With-profits back from the brink?

Norwich Union endowment policyholders last week received the welcome news that the insurer is to abolish the exit penalty on all its with-profits policies. Could this mean that, after more than a decade of bad press, the tarnished reputation of with-profits could be redeemed?

With-profit funds were once considered one of the safest ways to invest. In theory the schemes allow savers to have access to stock market returns, which over time are generally better than ordinary bank savings rates, but with lower risk.

The advantages of with-profits are supposed to work in two ways. First, the investments are "pooled", allowing policyholders to invest their money in a wide range of shares and other assets. Secondly, unlike other pooled investments, such as unit trusts, returns are also "smoothed".

This is supposed to mean that the investment provides steady growth by holding back a bit of the profit in the good years to top up performance during poorer years, thereby protecting investors from the full rollercoaster effect of the rises and falls in the stockmarket.

How did 'with-profits' become 'without-profits'?

However, in the 1990s, after vast numbers of endowment policies invested in with-profits funds were sold to back mortgages, the concept all went horribly wrong.

First of all, interest rates plummeted, while underlying charges in percentage terms stayed largely the same. This meant that charges ate up a growing proportion of returns as the effects of inflation were no longer there to absorb them.

Secondly, tax advantages [life assurance premium relief] had been abolished on new policies started after 1984, meaning investors' money had to work harder for the same return, and, finally, three years of falling stock markets brought the whole with-profits house of cards crashing down, as the smoothing concept could no longer be sustained.

With-profits works by giving to each policyholder an annual bonus that is added to their guaranteed fund. Once guaranteed, as long as the policy reaches maturity, the bonus cannot be taken away. Because smoothing is in place, the bonus does not directly relate to investment performance but is determined by actuaries, who make assumptions about how much should be held back in good years to cover the poor years.

But suddenly the smoothing process no longer worked - because, amid such a prolonged downturn, not enough had been held back by the funds in the past, so they now found themselves running short of cash.

10 July 2007 © Moneyextra.com

back

Moneyextra.com recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.