with-profits funds of these companies, with particularly big average holdings in NPI which has historically been very successful in marketing its with-profits pension contracts (not least on the back of regular appearances in past performance tables, “bought” by regular raids on reserves which, one way or another, helped to bring about their parlous financial situation).

These people need advice as to whether or not to retain their investments or cut and run by transferring to an alternative provider and, indeed, an alternative asset allocation.

I briefly outlined in my last article the mathematics which I feel to be useful or essential in helping these investors make their decision – broadly being a 2 per cent annual bonus rate applied to the current fund value compared with a higher projected rate of investment return (from an alternative investment strategy) applied to the current surrender value.

This mathematics I can summarise for NPI (of particular interest because of the generally much larger amounts involved) generally reveals that investors with less than around seven years to maturity would probably be better advised to remain where they are while those with more than seven years should seriously consider transferring the benefits.

The decision is even easier for investors with more than 10 years to maturity. The comparison is determined primarily by a combination of the respective rates of projected investment return (very easy for NPI, as noted above) and the difference in each case between the fund value and the surrender or transfer value.

This article, and the suggested guidance which comes from its reasoning, is not meant as an attack on these insurers. Simply, it is written as an attempt to help advisers give more considered recommendations to appropriate clients and prospective clients including accountants and solicitors who should be a good source of introductions to a wider audience for this advice.

So we can now subjectively and mathematically assess the potential benefits or otherwise in transfers out of Equitable Life, AMP companies and any other with-profits offices which invest their funds entirely or nearly entirely in gilts. I have been told of a few big companies which fall into this latter category and I would suggest that advisers keep a close eye on announcements and comment in our financial papers about companies&#39 changes in with-profits asset allocation Fundamentally, financially weak with-profits funds will switch to gilts to reduce volatility significantly, thereby securing their continued existence, albeit, as discussed in this article and my previous article, at the expense of attractive investment returns to policyholders.

But what about with-profits funds which have not made this transition to gilts? Well, I have written in recent articles about suggested appropriate rates of projected return from different asset classes so suffice, here to only very briefly summarise. The cash element of a fund could be expected to produce gross returns of around 3.5 per cent (derived from the money market), gilts are producing around 4 per cent (redemption yield), high grade corporate bonds around 5 per cent, mid-grade corporate bonds around 6 per cent, property around 7 per cent and equities – a much more subjective assessment, by necessity – might be expected to produce total returns of around 8 per cent per annum.

Applying these suggested rates (accepting that some advisers will feel more comfortable with a different projection for equities) to the asset allocation of each with profits fund will give an excellent idea of the overall investment returns being enjoyed by the fund which in turn, of course, gives a good idea of the maximum level of sustainable bonuses that life office is likely to be able to declare.

Add or take away from this number an allowance for a strong or weak level of reserves and an assessment of individual with-profits funds becomes much less subjective than simply a blanket support or condemnation of this type of fund.

As a quick example, I was recently talking to a major with-profits office who advised me that its asset allocation was split roughly 60 per cent equities (UK and overseas), 20 per cent property and 20 per cent gilts and high-grade corporate bonds. My quick assessment of fund returns was, therefore:

60% equities at 8% 4.8%

20% property at 7% 1.4%

20% fixed interest at 5% 1.0%

Total returns 7.2%

Expenses must, of course, be deducted from this figure but I would suggest that, combined in this case with relatively strong reserves which retains the ability to help smooth investment market volatility(a simple yet oft forgotten principle of with-profits), this projected return could be seen as attractive to many investors.

I know this suggestion flies in the face of current perceived wisdom that all with-profits are now bad with-profits, yet the mathematics and logic of my reasoning is hard or impossible to fault.

At the very least, I would strongly suggest that in the case of this particular insurance company (and a number of other strong with-profits office), it would be hard to justify a transfer out where quoted surrender values are significantly lower than the fund values.

In summary, whether as potential new investors or in the assessment of a possible transfer or surrender of existing investments, advisers should undertake an analysis of the likely future returns from individual with profits funds, based on their individual asset allocation.

Next time, I will continue this theme towards an assessment of the volatility and investment returns from managed funds. In particular, I will investigate and discuss the reasons why most managed funds have historically been only marginally less volatile than equity funds and why even many defensive managed funds have been more volatile than every other asset class apart from equities. Without stealing my own thunder for the next article it is again, of course, all down to asset allocation.

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