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The Actuary The magazine of the Institute & Faculty of Actuaries

Profits of doom

W ith UK sales of over £12bn last year
and sales expected to breach £15bn
this year, with-profits bonds have returned big results for the life industry in recent times, but at what cost?
Novice investors like capital guarantees they assist with the transition from deposit accounts to equity investment. They also understand the benefits of equity exposure over deposit savings, a comprehension tempered by a reluctance to commit long-term capital savings to market volatility. Life companies love with-profits structures the only investment product unavailable to unit and investment trust managers. Dangerously, the superficial attractions of the with-profits bond make it as easy a buy as it is a sell an explosive cocktail for an industry already severely tarnished by a series of mis-selling scandals, often of more ‘involved‘ products.
But the recent Life Board letter to appointed actuaries, highlighting the dangers surrounding the marketing and promotion of with-profits bonds, threatens the peace of this all-too-comfortable provider/investor love-in.
The practice of marketing high first-year ‘bonus’ rates drawn from anticipated bonuses, enhanced allocations, and expected terminal bonuses should be outlawed. It is utter folly to market misleading double-digit first year returns to draw in business from an unsuspecting audience, particularly as no one really expects even current bonus rates to be sustained. Will the life industry ever learn to sell on genuine benefits rather than resort to false claims perhaps there are few genuine benefits left for UK life offices in the investment market?
Likewise, where salesforces IFA or direct are selling on the presumption of no market value adjustment, there is a requirement for additional reserving. While life offices can always try to resort to the small print, the recent Equitable Life ruling has surely proved that consumerism is the order of the day and long overdue, we would argue. Overall, while the Faculty and Institute’s intervention is generally to be welcomed, it seems that that they have continued to overlook some of the more important points concerning with-profits investments. The real issues are the high implicit charges, enormous commission rates, and the lack of transparency between asset returns and declared bonuses.
Much is made in marketing material of the benefit of smoothed annual returns for investors. However, considering UK equity returns over the past ten years, it is hard to believe that most investors would not have preferred a volatile 17% each year to a smoothed 10%. Indeed, most could have doubled their return simply by investing in a tracker fund. With many with-profits funds claiming equity exposures of up to 85%, there is a disturbing lack of analysis and press commentary about this disparity, which can only be attributed either to poor life company investment performance or to the excessive cost of guarantees and smoothing. Where is the added value?
Of course, a large part of the margin is going to meet commission costs. In the IFA market, it is not unusual for companies to pay more than 7% to attract business. Assuming initial commission only, why can an IFA who can perhaps receive 0.25% on cash and 5% on an equity unit trust be able to generate 7% on a product with a risk profile between cash and equity?
The recent debate over with-profits performance has concentrated on the relative financial strength of providers, the perceived performance advantage that mutual companies have over their proprietary counterparts (hard to square with Prudential’s market dominance), and the fund’s equity exposure.
The most recent high-profile entrant has even gone as far as suggesting that mutual companies may also have profits from other business lines to supplement the returns. Apparently, this could ‘make a difference to the annual return of up to 0.75%’. Surely the converse is also true!
It is obviously logical that other business ventures can contribute losses as well as gains. Might not the cost of new head offices, loss-leading retail banks, and provision for pensions mis-selling equally euphemistically be termed ‘business lines’? But detailing the absolute additional increase in returns such ventures can produce only highlights the lack of transparency in the structure.
Some in the industry are predicting 2000 as the watershed year for the structure. A flat equity market and the spiralling cost of gilts as supply dries up are expected to lead to a drastic scaling back of some companies’ bonus rates.
The truth is that, while some of the core features of with-profits are attractive, the current means of delivery is doomed and has only a short shelf life. A fund that makes a virtue from having no explicit management charges (but often quite horrendous implicit annual deductions) has no place in the more transparent world we are entering. The sooner the life industry unshackles itself from its Georgian roots, and begins to deliver more modern solutions, the better.