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With-profits workbook

Stuart Tragheim, director of intermediary business at LV=, outlines how advisers can assess whether a with-profits investment is still suitable for a client.

Moving clients out of with-profits policies is reckoned by many to be a foregone conclusion but this ignores one of the pillars of fair treatment of customers which says: “Advice must be suitable and take account of circumstances.”

You need a balanced, caseby-case approach – the client’s profile, the policy held and the provider.

All advisers should review their clients’ investments and if it is evident that the investment no longer meets their clients’ objectives, they should consider alternatives.

Access to up-to-date, relevant information is critical to ensure advisers can make a balanced and pragmatic recommendation, based on an individual’s circumstances.

It is not an inevitable case of cutting a client’s losses. Some with-profits providers’ returns have been devastated by market conditions over the past decade but others have delivered returns at least in line with those expected for the risk that the client was prepared to take when they took out the policy and in some cases they have exceeded expectations.

There are many myths that still prevail. One is “You should get your client out of this fund as the equity backing ratio is really low.”

A fund with a low EBR is not necessarily wrong for a client. For a start, what is their attitude to risk now? If they have just retired, it could be that a fund offering a more stable return without the worry about what the equity market is doing is what your client wants.

There would also not be much point in removing a customer from a with a low EBR just to put them into a corporate bond fund with a similar asset mix.

However, the need to retain a high proportion of fixed-interest securities in the fund may be because a higher proportion of equities could increase the risk that there will be insufficient assets to meet significant guarantees.

A low EBR always warrants investigation. What is the financial strength of the fund and is the low EBR a portent of other issues which suggest that the client should leave the fund? Smoothing is largely irrelevant in a fund where there is no volatility.

Another myth is: “It is a closed fund. Why would the administrator be interested in the returns – it is simply in runoff.”

Treating customers fairly is not just about new business acquisition. All providers must ensure their customers are being treated fairly, wherever the product may be in the lifecycle.

Of the 88 funds included in last year’s AKG fund reports, two open funds had 10 per cent or less invested in equities while eight closed funds had an equity backing ratio in excess of 60 per cent. It is simply not true that all closed funds will have a low EBR and will perform poorly.

Another myth is: “The MVR has just come off so the time is right to get out’.

This should not be used as a trigger to change a client’s investment. Why is the day that an MVR reduces or is eliminated any different to a day when the final bonus rate increases?

If a fund is wrong for a customer, then it is wrong whether or not an MVR is applying. Clients in funds with a low EBR, which still have an MVR applying could have a long wait to see its removal but, again, that in itself is not a reason to exit.

And finally, the myth: “I could get a higher interest rate in my building society.”

Having reminded myself of the need to look objectively at a client’s with-profits product closely before making a recommendation, what should I look for?

Well there is always whether the regular bonus rate is above or below bank/building society interest rates? Wrong.

In setting their regular bonus rates, firms will usually not only be looking backward to the returns that have been achieved but also forward to what is expected over the longer term.

LV=, for example, sets the regular bonus rate on its unitised with-profits fund range as broadly half of the expected long-term future investment returns. It is not valid to compare this with the interest rate on a building society account. It is not unusual that when investors see, for example, a 2.5 per cent regular bonus, they think of this as an interest rate and that this is the total return on their policy in that year.

It is important to under-stand that regular bonuses are only a proportion of returns and they certainly do not represent the total returns on the investment. The total return also includes the addition of a final bonus (or MVR if returns have been poor) at the time that the investment is cashed in.

In funds with a high EBR, it is likely that regular bonuses will be lower. This is actually good news as they require less fixed-interest assets for matching, enabling more equities to be held, which, over the longer term, should lead to higher returns.

Smoothing is another consideration, as understanding the approach that a provider takes is key to taking a view on whether it is an unwise time to leave a particular with-profits fund. When advising a client, it is essential to consider the returns yet to be smoothed in. Even if there was 0 per cent growth in the LV= with profits fund over the next two years, with-profits bond investors would still receive a return of 10 per cent in 2007 and 1.6 per cent in 2008, credited to their asset share.

The actual return will be higher if the fund sees growth in these years, or lower if the fund has a loss. It would be a particularly bad time to leave the fund in this instance because there are valuable returns yet to be received by existing investors in the fund, and because there is strong growth yet to be smoothed in.

Access to information on providers’ performance and approach is central to reviewing the suitability of clients’ with-profits policies against their objectives and attitude to risk. There is always uncertainty in financial markets, and smoothing exists to remove day-to-day risk of fluctuation from clients’ investments.

Where else could a risk-averse investor receive a return of 10 per cent in 2007 even if underlying assets did not grow?

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