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With-profits alternatives

Over recent months and years, it has been a dangerous time to be a tree.

More likely than not, you will have been chopped down and turned into a consultation paper on some aspect of the financial services industry. Indeed, it is difficult to imagine a period when the industry has been subject to more scrutiny than has been the case recently.

Judging from the FSA feedback statement on the with-profits review, it appears this trend will continue. Having already published around six papers on the subject in the last year, the regulator is aiming to publish a further seven consultation papers over the next 12 to 18 months, focusing solely on the reform of with-profits products.

In many ways, with-profits products can be viewed as a huge success, as they have enticed millions of people to save over the long term. The allure of smoothed performance, returns above building society deposits and apparent simplicity have been an attractive combination.

Also, the idea of holding a little back in the good years to maintain performance in the bad years is an attractive concept which is easily explained.

This cosy environment has taken a hammering recently as a result of some fairly sustained poor market performance. These conditions have driven cuts in bonus rates, market value adjustments and a greater scrutiny as to exactly how these products work. This greater scrutiny has highlighted a range of unattractive features which to a greater or lesser extent had been ignored during the good times:

•High entry and exit charges, particularly in the early years.

•No beneficial ownership of underlying assets, making the link between underling asset performance and investor return opaque.

•Inflexible product structure.

•High equity content – great when markets are going up, a cause of concern in difficult market conditions.

The FSA&#39s move to reform with-profits and bring greater clarity to investors is laudable and in many ways long overdue. However, in removing their unattractive features, it is likely that many of the positive aspects of these products will also be significantly diminished.

We are therefore likely to see reduced investor demand for these products.

Providers will obviously look to fill the gaps created by this shifting environment. There are a number of alternatives for investors&#39 savings:

Cash deposit

The deposit account is obviously the starting point for most savers. It is certainly a sensible idea to have some rainy day money on deposit. However, investors pay for this lack of risk through the huge opportunity cost of missing out on the higher long run returns available in alternative, areas as discussed below.

Bond funds

Recent years have proved the popularity of bond funds, not just for those seeking a regular income but also for those looking for a lower-risk, fully transparent home for their money. The availability of the annual £7,000 maxi Isa allowance also helps enhance their marketability relative to a cash deposit.

Structured products

The popularity of these products has increased significantly with the coupling of a low interest rate environment with volatile stockmarkets. These products also offer the possibility of creating some form of with-profits substitute product.

The cloud on the horizon with these types of products is that there have been a number of higher-risk products launched which may deliver some nasty surprises as they mature over the next couple of years. Hopefully, if this happens, the fallout will be contained to those particular failing products as arguably this is an area where products can be created with far fewer fundamental flaws than with-profits products.

Protected investment funds

It is possible within the regulatory framework to create and run an Oeic or a unit trust which as well as actively investing in equities and/or bonds has a protective element to its portfolio through dynamic but tightly controlled use of derivatives.

Balanced investment funds

For the majority of savers prepared to commit capital over the long term, the best solution is probably a balanced unit trust or Oeic (or collection of funds giving similarly diversified exposure).

Over the long term, market volatility becomes far less of an issue, so instead of paying for protection, a saver can fully benefit from the long-term potential offered by a portfolio of equities and bonds.

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