With-profits policies: everything you need to know

Has Prudential done you proud, National Provident left you disappointed, or Aviva made you vexed? Over the past eight weeks, insurers have announced the bonuses they are adding to with-profits policies and the payouts people can expect if their pensions or endowments mature this year. The tables below show which investors are the winners and losers, after which Patrick Connolly of independent financial adviser AWD Chase de Vere answers some of the questions investors may have about their policies. 1. What is the difference between the annual and final bonus, and why do they vary so much from company to company? The annual (or reversionary) bonus is added to your policy and increases the value on an ongoing basis. Once annual bonuses have been added they cannot be taken away. This creates a problem for the weaker with-profits providers, because each time they add an annual bonus they are creating a liability which they then have to pay for. Therefore the weaker providers pay little or no annual bonuses because they don't want to create liabilities which they may struggle to afford. Instead, they focus more on a final (or terminal) bonus. This is added when a policy matures and its size depends on how the assets in the fund have performed. You have little idea how big a final bonus you will be paid: if your policy doesn't perform well it could be zero. By contrast, stronger providers are more likely to pay bigger annual bonuses and have a better track record of adding generous final bonuses when policies mature. 2. Why have payouts steadily decreased over the past decade when the stock market has seen a pretty steep ascent (with a couple of blips) since before 2010? The reasons for this go back to the period between 2000-2003 when stock markets fell heavily. In the late 1990s, markets performed well and with-profits providers naively thought this was going to continue. They invested too much in shares within their with-profits funds and then suffered when the markets fell: bonus rates were cut dramatically and many providers pulled out. With-profits funds are still paying for these mistakes, because rather than slashing payouts a decade ago they have been gradually reducing them year on year to reflect the losses they made. This trend looks likely to continue. 3. My with-profits policy seems to be performing pretty badly compared to others. Should I switch? There isn't usually a simple answer to this. Whether you should retain a with-profits policy or get out depends on a whole host of factors including the strength of your product provider, how your fund is invested, the bonus rates being paid, whether your fund is open to new business, any exit penalties, how long the policy has left to run, any guarantees on your policy, and whether you need to get your hands on your money. Even when you have all of this information there often isn't a clear solution as to whether you should stay or go. 4. I am fairly risk adverse, and currently only have cash savings. But I know I should start a pension – would a with-profits based pension be a good option? If so, which company should I choose? It is sensible that you are looking at long-term savings, and for many people a pension is a good option. You can invest in a pension and still adopt a cautious approach, and with-profits may be a way in which you can achieve this. However, few providers still offer new with-profits investments and there are a number of drawbacks such as falling returns and a lack of transparency. So, while there are good reasons why existing with-profits investors should retain their policies, they are unlikely to be the best choice for new investments – we would instead suggest investing in a range of different assets such as shares, fixed interest investments and property in order to spread risks. 5. I see that mortgage lenders consider endowments a more acceptable repayment method for interest-only mortgages than cash savings. Should I consider a with-profits endowment? Some mortgage lenders are nervous about customers having cash savings to pay off a mortgage, as they fear this money could be spent before the mortgage is redeemed. However, a with-profits endowment is not a suitable alternative as they are inflexible, have high charges, and bonus rates and payouts are falling. The best approach for paying off a mortgage, and the approach most preferred by lenders, is likely to be a repayment mortgage where you pay interest and pay off capital each month. With a repayment mortgage there is no investment risk. 6. I have a with-profits bond from which I am considering withdrawing money. Is now a good time to do that? As a with-profits bond is an open-ended investment with no maturity date, it is up to the policyholder when they want to withdraw their money. An important consideration is whether your bond charges an exit penalty, otherwise known as a market value reduction (MVR). This charge is used by insurers to reflect any fall in value of the with-profits fund after a stock market crash to make sure investors who leave the fund do not benefit at the expense of those who remain. If an MVR is charged you will get back less than the declared value of the units in your bond. You can either decide to pay the penalty and get out or retain the bond in the hope the MVR will reduce in the future. Some with-profits bonds also have MVR-free clauses which allow you to exit with a guarantee that no MVR will apply. This is usually, but not always, on the bond's 10th anniversary. If your bond has an MVR applying you should find out whether it has an MVR-free clause before you look to withdraw your money. 7. My with-profits policy is being managed by a company called Phoenix. Who are they and what does it mean for my policy? The Phoenix Group is a consolidation company which has bought and manages a large number of closed with-profits funds. Most Phoenix policies are paying low or no annual bonuses, and some of these haven't had a bonus added in a decade. The performance of many of these funds is also poor. This would suggest policyholders should get out. However, some Phoenix policies also have valuable guarantees which policyholders would lose if they surrendered their investment or moved elsewhere. You should find out if your policy has such a guarantee because if it does they could significantly improve the performance of your investment. 8. I don't like the sound of that. Can I get out of this situation? You can always get out, whether it is a with-profits bond, endowment or pension that you hold. However, it is important that you understand the full costs of doing so in terms of exit penalties and guarantees that you may lose. This is a complicated area and getting it wrong could prove costly. If you are in any doubt you should obtain Independent Financial Advice.