Beware pitfalls when jumping into the ‘with-profits’ market

In these highly uncertain economic times with stock markets jumping around, many savers are attracted to with-profits bonds but they should be aware of the drawbacks.

Strong financial providers and the easily understood marketing phrase ‘with-profits’ are powerful plus points but the performance is not always great and the opportunity to exit can be limited.

The theory is that by placing money in a large pool with other savers, an insurance company can use its expertise to buy assets for long-term growth, usually 10 years plus. It will aim to give some protection from market volatility by smoothing out the peaks and troughs of performance.

‘Smoothing’ means some gains earned in good years are held back and help to pay bonuses in poor investment years.

Diversity is certainly a benefit, allowing investors to share in a greater range of assets than they could individually. However, transparency is not usually evident and insurers often hide their asset breakdown behind just a few terms. This makes portfolio management difficult when you may not want too much exposure in certain markets, notably continental Europe currently.

Guarantees are often limited. Aviva, better known as Norwich Union, simply promises that if your saving is held for a decade, “you’ll get back at least your original investment less any withdrawals”.

One area that insurers are quiet about publicising is the Market Value Reduction (or MVR) which is effectively an exit penalty. It is a charge for taking money out other than when the insurer has prepared sufficient free assets. When buying a with-profits bond, always note the date when money can be withdrawn without this charge.

“Many consumers find themselves caught between a rock and a hard place as to whether to remain within a fund,” said Sarah Lord, chartered financial planner at private client stockbrokers Killik. With some annual bonus rates cut to zero, she reveals that MVR fees can be up to 20 per cent of the fund value.

This leaves the investor having to decide whether to continue to accept poor performance and not suffer the MVR or accept the charge and seek better performance elsewhere.

Research by Skandia shows that half a million savers in with-profit bonds will see their £15bn investment reach its tenth anniversary this year and a third will be able to withdraw without the MVR charge. This affects 90 different bonds run by 23 providers.

On average, these with-profit bonds paid an average of just one per cent last year, which is less than the average cash ISA. Yet the FTSE 100 rose nine per cent. Across the asset range, most insurers would have secured double digit returns both in 2009 and 2010.

Gross investment growth on with-profits funds in 2010 was higher among mutual providers such as 15.5 per cent at LV= (formerly Liverpool Victoria) and 13.7 per cent at Wesleyan Assurance but still appealing among non-mutuals such as 13.3 per cent (Standard Life), 12.8 per cent (Legal & General) and Prudential (12.7 per cent).

If you are with-profits bond holder, check with your financial adviser or insurer as to the free exit dates so as not to miss a withdrawal opportunity if you wish to take it.

Consider to what extent gross growth translated through into better payouts or if the insurer held excessive amounts back for ‘reserves’.

Independent research by Investment Life & Pensions Moneyfacts shows how with-profits bonds have actually performed, assuming a £25,000 investment by a male aged almost 30 at outset and with no income withdrawn.

Over 10 years, performance averaged £35,078 from £41,606 (Wesleyan Assurance Capital Investment Bond) to only £29,342 (Co-op Platinum Bond Plus). This means that the best performer secured £6,528 more for their investors than the average.

Over five years when more providers can be compared, the average was £29,352 – a fair but not spectacular 17.4 per cent return. The top stars were:

• Wesleyan Assurance (Capital Investment Bond) with £32,764, a 31 per cent growth;

• Aegon with £32,039.

Yet poor performance was made by both Co-op (Platinum Bond Plus) with £25,518 and Legal & General (With-Profits Income Bond) with £26,772.

So many insurers have cut down the share element and increased their exposure to fixed interest since 2000 that performance must suffer. The Prudential now has 41 per cent in fixed interest, 13 per cent in property and just 12 per cent in non-UK equities and Aviva 17 per cent in the latter with 31 per cent in fixed interest and 18 per cent in property.

Since with-profits bonds are deliberately to be long-term investments, this is a wonderful opportunity to find emerging market acorns – notably Brazil and India – that will have achieved young oak status after a decade.

Look at the strength of each potential provider. The strongest are best placed to provide more consistent returns. Weak ones like NPI, Scottish Mutual and Scottish Provident have had to be taken over. If you are in a closed fund which is not accepting new business, consider coming out as soon as possible as the fund will probably be run to manage liabilities rather than to provide reasonable returns for investors.

If leaving a policy, consider the tax position. “Whilst tax is deducted within a with-profits bond fund, investors can still potentially face an additional tax charge if they surrender a bond,” said Elizabeth Hastings, chartered financial planner at AWD Chase de Vere in Leeds, who adds that this can particularly affect higher rate taxpayers and savers with age allowances.

Wakefield-based Kingston Unity Friendly Society introduced its with-profits bond in October 2009 with a minimum £1,000. One of the attractions is that up to five per cent of the original investment can be withdrawn annually without immediate taxation. Its net growth is 3.6 per cent which includes last year’s annual three per cent bonus. It is open to anyone 18 years and older with no upper age limit.

Many insurers are now placing undue reliance on a terminal boost rather than annual bonuses. For an investor, this makes planning impossible as they have no idea how much will be finally applied. If the trend is not corrected, financial advisers will have to turn their backs on the product as it then offers too intangible a return.

With last month’s closure by National Savings and Investments of its inflation-beating savings bonds, many are looking for an alternative source. With-profit bonds could be an answer but most providers need to make some urgent changes. If with-profits bonds are not to become dinosaurs, insurers must return to far greater balance in their asset allocations and make them fully transparent, seek out fledgling investments with real potential, pay good annual bonuses, cut terminal payouts, communicate regularly with bond holders and reduce exit charges.