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When is a with-profits policy not with-profits? When it is invested in bonds

Many with-profits funds are now entirely invested in bonds. Who ever would have thought that Pearl, NPI, London Life, or the Equitable Life, Royal, Sun Alliance and indeed many other WP funds would eventually be exclusively, or at least nearly so, invested in bonds?

The impact of this will be to guarantee that investment returns will be most unlikely to exceed 4 per cent a year net of costs and tax. The impact on maturity values where the policy is associated with a mortgage, will ensure a guaranteed shortfall to repay the mortgage, especially where the original premium was based on an assumption of perhaps 10 per cent return, which was common 10 years ago.

The reason for the investment in fixed-interest only, in WP funds is, in many cases, that they are closed to new business. The companies which offered them have deserted them, together with the unfortunate investors who invested in them and the advisers involved, believing in the long-term probity of the companies which offered them.

In some cases, the problem was that the WP fund was raided by a predator which subvented assets from the WP policyholders. The classic example is Australian Mutual & Provident which bought Pearl, London Life and NPI. Don&#39t ask where the “surplus assets” of Pearl went. Let us just say they went southward, just as it appears that surplus assets of Sun Life may have vanished across the Channel. Those surpluses, if retained in the with-profits fund, where they morally belonged, may have protected policyholders from the debacle they now face. In particular, the policyholders of AMP companies Pearl, NPI and London Life could have had a far better future if money had stayed where it was in the WP fund.

The issue now is what to do for the future, with many thousands of policyholders affected, should AMP be allowed to get away with such cavalier treatment?

Assuming that nothing is done – that will be up to the Treasury and its FSA – can anything be done for the rights of the policyholders? I believe the only way ahead is for WP funds to be reinvested, substantially back in equities. Bonds are most unlikely to offer much return, given the current low-interest environment in the world and risk of future interest increases, which will reduce long-dated bonds and gilts values.

An investment shift back to equities increases the risk profile of a fund with inadequate surpluses to deal with an unexpected downturn in stockmarkets. Fund growth will be bad if invested in bonds but the systemic equity risks are increased if equities are used – damned if you do, damned if you don&#39t.

In the long term, those who have, say, eight years or more to maturity would probably be far better off in equities. Surely, as these unfortunate investors are usually locked in to the investment with massive penalties for early exits, they should have the right to see their money invested in higher potential growth equities, rather than certain low-risk low-return fixed-interest bonds.

As it is their money and the company which sponsored the fund has deserted them, I suggest that all such closed WP funds be placed in the hands of an independent trustee who should ensure that all returns in the future accrue to the policyholders, not left in the hands of vultures who, in many cases, stripped the pol-icyholders of what were then surplus assets but what were, in reality, the safety net of surpluses to insulate against the shocks of the last few years.

The policyholders could vote on how they want the fund to be run either with high-risk/reward equities or lower-risk/reward fixed-interest investment. Perhaps the fund could be split into two parts, one low-risk with bonds and one high-risk equities with the policyholders allowed to choose between them in varying proportion according to their choice of risk and the term left to maturity. At least, the policyholders should have the chance of having input on how their money is managed.

Looking now at Standard Life, with its very large WP fund which is now looking healthier than newspaper reports were indicating, should it demutualise? If it does then the conflict arises once again, as who it is run for – the policyholders or the shareholders? How can demutualisation possibly be of real benefit to policyholders?

The truth is that it is now clear that the WP fund is solvent, it does have adequate reserves and, provided that the world&#39s stockmarkets do not go into freefall again, policyholders will probably do far better out of a Standard Life with-profits policy than the unfortunates who were on the receiving end of a sales pitch from the Pearl salesperson a few years ago, when they were promised 10.5 per cent annual growth.

The bombshell, however, landed recently when we discovered that Standard Life&#39s WP fund is no longer about 75 per cent in equities and good quality property but, secretly, over the last few months has sold off a further 25 per cent of the equity fund and placed it in cash and bonds. As it has done it using derivatives, will we see a closing of positions in the derivatives&#39 market at the end of the March quarter?

The following questions must be answered by the company. Was this decision taken on its expectation of poor future investment opportunities in equity markets? Does it feel that the markets are overvalued and poised for fall? Does it confidently expect that bonds will deliver better returns than equities after allowing for taxation of the life fund? Is it, alternatively, a position that the bean-counting actuaries in Edinburgh have decided that, on account of guarantees on some funds, a much more cautious investment view must be taken?

Is it, however, a case that after the Equitable Life debacle that the Treasury, or its FSA, have run scared and feared another similar case and pressurised the company accordingly against the commercial judgment of the Standard Life actuaries?

Either way, I fear that the consequence is most likely to be that Standard Life WP investors have suffered the pain of being in equities since 2000 but will not now share the gain if equities rise. They should have been in bonds since the millennium day but should they now be back in equities and probably largely clear of bonds?

Many bond fund managers are now worried about the bond markets. Put simply, where is the upside? The Bank of England and Ed Balls have stated that interest rates are going to rise. Where does that leave the Standard Life and other WP funds over-burdened with fixed-interest investments?

How safe is fixed interest? Bonds can vanish without a trace of value if the issuers go bust. Do you remember Barings and what happened to its bondholders? I understand that Barings is bringing out a new fund which will work on a strategy of making money if bond yields rise, which usually means that capital values fall. Do you still feel lucky about bonds?

Looking at Standard Life in the context of its, perhaps enforced, move into bonds, demutualisation sadly rewards the wrong people, distributing the company&#39s assets according to who has the biggest fund. Thus, those with near maturity policies holding big funds, obtain a bigger share although they have already benefited from the extra growth to their fund because they have not had to share past gains with shareholders. Newer policyholders will receive very little from the demutualisation but will suffer the big fall in future profits to the WP fund, as these will have to be shared with shareholders.

The fact that Standard Life now only has 25 per cent of its overall managed assets in the WP fund and the balance in unit-linked is not really relevant to an argument in favour of demutualisation. Standard Life is not insolvent, it is still adequately financed and policyholders funds are safe. It has a philosophy of looking after its policyholders.

Compare this with the cavalier treatment of AMP to its policyholders. I believe that Standard Life need not and should not demutualise. Those who demand it are doing it for their own selfish reasons. Now that its results have been published, it is time for an accounting analysis to judge if such a move into fixed-interest securities is required on account of possible diminished reserves and if such a strategy is right for the overall profile of the investors in that fund.

One fact is very clear, however, if demutualisation takes place and if the past is anything to go by, investment returns for policyholders will fall and the proportion invested in bonds will increase at the expense of growth. How will I advise my own son, who has a Standard Life endowment policy and pension, to vote if the issue goes to a vote?

Until the recent announcement that Standard Life had reduced equity exposure by a further 25 per cent of the fund, I would have said “Vote against it” unless it can be proven that the company is financially too weak to carry on. Now I have to wonder, on behalf of my son and the clients in the WP fund.

I am not convinced either way at the moment as I still feel that it may be far more secure than some would have us believe.A possible demutualisation bonus will defer the decision anyway. Afterwards, probably leave.

If the general trend is towards a low proportion of equities in a WP fund, then long-term investors should consider cashing in WP funds if there is low MVR or early exit penalty. What we may be looking at now is the classic example of the self-fulfilling prophecy.With-profits policy returns will fall, more people will cash endowments in, they will be a backwater product, they will suffer from fund shrinkage, risks will increase for the remaining members, the funds will invest more cautiously and therefore returns will fall.

A serious issue is that Standard Life and Norwich Union provided an undertaking to policyholders that their WP endowments would guarantee a 6 per cent return, provided that the underlying assets grew at that rate. Well, of course they would, wouldn&#39t they? On the admission of some in Legal & General now, it had doubts a few years back. Now, that promise, with the benefit of hindsight, is looking worrying. How serious is the issue of mortgage-related endowments failing to deliver?

Imagine a scenario that Treasury and FSA pressures, plus earlier plundering of WP funds by life companies were responsible for mass failure to repay mortgages, only to find that if the fund had been left in equities, it would have repaid the mortgage. There would be much baying for blood. Are we now looking at covert Government direction of investment strategy? Well, of course, if a life company does fail, the Government will end up having to pay compensation, at least that is what we are taught to tell our clients.

If we do have another equity market collapse, it is likely that the problems will affect all bonds equally apart from gilts and other secure Government debt. But how secure is, say. Japan government debt? With Uncle Sam printing US government bonds as fast as they can and using them to pay for excessive Chinese imports, and even our Gordon spending £40bn more every year than he raises in taxes, how good are fixed-interest securities?

Those advisers who have the awful responsibility of advising clients how to invest their savings for income or to provide for old age with a suitable pension, these issues are paramount. This applies whether in a WP fund almost exclusively in fixed-interest securities or faced with a managed portfolio using an investment mix.

We live in a capitalist society. It works by applying labour and money to make profit above the cost of borrowed money. If that is the case in the long term, equities will make a small margin over bonds, which are, of course, loans. This extra profit is known as the equity risk premium.

The problem for all of us in deciding the investment strategy is how long is long term. Well, of course, in the long term we are all dead. We have, however, some living to do in the meantime and politicians tell us that we must make more provision for ourselves for our old age.

Where do we save then – bonds or equities? If you believe the latter, then get out of the new design of WP funds invested heavily in bonds, ASAP.



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