The £274 billion ‘with profits’ market is under review by the Financial Conduct Authority – again.
My first ever column on this opaque investment was exactly twenty years ago, and in 2010, I thought I would have written the last one!
Since then, the market has shrunk considerably (down £36 billion in the last year) (2) and many funds have closed due to lack of new business when commissions were banned. Two more funds were wound up last year.
The process has left us with strength in some of the larger remaining providers but my views from twenty years ago remain the same about the opaque concept that is ‘with-profits’.
You may or may not be aware you have them in your portfolio but if you do, its time you had a good look at whether or not they should stay there.
One of the most important focuses of this column is to negate our biggest risk, which is ‘information advantage’ – what we are offered to read, we can read and understand, and what we choose to read.
With-profits is a victory for marketing versus actuaries, and available information.
The objective of investing is to beat inflation over and above the income you are taking from your capital. If you don’t, your capital will fall in real terms.
Whilst we might have to take risk with our capital by buying a second home or investments for example. The potential risk has to match the potential reward, but for this purpose we can assume no one wishes to lose all their capital, so risk is better described as the fluctuations in your money, in pursuit of the best return.
If you were asked to walk across a plank on the floor for £10, other than looking daft, you would do it. If it was fifteen feet in the air, you would hopefully decline, but for £1 million, you might give it a go. And so the obvious transparent trade off exists between risk and reward.
A with-profits fund doesn’t work like that and its risk or return is virtually impossible to assess given its opacity.
A with profits fund is simply where your capital is invested across a wide range of assets like cash, UK and International equities, property, government and corporate bonds (exactly like a managed fund does). The objective is to spread your risk.
The difference is in how the risk or return is given to you. With a managed fund, the investments could typically be the same and so, as the fund rises, your value rises and vice versa. In a with-profits fund, you are given an annual bonus of some of the returns and an offer of a bonus at the end of the plan – whenever that might be. In its simplest form, it’s your parents holding on to your holiday spending money and deciding when you get it.
Defenders of the concept say the returns are smoothed but that is flawed in so many ways. Firstly, the with-profits investment cannot pay out more than the underlying investments it is invested into achieves. It has to pay out less. If it is offering guarantees, they have to be paid from somewhere. There is no free lunch.
This is why, when the stock market collapsed, the ‘parents’ hadn’t budgeted enough for the whole holiday, the concept collapsed, and huge funds like Legal and General’s had to close. It has been joined by many, now named, ‘zombie funds’.
Phoenix, who took over such funds declared they were no longer paying bonuses because ‘the guarantees which must be met often exceed the underlying value of the investments attached to that contract’. No spending money left.(3)
Worse still, the chance of this reversing is limited as many of these funds are then forced out of the assets that would produce the best returns as the fund cannot take the risk.
Secondly, the with-profits fund will not have expertise on each of the assets it is investing into. We would always recommend the best manager for each asset, i.e. the best property, UK equity manager etc.
More next week …
Peter McGahan is the owner of Independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority.