They say that some things improvewith age like good wine and
cigars.With-profits bonds also exhibit suchfine qualities.
In this era of Isas, derivatives contracts and other new products that
have escaped proper public understanding, with-profits bonds retain a high
degree of public confidence and may be an ideal investment vehicle for
According to ABI statistics, the IFA with-profits bond market has grown
from under £2bn in 1993 to almost £9bn last year and the IFA
share of the market has grown from 57 per cent in 1995 to 62 per cent last
In 1999, with-profits bonds made up 38 per cent of the lump-sum
investment market, which includes Isas, Peps, unit trusts and other life
bonds. So, however untrendy with-profits bonds might be with some IFAs,
they are increasingly popular with investors.
Many investors do not want to manage their investments actively or pay an
investment manager to do so. They want to place their trust in a life
office to manage their money for them, smooth returns to iron out
short-term fluctuations of the market and give them a good return over the
medium to long term.
With-profits bonds have an excellent track record of providing much higher
returns than deposit accounts but with less risk than direct stockmarket
Many people do not only want growth but also the option to take an income
from their bond. Most bonds offer the flexibility to take income as a
sterling amount or a percentage of the fund and to start and stop income as
desired. Some bonds also offer the option of taking out the growth in the
bond and preserving the original capital. It is important only to sell
bonds which have full income flexibility.
So, for someone who has cash to invest for the medium or longer term,
wants the flexibility to take income now or in the future, is prepared to
accept a degree of risk to their capital but with smoothed returns and
wants to leave the management of their money to the experts, with-profits
bonds are the ideal answer.
Some bonds also offer the option of add-ing further investments by topping
up the original bond. This can have considerabletax advantages.
Are there no disadvantages or drawbacks to with-profits bonds? Some would
say they are an excellent example of actuaries applying smoke and mirrors
to something straight-forward. There have been arguments for life offices
to reveal more about how they manage smoothing on the fund. However,
customers do not seem to want it.
Those with special knowledge can buy investment products where they can
use their knowledge to decide which sectors or geographical areas to invest
It is a bit like buying a car. Some people want a mode of transport that
will get them to where they want to go safely and economically.Others want
the technical details of what is under the bonnet, the braking system and
So, for some people, being told about the technical details of how bonuses
are smoothed would be like being told how the electronic systems on a car
manages the petrol injection system to maximise performance and efficiency.
Are the product terms all that matter? Selection of the right life office
is critical and can be tricky. The IFA has to make an assessment of the
certainty of the product provider being able to maintain good returns over
the medium to long term.
The critical factors are the investment performance along with the capital
and strength to maintain smoothness of returns. It is true that past
performance is not necessarily a guide to future performance but it remains
an essential part of that assessment.
The other part of that assessment is the size and strength of the
with-profits fund. The poorer the strength of the fund, the lower the
proportion of real assets that the fund will be able to hold. Real assets
such as equities and property are those which have the potential to provide
the best return over the longer term. Indeed, since 1900, the probability
of UK equities outperforming gilts has been 79 per cent over five-year
periods and 86 per cent over 10-year periods.
With-profits work by the life company putting the investment into its
with-profits fund. The fund invests in a wide range of assets, including
equities, gilts and property. The balance of types of investment in the
fund can be crucial in determining long-term investment returns.
What puts many people off investing in the stockmarket is its volatility.
They see not only significant fluctuations from day to day but occasional
The product provider will smooth the returns by holding back some of the
gains in good years to help to avoid having to reduce them in poor years.
So, for someone who does not want to have to watch the markets closely to
be able to sell on a high or who may have to sell at a particular time
because of unforeseen circumstances, this type of bond is a good solution.
It is smoothing that differentiates it from a unit-linked managed fund.
The actual investment return in any year will be divided between four
elements – the expenses of the fund, annual (reversionary) bonuses, the
terminal bonus – this is now normally paid on all withdrawals whether for
death, full or partial surrender or for income – and the smoothing reserve
which is used to maintain annual bonus and terminal bonus rates through
short-term market fluctuations.
What happens if there are longer-term fluctuations or major shifts in the
short term? In these cases, the life office may apply an adjustment to
withdrawals other than in the case of death. Known as a market value
reduction or market value adjustment, the circumstances when one will be
applied will vary from life office to life office. In general terms,
however, an MVA will be applied where:
The bonuses declared over the life of a bond are no longer supported by
the investment returns over that period.
Either the investment outlook is such that a recovery is not expected or
withdrawals from the fund are running at such a rate that not to apply one
would be to the detriment of policyholders not withdrawing.
The latter is the key reason that life offices reserve the right to apply
an MVA. Most apply it simply to reduce the amount being taken out of the
fund and no part of the MVA goes to the life office. MVAs are there to
protect thepolicyholders remaining in the fund.
Potential purchasers should check that the product provider they favour
does not use MVAs to apply charges by asking for its interpretation of
policyholders' reason-able expectations.
Overall, I believe that everyone who can afford one should consider a
with-profits bond as a bedrock of their portfolio – along with some good
wine and cigars.