Q&A: How will bonus cuts affect with-profits policyholders?

Standard Life, which has cut the maturity value of its with-profits funds by an average of 15%, has become the latest in a long line of life insurers to reduce payouts on with-profits policies. What does this mean, and how does it affect you?

What are with-profits policies?
With-profits policies invest in a mixture of assets including shares, bonds, commercial property and cash. They aim to smooth out stock market volatility during the course of the investment period by holding back some returns from good years to pay returns in poor ones. Policyholders receive returns each year, known as annual or regular bonuses, as well as a final or terminal bonus at the end of the investment.

With-profits policies can run for between 10 and 25 years and are often taken out as a pension or endowment policy to pay off a mortgage, or as a lump sum investment in the form of a with-profits bond.

Why have bonus rates been cut?
The FTSE-100 index has fallen by nearly 50% since its peak in December 1999, meaning with-profits funds have been producing negative returns for up to three years. Life insurers can still afford to pay bonuses because of the smoothing mechanism they use, but these bonuses must be reduced to reflect falling investment returns.

Which life insurers have cut bonuses?
Nearly all the major life insurers, including Standard Life, Norwich Union, Prudential and Scottish Widows, have cut the bonuses on with-profits funds. Britannic recently announced it was deferring its annual bonuses.

What does this mean for policyholders?
The reductions mean policyholders will see the size of their annual bonus, final bonus, or both, reduced - meaning the final maturity value of their policy will be lower than if the cuts had not been made. This may lead to an increase in the number of people with endowment policies that will not be large enough to pay off their mortgage.

However, because of the way with-profits policies are structured, people who pay regular premiums into them will not have lost any of the money they had saved - unlike if they had invested directly in the stock market - provided they do not move the policy before it matures.

Will bonuses ever be increased again?
Over the long term as stock market performance improves, bonuses are likely to be increased. However, life insurers have warned that, even in the future, investment returns are unlikely to be as large as in previous years, and many insurers have substantially reduced the proportion of assets they hold in equities, meaning future stock market growth will have less impact on the funds.

Are with-profits policies still a good investment?
Financial advisers say with-profits funds still have a place in a balanced portfolio as a long-term, low-risk investment, provided investors understand how the policies work.