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The Actuary The magazine of the Institute & Faculty of Actuaries

Is there a future for with-profits?

With-profits investment has taken a large share of the UK long-term savings market over the past 50 years with total funds standing at £350bn at the end of 1999. One could successfully argue that with-profits had been a great success story enabling many investors to obtain equity exposure while benefiting from features such as pooling of risks and smoothing of returns over time. Until recent years this would have been the view of the vast majority of commentators and informed public. However, a series of ‘negative’ factors (see table 1) have caused many commentators to doubt the suitability of with-profits as a modern investment option.
As a result, the Financial Services Authority (FSA) recently launched a major review of with-profits. It will cover all aspects of with-profits business, including the way companies communicate with policyholders, the governance structure, the way discretion is applied to with-profits funds, fair treatment of customers, and the management of inherited estates. The FSA review follows a number of other recent initiatives touching on or specifically covering with-profits (see table 2).
Opposing factions
It is likely that the FSA review will highlight the views of two distinct groups of stakeholders. The first group is looking to increase the level of disclosure, change the governance structure of the funds, and increase the level of policyholder involvement. It feels that customers must be given more detailed, understandable information about their with-profits investment to make informed decisions. The second group is keen to improve disclosure but sees significant difficulties with detailed disclosure and the erosion of discretion. The combination of more disclosure and limited discretion is perceived as likely to lead to the suppression of those factors making with-profits desirable (pooling of risks and smoothing).
Much of this disagreement could be resolved by further detailed explanation so that all parties can appreciate the difficulties with additional disclosure. Clearly the second group and particularly actuaries have an important communication role to play here.
Table 3 gives a flavour of some of the seemingly simple questions posed by stakeholders in the first group and the problems facing funds trying to provide the answer. In many cases such questions cannot be answered in a straightforward manner. In particular, the concept of asset share is central to the way with-profits funds work, but it is difficult to explain to the public at anything other than a very superficial level.

Some possible solutions
There is general agreement that with-profits fills a gap in the investment market, and that efforts should be made to retain the concept. However, taking away discretion or providing detailed disclosure is likely to kill off the most desirable features of with-profits. Against this it is important that the policyholder can regularly assess the performance and future prospects of his or her with-profits investment. The answers will evolve throughout the review, but I have set out below a draft framework in which practical solutions could be developed.

What could be provided at a fund level
– Information about assets
– Breakdown of the assets of the fund as a whole, and those deemed to back asset shares.
– Target range of future investment in each asset class in ‘normal circumstances’.
– Annual report on the performance of the assets of the fund.
– Information about how payouts are managed
– The concept of the asset share.
– Target percentages of asset share payable on leaving early on in the contract, or closer to maturity.
– The items which affect the asset share from year to year.
– The general concept of smoothing.

What could be provided at industry level
– Common methodology and best practice
– Common methodology for asset shares.
– Standard explanation for smoothing and bonus policy (assisted by the actuarial profession).
– Best practice guidance for managers of with-profit funds, covering the way the fund is operated and communication with policyholders.
– Objective assessment of risk and the impact of smoothing
– Provide information on smoothing and non-investment risk to an external agency, which could give each fund a rating for the degree of smoothing, and the degree of non-investment risk.
– Update information every year, to help investment advisers compare each fund against the needs of their clients.
– This would avoid the risk of financial selection from forcing funds to make public detailed information on the operation of the fund.
– Reporting on a realistic basis
– Show the financial position of the fund on a realistic basis, as well as statutory basis.
– Again, this information could be managed by external agencies, developing ratings based on financial comparisons of funds.

What could be provided independently
Funds should be audited each year by an external body to determine whether the fund had been operated during the year in accordance with stated principles. The review could include an analysis of the risks borne by asset shares and the calculations of payouts.

A rosy future?
Virtually all parties in the debate agree that with-profits has a place in the spectrum of investment options the challenge is finding a way to operate it in a clear and equitable manner. This is likely to involve a new generation of funds where participants do not share in ‘profits or losses’ as per the old concept but is about investment smoothing and sharing guarantee costs. Other pooled risks may include mortality and expense experience, but not business risks that are too difficult to explain and quantify. Actuaries have a key role to play in shaping and explaining these products the challenge has started!

Table 1 ‘Negative’ industry/with-profits issues

– The emergence of significant compensation and guarantee costs borne in part by with-profits funds.
– Poor persistency, low early surrender values, and the application of market value adjusters have drawn substantial criticism in the press. There is a suspicion that surrender profits are being used to bolster maturity values and free assets.
– As interest rates have fallen so the cost of with-profits guarantees has risen significantly. At the same time there is little perception of how valuable and costly these guarantees are in current conditions.
– Companies have been cutting payouts as interest rates have fallen. Policyholders don’t understand why they are particularly upset when payouts fall in a year when FTSE rises!
– The emergence of guaranteed annuity option (GAO) costs has focused the minds of (non-GAO) policyholders on the risks that they have been (unknowingly) exposed to.
– The AXA court judgment on the attribution of inherited estate between policyholders and shareholders raised issues about the equity of the arrangements. The Consumers Association argued that shareholders were favoured at the expense of policyholders.

Table 2 Recent with-profits initiatives

– The Treasury select committee in its summary of the Equitable investigation highlighted the need to review the degree of discretion employed by managers of the fund and the relationship of the appointed actuary to the management board and policyholders.
– Under the ABI raising standards initiative quality mark scheme, accredited companies will have to explain in simple terms how a with-profits investment works, how the bonus system works, the impact of smoothing, how payouts are managed on maturity and early surrender, and the investment policy of the fund.
– The Faculty and Institute Transparent With-Profits Working Party reported in May 2001. It suggested a framework in which the operation of the with-profits fund could be reported.
– The Consumers Association issued a report in February 2001 making wide-ranging criticisms of with-profits funds, including the high level of charges levied, poor early surrender values, and the way surplus assets are used.


What are the assets of the fund?

What is the rate of return on the fund?

How are payouts calculated? Is the methodology in line with industry practice?

Are policyholders’ asset shares bearing non-investment risks? Can information be provided to compare likely risks and rewards?

What are the guarantees and when would they apply?

How does the fund ensure fairness between policyholders and shareholders?

How do we know that the fund is operated in the way promised?

Who owns the assets of the fund over and above asset shares?
Details sought

Proportion invested in the main asset types, eg UK equities, gilts, and property

Possibly detailed asset returns by class

– Basic concept determining payouts
– Target % of asset share for early and late exits. If under 100%, why? Where do the ‘profits’ go?
– How smoothing works what is smoothed, over what period, how much?

– Type of risk eg mortality, expense or business risk
– Extent of risk, relative to total fund

– Benefits of having the guarantee
– How much is charged? If the charge is too low who meets the extra cost?

What is the shareholder taking out of my policy?
How focused is the management on my interests?

In particular how has the management exercised its discretion?

In particular, how much, if any, will policyholders get? Should we worry about how it is being used?
Why it is important

To understand the volatility risk they are taking in the short term (when generally smoothing might apply less) and the longer term

To assess the relative success of the investment manager and progress of their asset share

To assess the risk that they will not get back asset share on exit at various points
To assess the impact and extent of smoothing

So that customers can assess the risk/return profile of their investment

So that customers can assess the relative value and cost of guarantees

So that investors can assess the relative benefits and costs of investing in a proprietary company

To give investors comfort

Could be very material to investment decisions?

– Is information required for the whole fund or those assets backing the asset shares?
– The mix of asset is not fixed and can change over time

Is information required for the return on the whole fund, the asset shares or the credited rate on asset shares?

– Providing detailed information could be harmful
– How to ensure that (necessarily) complex information is not misleading
– Need an industry benchmark for asset share methodology

Many non-investment risks are complex and hard to explain

– There are different explicit and implicit ways of “charging” for guarantees
– The charge may need to change

The shareholder is being remunerated for providing capital support to the fund how can this be explained?

What ‘proof’ is required?

Not legally defined so don’t know/can’t say