With-profits funds explained What are with-profits?

With-profits policies are among the biggest causes of consumer harm in financial services

With-profits funds are a type of investment with a life assurance provider. The money you put in is pooled with other investors' money and invested in a mixture of shares, bonds, property and cash. If the investment performs well, you should get an annual bonus each year, as well as a 'terminal' bonus when your policy comes to an end.

What makes with-profits investments unique is the 'smoothing' process, whereby some of the return from the investments in the fund is kept back in the years when the fund does well and used to pay you more than the underlying return on the funds in years when it does badly.

With-profits investments: the problems

The idea of 'smoothing' is great in theory, but it has often not worked in practice.

Market value reductions (MVRs)

If you try to cash in your with-profits investment before maturity, you're likely to be hit with a market value reduction (MVR), also known as a Market Value Adjustment (MVA).

An MVR is applied by some providers, particularly in times of weak fund performance, to ensure you don't leave with more than your fair share. MVRs of as much as 18% are not uncommon.

The good news for some is that many with-profits policies include an MVR-free date, often at the 10-year mark. This is a day when you can escape from the policy without paying a penalty. If you have a with-profits policy, it's worth checking your MVR-free date, if you have one.

Research from Skandia shows that around £13bn of new with-profits bond business was written in 2000, with a further £15bn in 2001, meaning many policies are now coming up to an MVR-free day. In contrast, 2003 to 2008 saw less than £3bn in annual sales.

Commenting on the MVR-free exit opportunity, Michelle Cracknell of Skandia said: ‘For those investors who have become disillusioned with the performance of their investment, this is a golden opportunity to get their money out without paying a penalty. It is crucial that people review their with-profits funds.’

It’s also worth considering that the recent rally in the stock market has led some providers to remove their MVR. Friends Provident, for example, dropped the MVR from most of its investments in early 2010, so now could be a good time to consider getting out.

Fees and commission

Because returns over the years are smoothed, it's difficult for the investor to calculate the fees they're being charged, and to discover whether returns are being held back because of smoothing or are being deducted in management costs and adviser commission.

Who owns your money?

Once you invest in a with-profits fund, the legal ownership of the fund resides with the insurance company – policyholders have only a contingent claim upon it. Given that the directors have significant discretion to manipulate returns and charges, policyholders are vulnerable.

Policyholders who want to switch find it difficult because of the penalty charges, lack of access to advice and poor information provided by many insurance firms.

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