60 second guide to with profits bonds Policyholders endure a decade of poor returns

27 September 2011

Guide to with profits bonds

Many with-profits investors have been left disappointed over the years

Originally pitched as an alternative to putting your money into a savings account, with-profits funds aim to smooth out the highs and lows of the stock market by holding back returns in good years to make a payout in bad years.

They have been sold to millions of consumers over the years but many policyholders have been bitterly disappointed with the returns. Years of poor management and stock market crashes have left some with-profits investments delivering far less than projected.

Latest research from Which? found that the average with-profits bond has returned just 2.7% a year over the last decade. Compare that to the average cash Isa, which has paid out 4.6%, and consumers have lost out significantly. Yet despite this, with profits bonds are still doing a roaring trade – in 2010, £1.7bn was invested in them by over 50,000 consumers.

With this in mind, Which? Money gives you the lowdown on with-profits bonds, how they work and the pitfalls you need to look out for.

What is a with profits bond?

With-profits bonds are set up by insurance companies and can be a tax-efficient way to invest in a with-profits fund, usually with a lump sum of £5,000 or more.

You can take an annual income of up to 5% of the amount you originally invested without paying tax straightaway in a with-profits bond, and they carry an element of life assurance – if you die, your beneficiaries can often receive 101% of the value of your bond.

How do with-profits funds work?

In a with-profits fund, your money is pooled with other investors and put in a range of assets, such as equities (shares in companies), gilts (loans to the government), corporate bonds and property, all managed by an insurance company. This diversified mix of investments aims to spread risk and cushion losses if one of the assets falls in value.

However, with-profits funds are quite different from other types of investment funds – they're managed through the process of 'smoothing.' This means when the underlying investments grow, some of the profits are held back and put in reserve to pay a return even when the fund has performed poorly.

In the good years, your payout is lower than the actual growth of the fund, so that in bad years you can still get a similar payout.

How does your bond investment grow?

With-profits funds pay their returns through regular annual bonuses (commonly known as reversionary bonuses). Once these have been added to your policy, they can't be taken away.

The size of the bonuses are decided by the insurance company running the with-profits fund, but they're not simply based upon how well the fund has performed. If the insurer has shareholders, a proportion of the bonus (usually 10%) is shared with these part-owners of the company.

When your bond matures, you might get a final (or terminal) bonus. This amount is the extra growth that the with-profits fund has achieved which has not already been paid out through reversionary bonuses over the course of your investment. This is not guaranteed, and depends on how much is left in reserve and on the discretion of the insurer.

What are you charged in a with-profits bond?

Charges are very opaque. You often pay a fee to establish your policy and annual management charges too. If you're an older investor, you may experience lower allocation rate (less of your money is allocated to investment) to cover the cost of life assurance.

When you want to cash in your with-profits bond, you may also face a number of charges. If you want to get your money back within the first five years of investment, some bonds will charge you an early surrender fee; the earlier you want to leave, the higher the charge.

What are market value adjustments?

The most frustrating exit charge for with-profits bond investors is the market value adjustment (MVA), although in most cases it's a market value reduction (MVR). These are often levied during a period of poor performance in the with-profits fund.

Insurers reduce the value of your investment to ensure that you get your fair share of the bond's assets so that there’s enough for remaining policyholders. Most insurers evaluate your bond on an individual basis to see what kind of reduction might apply to your investment and MVRs might be higher depending on when you first invested.

There is some relief, though. About 40% of providers allow you to cash in your bond MVR-free on the 10th anniversary of investment. The terms and conditions differ from provider to provider, so it’s worth checking your policy to see when you might be able to exit without a charge.

Which’s campaign for with-profits policyholders

Which? believes that with-profits funds have been one of the biggest sources of consumer detriment in the financial services industry and insurance companies have been abusing with-profits funds, and their policyholders, for their own gain.

Which? is working to ensure that policyholder interests are better protected and will carry on meeting with the regulator and Government officials to press the case for change.

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