With profits investments - zombies that won't die

Zombie funds, despite the name, are not some obscure archive of horror films. They are the investment world's living dead - funds that are still just alive, but closed to new business. They have no long-term future - since they are closed to investment from new sources they are essentially in run-off - but they refuse to lie down and die.

Zombie funds are more properly known as closed with-profits funds. With-profits was once the investment world's darling. The apparently ingenious schemes, which use "smoothing" - holding back some of the profits in the good years to bolster returns in not so successful years - used to be regarded as among the safest forms of investment.

Not such a 'smooth' ride after all

When back in 2002 Ron Sandler, the man currently in charge of the rescue of the beleaguered mortgage bank Northern Rock, reported to the Government on the future of long-term savings, he recommended that with-profits should be part of the core tools for financial planning, and that with-profits investments were so safe that they should be available for purchase by investors without the levels of professional advice that are required for complicated investment products.

That was then.

Since the heady days of the 1990s, when with-profits schemes were providing record returns, the funds have been widely discredited for their lack of transparency, high charges, poor asset allocation, patchy performance, high exit penalties, the massive commissions paid to salesmen to promote them, and dubious practices such as the manipulation of bonus rates to make the funds more attractive to new investors.

Many homebuyers who were sold with-profits endowments policies to pay off their mortgages have found themselves with shortfalls, as returns have plummeted and mis-selling claims have mounted. Little wonder, then, that figures from life companies' expert Cazalet Consulting show that sales of with-profits endowment policies crashed from not much short of £1 billion in 1999 to just £23 million in 2006.

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Not all is doom and gloom, however. There are some bright spots in the picture, and with-profits investments in strong funds remains popular. Indeed, Prudential and Norwich Union have seen their with-profits business increase. Prudential alone announced a 59% increase in its with-profits bond sales during 2007.

But, sadly, investors in weaker funds don't have such a happy tale to tell. Many thousands of investors in mortgage endowment policies and with-profits bonds have experienced disappointing returns. Money Management, a magazine for financial advisers, shows in its annual report on the with-profits industry that the average return on a 25-year endowment policy, into which a 29-year-old man had contributed £15,000 at the rate of £50 a month, has dropped by over £20,000 compared with five years ago, and a horrifying £61,000 compared with 10 years ago. Over 25 years even the best performing product, from Wesleyan, paid out only a little more than half the sum it paid in 1998.

A Pearl beyond price...

Among the worst performers in Money Management's table are the zombies. For example, in 1998 a £50 a month 25-year policy with Scottish Mutual paid out £108,162, A similar policy held over the past 25 years would pay out just £34,851 - £73,000 less and a fall of some 68%.

Scottish Mutual is now part of the Pearl Group. The fund was taken over, along with other closed funds Scottish Provident, Royal Life, Life Association of Scotland, Phoenix, Britannia Life and Crusader, by Clive Cowderys Resolution group, which sold them to fellow consolidator Pearl earlier this year.

The consolidators say that bringing several closed funds under one roof allows them to benefit from greater management efficiency, and accordingly brings greater returns for policyholders. The jury is still out on whether performance can be improved to a significant degree, as the closed funds have usually had to shut up shop because they are weak, so there is a disproportionate amount of catching up to do. However, some funds are restoring bonuses which had been frozen for several years.