Investing without profits?

As a nation we have about £320bn invested in them, but we know little or nothing about how they are run. They are sold as medium to low-risk investments, but now stock market falls are leaving yawning gaps in household mortgages and pensions. Yet, if we want to get our money out early, we may face big penalties.

We're talking about with-profits funds and the mass market products backed by them: endowments for mortgages, retirement nest eggs and pensions. They are sold as a way to have your cake and eat it from the stock market - steady returns without the nasty shocks of price slumps. But recent events will have left many small investors wondering whether these investments wouldn't be better described as "without profit".

The most dramatic illustration of what can go wrong in a with-profits fund has come from insurer Equitable Life, although its difficulties are compounded by its corporate structure. As a mutual it has nowhere to turn but to the members of its with-profits funds to raise the shortfalls it now faces.

But the prolonged slump in share prices - the FTSE 100 index fell to to a three-year low last week - is also taking its toll on these funds, despite their claims to smooth the ups and downs of the market. Returns, delivered through bonuses (see below) have been cut successively over the past few years, and insurers are imposing special penalties, known as market value adjusters (MVAs) or market value regulators (MVRs), to deter people from cashing in.

John Chapman, a former office of fair trading (OFT) official who now works as an independent consultant, last week added his voice to the swelling chorus of criticism engulfing with-profits investments.

In a report sponsored by a firm of stockbrokers, Chapman listed four major flaws.

• Insurers do not explain how payouts have been worked out because they keep their "smoothing" mechanisms secret. In some years fund managers pay more than investments have earned, and in others less. The secrecy is aimed at stopping investors rushing to cash in after years in which payouts have been bigger than growth on the underlying investments.

• Exit penalties applied during share slumps negate much of the smoothing.

• The investments held by with-profits funds may not produce the best returns for long-term investors - because of the need to keep some money in conservative investments to cover guarantees.

• Companies can make decisions under a cloak of secrecy.

Chapman points out that with-profits funds have spawned an estimated £45bn of "orphan" assets, excess profits whose ownership is not clear. He believes insurers may have dipped into the with-profits funds to pay for management blunders such as the £14bn cost of pensions mis-selling and honouring guaranteed pensions of the type that have brought down Equitable Life.

The cloak of secrecy and obscurity over the way insurers determine payments extends to other practices in the business, which appear "unfair if not scandalous".

This extends to the insurers' jargon: even the word "bonus" is inappropriate, according to Chapman. "It's not a little added extra for being nice,' he says. 'It's the return on your investment."

He argues that investors seeking growth from stock market investments over a long period would probably be better off putting their money directly into shares.

He compared returns on with-profits funds with the performance of UK shares over 25 years, as measured by the FTSE All-Share index (see table). In most years shares did better than funds with the average mixture of assets in use at the end of last year: half in UK shares, 15 per cent overseas, 10 per cent in property, 20 per cent in gilts and 5 per cent cash.

A fund such as this would have outperformed UK shares in only eight of the years. In some years the differences in returns was substantial: 49 per cent for shares against 34 per cent, for example.

Chapman also compared cash returns before charges and the smoothing process on with-profits funds, against the market. In the early years of the 25-year cycle the differences were small. But by year 10 the return from the UK market was some £6,000, or 17 per cent more than on a with-profits fund. By year 25 the gap has grown to £119,000, or 40 per cent.

Those investing in a with-profits endowment or personal pension with an average asset mix over the past 25 years would have seen returns some 40 per cent higher if they had instead invested in a fund tracking the FTSE All-Share index.

Chapman suggests a range of reforms for the with-profits funds - the most dramatic of which would be to close them to new business.

Alternatively, insurers should be forced to "come clean about the inherent flaws" of the funds. Only firms that change questionable practices would be allowed to launch new with-profits products.

Vince Whitefoord, an actuary working in investment management, says the with-profits funds' original aim has become distorted, or even corrupted. "They used to be more conservatively managed", but "as compet-itive pressures arose, the assets backing with-profits policies changed", and there was "an aggressive reinvention of the concept".

"It was presented as having all the investment return prospects of unit-linking, with guarantees and smooth returns to boot," Whitefoord says. "The Equitable debacle has shown that the price of this defiance of natural laws is potential ruin."

Change is on the way. The consumers' association is campaigning for an overhaul of the multi-billion with-profits industry. The financial services authority launched a review last February, prompted partly by the Equitable crisis. A government-backed inquiry into the investment industry, headed by former Lloyd's insurance market chief executive Ron Sandler, is expected to express severe doubts about with-profits funds when it launches a draft consultation paper tomorrow.

Many independent advisers remain enthusiastic about certain with-profits products, particularly bonds (see box, page 3). But few of them would now recommend long-term savings plans based on with-profits funds, such as endowments, because of their inflexibility and early exit penalties.

Patrick Connolly of Chartwell Investment Management says: "I think [insurance] companies have realised they have to adapt."

For the millions of small investors with money tied up in with-profits funds, the doubts are not a reason to cut and run. But it is time to accept that you cannot have your cake and eat it, and to think about other ways to save in the stock market.

What to do next

Endowments and savings

Endowments are providing some of most dramatic examples of how with-profits investments can disappoint, with millions of investors facing shortfalls on homeloans.

Homeowners should consider converting part of their mortgage to a repayment loan. Insurers are still peddling endowment savings schemes with early surrender penalties.

But if you want to build a nest egg over more than five years, consider Isas, unit trust and investment trust savings schemes.

Pensions

Criticisms of with-profits funds should not prompt you to transfer an existing plan without considering transfer penalties. All stock market funds are suffering from the market slump; the concern about with-profit investments is lack of clarity about returns and whether investment profits are divided fairly.

Stopping payments on an existing fund may incur heavy charges, but if you want to increase contributions consider another provider for the extra payments, possibly a low-cost stakeholder pension.

With-profits bonds

These have been sold as halfway houses between deposits and full-blown stock market investments. Bonuses are expected to fall, but many advisers remain enthusiastic.

Investors should look to strong companies such as Prudential, Norwich Union and Legal & General. Insurers may impose early get-out penalties.

Alternatives for income would be corporate bond funds or income unit trusts.

With-profits annuities

Because returns on annuities have fallen dramatically, insurance companies are developing with-profit annuity funds with the aim of offering higher incomes. But these can fluctuate.

The alternatives are conventional annuities or, for those with substantial pension funds (of £250,000 or more) income drawdown schemes.

Look for a fund that offers a high equity content, say 70 per cent, a strong management company and a flexible contract.