WITH PROFITS FUNDS - A HIDDEN SCANDAL?
This article examines the problems behind with profits funds, and explains why they may not be a suitable investment. This article may be relevant to you if you have an older style pension or investment plan invested in with profits funds.
- What are with profits funds?
- Problems over with profits funds
What are with profits funds?
These are investment funds from a different age. They were originally created to act as a catch-all investment vehicle, which would allow investors to get professionally managed investments with some of the upsides but without the downsides. They were generally marketed as low-risk, even though this was not always the case. If you currently hold a with profits fund you probably view it as low risk. This article may change your mind.
The idea is that you would pool your money with others investing in the same fund. This fund would then be managed with a combination of stock market investments, property, cash and corporate bonds. This was supposed to be a low to medium risk investment.
The marketing genius behind these funds was that each year the fund would declare an annual bonus. Once declared this bonus can not be taken away.* Therefore, if you are a client you would never see the funds drop in value (unless the fund was unitised). The funds would act like a bank account in that you would see only the declared bonuses added, and there would not appear to be any charges taken from the funds (even though this would be the case in the form of a reduced annual bonus).
The fund should also pay out a final bonus when you cashed in the policy.
This is where it starts to get complicated. The final bonus by its nature is very difficult to quantify since it is based on a variety of factors such as the underlying performance of the with profits fund. The problem for the investor is that this underlying performance is never disclosed, meaning that you have an impossible task to value your investment. Sure, it is not going down in value, but should it actually be increasing by more than it is?
Market value reduction
A further complication is the market value reduction. This is a mechanism through which the fund can claw back some of the fund if you leave early and the underlying performance does not match the bonuses declared. *We said that the annual bonuses can’t be taken away once added; well, this isn’t quite true.
So you are left with this rough formula for calculating your with profits investment fund:
Your contributions + declared annual bonuses + (possible) final bonus – (possible) market value reduction
Confused? You are not alone!
Problems over with profits funds
In recent years with profits funds have been hit by a general malaise. The funds are not generally being supported by investors since they are confusing and opaque. It is nearly impossible to value your assets, and you have no way of detecting the underlying charges. All the advantages are with the fund managers, not the investors.
There is a better way. Instead, we much prefer the more modern way of making investments simpler. Choose your own investment strategy by combining a number of different investment types. This has the advantages that you have much more control over your investments, and more importantly you can know exactly how much you have in each fund on each particular date.
With profits funds have been badly hit by recent investment downturns and regulatory changes. In 2004 funds needed to change their investments, and since then most funds found themselves losing money due to their over reliance on shares. This was also a problem for generally cautious investors who probably didn’t real;ise they had such a risky investment. When funds started to lose money (but couldn’t declare this through their bonuses) their solution was to cut back on the shares element of the funds, and to stop declaring annual bonuses. Final bonuses were reduced and market value reductions were applied.
There is also the thorny problem of ‘inherited estates.’ If funds hold back too much as part of the smoothing process between years, they don’t have to give all this money back to with profits fund holders. Instead, companies have in the past used this money towards their own business costs, or even to pay compensation when thei have mis-sold a policy!
Investors were left with:
Your contributions + declared annual bonuses + reduced final bonus – actual market value reduction
Since this occurred most with profits funds have not been adding annual bonuses. This means that investors are actually losing money in real terms once you add in the effects of inflation. Fund managers argue that any performance could be gained through the final bonus, but we would counter that this is a big unknown for the investor. We recently advised a new client who had not received any annual bonuses on his pension plan for 6 years!
Therefore, in general, we are advising new clients to take their money out of with profits funds so that they can have a better chance of achieving growth in the future. Of course, this does depend on a wide number of variables, so please seek advice before taking any such decision yourself.
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Photo credit: Flickr>wwarby
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