Payouts are falling for with-profits policyholders and they don't look like getting better any time soon.
With-profits policies used to sell like hot cakes. In fact, there's still billions of investors' money sloshing around these funds. For many people wary of investing in shares, with-profits seemed the perfect solution offering all the thrills of the stock market, but none of the spills.
That's because with profits funds are supposed to provide a smoothed return which eliminates all the ups and downs of the stock market. This is achieved by holding back some of the growth in the good years to bolster returns in the bad. Also the funds don't just invest in shares, they also put money in property and bonds which should, in theory, reduce the risk for investors.
The returns are paid out to investors by annual bonuses, which are set at the discretion of the insurer running the fund. A final bonus may also be paid when the policy matures.
Trouble is, the smoothed returns aren't guaranteed, and the charges are often too high. That's why we've been critical of with profits funds for a long time.
Where did it all go wrong?
The problems with with-profits became more obvious after the technology boom and bust. Insurers persistently paid bonuses which were too high during the prolonged stock market downturn. In fact, for a time, bonus rates routinely exceeded the actual growth produced by the with-profits fund itself.
Of course, this situation couldn't continue, but some insurers were better equipped to cope than others. The weaker funds were forced to slash bonus rates, often to 0%. Meanwhile the stronger funds -- such as those run by Norwich Union, Prudential, and Standard Life -- managed to carry on paying a reasonable return to policyholders.
But stock market turmoil has reared its ugly head once again with stock markets falling dramatically around the world as a result of the global credit crunch. What's more, commercial property and corporate bond (company debt) returns have also weakened significantly since the beginning of the year.
As a result, Norwich Union -- a leading with-profits insurer -- last week announced it is reducing payouts on with-profits investments following poor investment conditions throughout 2008.
The insurer says it has decreased bonus rates to ensure policyholders who leave the fund don't take more than their fair share at the expense of those customers who remain. Final bonus rates will drop on a range of policies which are due to mature from September onwards. No changes are being made to regular bonus rates.
What does this mean for investors?
Norwich Union is certainly not the first to cut payouts this year, but it's a greater concern since it has always been considered one of the more robust funds.
This is very disappointing, especially for those policyholders who have been holding on for Norwich Union's reattribution offer.
Reattribution is a process where surplus assets held in the with-profits fund are distributed to policyholders. Norwich Union finally agreed in July to pay out £1 billion of the excess to one million eligible policyholders. The average cash payment is £1,000. (Find out more about the reattribution offer here.)
But the poor performance of NU's with-profits fund itself is even more unsettling. It has returned -7.3% before tax over the year to 30 June 2008. (That figure represents returns from the two largest NU with-profits funds -- CGNU and CULAC).
Alas, this negative performance has translated into a reduction in final payouts of 5% on average for some policies, although other policyholders will see their payouts cut by as much as 10%.
Of course, this isn't great news, but there are further implications. The fund's overall holding in shares has also been cut. At the end of 2007, 53% of the fund's assets were held in UK and international shares. But, by the end of July this year, that figure was reduced to just 46%.
This is pretty significant because with-profits funds need to maintain a reasonable share content to provide long-term capital growth. So reducing the holding in shares is not a positive sign. But to put it in perspective, some of the worst with-profits funds have no exposure to shares whatsoever.
What should you do with your with-profits policy?
Whether you're with Norwich Union or another insurer, if you're worried about prospects for your with-profits policy, here are some points worth considering:
- Think twice before cashing-in your policy - You may be tempted to give up, but cashing-in your policy early means you won't benefit from any final bonus. Although final bonuses have been cut, they could still be worth waiting for if your policy is due to mature soon.
- You could by hit by a withdrawal penalty -- known as a Market Value Reduction (MVR) -- if you cash the policy in early. Find out what you stand to lose from your insurer.
- If you're paying regular premiums into your with-profits policy, you may be able to stop without surrendering the policy or triggering an MVR. This is known as making the policy `paid-up'. Your savings can then be put into an alternative investment you feel more comfortable with.
- If you have an endowment policy, think about selling it through the TEP (traded endowment policy) market. Find out more by reading my recent article Should You Sell Your Endowment Policy?
And there's more help available in Should You Ditch Your Endowment? The principles discussed here can be applied to with-profits investments in general, as well as endowments. Deciding what to do for the best can be tricky. If you're at all unsure speak to a good independent financial adviser. Good luck!
More: An Investment So Safe It's Lost Money | Is Your Endowment A Letdown?