Home > News > 2001 > December 2001 > With-profit - past its prime?
With-profit - past its prime?
Tony Leandro and Rajeev Shah from our Life insurance consultancy team discuss the future - if there indeed is one - for with-profit contracts.
With-profit savings contracts as issued by life companies have a long history and come in many forms. However, the main feature shared by all of them is that they provide investors with a smoothed investment return. This is achieved by holding back returns in times of plenty and subsidising returns when investment conditions are adverse.
Given the recent controversies about orphan estates, falling returns and the problems of the Equitable there has been criticism of the with-profit concept by commentators in the media and by the Consumer's Association. These criticisms have been directed at the opacity of the products and the lack of information provided to policyholders on how the smoothing mechanism works. Some have even questioned whether the smoothing of investment returns provides any real value to policyholders. The media has speculated that with-profit is past its prime and is an outdated concept in the modern investment world.
While some of the criticism regarding opacity is valid, it is being met through new product designs and initiatives to improve transparency. However, in our view the criticism of the idea of smoothed investment returns is misguided.
With-profit products enable policyholders to share in the higher returns available through equity investments while avoiding some of the volatility associated with direct investment. Further, with-profit products provide guaranteed minimum payouts on maturity, which further cushions against poor equity returns over short periods, especially just before the product matures.
Many millions of policyholders could be taking such risks with their retirement pensions if they invest more directly in equity markets. If they decide to avoid the equity market, they risk lower investment returns. If they want to retire when markets are low, policyholders may not have enough other savings to enable them to wait for the equity markets to recover before cashing in their policies. Nor may their funds be large enough to go down the Income Drawdown route.
As recent experience has shown, returns under with-profit policies can go down when investment conditions are poor. Even so, the 2001 reductions in with-profit maturity values has probably only been half the fall in the level of the stock market. In this situation the benefit of smoothing is clear although some commentators still seem to think that any reductions are unreasonable. In general, we would not share that view. Policyholders who had invested directly in equity markets would have seen much bigger reductions with their maturity values reflecting the market falls in full. "No reduction" policies can only be written at the cost of investment performance and hence reduced returns for all policyholders.
It has been argued that similar protection against poor investment performance just prior to retirement or maturity can be re-created through the use of "life-styling" with unit-linked funds. Here, the funds are shifted from higher risk equity funds towards lower risk funds like bond funds over the last few years of the policy. However, this does not provide protection against falls in equity markets that last more than a couple of years. The cost (through lower expected investment returns) can be high as the exposure to potentially higher equity returns is reduced, particularly if the switching is performed over longer periods. Further, unlike with-profit products there is no minimum guaranteed payout that can provide protection against a severe and long running fall in investment markets.
Another alternative sometimes suggested is the use of "Guaranteed Funds" where derivatives are used to protect the fund against equity market falls. However, the cost of using a derivative based approach (which would lower the investment returns) is significantly higher than that involved in the with-profit approach (ref. ABI response to Stakeholder consultation). Further, the cost of derivatives can be expected to increase and their availability reduce precisely when they would be needed most - i.e. when the markets go through periods of increased volatility.
Another criticism sometimes made of with-profit products is that they underperform unit-linked products. However, the Insitute of Actuaries paper "Transparent With-Profits - Freedom with Publicity" shows that returns on with-profit products are comparable with returns on unit trusts. The returns on unit trusts, though, have been much more variable.
New product designs mean that with-profit products are now much more flexible. Unitised products allow policyholders to stop and start paying premiums without penalty. In common with new product designs for other types of investments, there are no surrender penalties. The new with-profit products have explicit charges for administration expenses and do not use the fund to provide capital for other parts of the life company's business, further increasing transparency and limiting the risks taken by with-profit policyholders.
Despite their antiquity the management of with-profit funds has been modernised and the techniques now available mean that the costs of smoothing and other guarantees can be correctly levied. This means that with-profit providers can ensure that cross-subsidies between generations and policy types are not unintentionally generated.
As payouts can now be better matched to asset shares, orphan estates should not be built up from the current and future generation of with-profit policyholders. Indeed, there is some evidence that, in recent years, orphan estates are being used to support some products where the guarantees are biting.
Given the very valuable benefits of guarantees and smoothing provided by with-profit investments and the moves to increase flexibility and transparency, these products continue to be well suited to investors who would like exposure to equity returns but are risk averse. With the shift away from final salary based pensions, more and more people will come to rely on their personal pensions to provide for retirement, increasing the need to mitigate the risks posed by investment market volatility especially just prior to retirement. This makes with-profit products a sensible choice for at least part of the savings of many investors. Removing this option, as some suggest, would reduce choice and increase risks for those people.
Tony Leandro and Rajeev Shah, December 2001.