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With-profits stand the test of time

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 on.

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

big drops.

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&#39 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.


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