As we are beginning to see, the recent recovery in equity markets has not halted the fall in the profit returns; or at least not to any significant extent. We consider how this has come about and what the future might hold.

During the past twelve months, the FTSE 100 has risen from about 3,300 to just on 4,500, an increase of more than a third, by the end of March 2004. Yet the first bonus announcements of the 2004 season indicate continued falls in returns, in most cases. Investors who have seen bonus rates fall for the last four or five years – mirroring the decline in equity returns – could well have expected to benefit from a return to better days; or at least a halt in the decline.

One of the principal benefits of with profit funds was that they have traditionally followed a diverse investment strategy, using property, gilts and deposits as well as UK and overseas equities, or provide a broadly based asset base that is intended to act as a bulwark against bad times in any one investment area.

Unfortunately, the dramatic – and very rapid – decline in share values during the two years to March 2003, when values were almost halved, left investment fund managers in a difficult position. As equity values fell, the proportion of their funds invested in property and gilts rose, putting more of their assets into less volatile, but also potentially less rewarding classes. Disinvesting from equities would not only contribute further towards the fall in share prices, by increasing the supply of shares onto the market, but also further increase the proportion of money held in cash. In theory, this is a good thing, as cash could be seen as a safe home for money when equities are weak, but it offers poor relative returns, particularly over the longer term and life insurance companies need good investment performance, if they are to sustain payout levels.

The life insurance companies also have to comply with strict ‘solvency’ rules, imposed by government, which broadly mean that they must hold assets in excess of their liabilities. When equity markets are weak, total asset values held by with profits funds fall, since most will hold at least half of their funds in shares. This means that reserves above the minimum level required by the government were depleted, adding further impetus for shares to be sold, to prevent further falls from pushing total fund requirements, during 2003, in order to help life insurance companies from having to act too dramatically.

The problem is that selling equities makes it more difficult to benefit from the up-swing, when it finally occurs – as we hope it has now – as the life offices have to re-enter equity markets, pushing prices up and preventing them from benefiting to the full extent of the growth.

What with profits funds seek to provide for policyholders is a smoothed return, removing the impact of sudden fluctuations in the value of underlying assets. They do this by holding back part of the profits made in ‘good’ years, using them to supplement losses made in ‘poorer’ years. The (completely fictitious) illustration above shows that while year-by-year results might fluctuate dramatically, the return to policyholders will be evened out. It also, however, demonstrates that where a long-term decline in returns take place – as has been experienced since the heydays of the 1980’s – a recovery over one or two years will not be enough to stem the accumulated decline brought about by a sustained period of poor investment returns.

It seems likely that it will take several years for investment returns to recover sufficiently for the decline in long term with profits to be halted and then reversed. Even sustained equity growth over several years will do no more than halt the long-term decline. Conversely, many people would argue that with profits funds still offer a positive return compared with inflation and many other forms of investment, particularly as they offer a diverse asset profile that has served many investors well, over a long period. That the charging structure is somewhat obscure (to put it mildly) is something that regulators and the industry are currently investigating and we might well see a new form of ‘with profits’ fund developing, in the near future.

You should always take independent professional advice before making any investment decision, as the value of investments can go down as well as up and is not guaranteed. If you would like any assistance, please contact us.

Source: FTSE figures from Yahoo.com