When With-Profits Becomes Without-Profits

by Cliff D'Arcy on 20 January 2009  |  11 comments
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With-profits funds were once very popular, as they allow investors to spread their risk. However, market crashes have exposed their weaknesses.

One of my relatives recently received a payout from his mortgage endowment policy. Over the past twenty years, he has faithfully paid his monthly premiums, part of which provide life cover, with the remainder being invested in a with-profits fund. In total, my relative paid in around £20,000 over twenty years.

My question for you is: how big was his payout? £25,000? £30,000? £40,000? In fact, he received a measly profit of £1,000, or 5% of the amount contributed. Frankly, this with-profits policy has been a dismal failure and he’d be richer had he deposited the £1,000 a year into a savings account from 1988 to 2008!

Why I hate with-profits policies

Personally, I’ve never bought a with-profits policy -- what’s more, I never will. There are so many problems with these funds that I scarcely know where to begin. Nevertheless, here are my five top reasons to give with-profits a miss every time:

1. High management charges

With-profits funds spread your money across a range of different assets, such as shares, bonds, property and cash. However, this diversification comes at a price, with many funds charging fees of several percentage points a year for their services. Of course, the larger the fee, the lower your return -- all other things being equal. Indeed, in the above example, the fees pocketed by the with-profits provider vastly exceeded the £1,000 profit made by my relative, making the provider the only winner.

2. Transparency is poor

I like cheap, simple, easy to understand products such as index trackers, which track a particular stock-market or other index as it rises and falls. With-profits funds, on the other hand, are extremely opaque. Other than a broad picture of asset allocation (the proportions of the fund held in each asset class), with-profits funds are largely opaque and obscure. This isn’t a great help to investors!

3. Smoothing doesn’t help

In theory, with-profits funds use ‘smoothing’ to lessen some of the volatility of investing. So, in the good years, they hold back profits to act as a cushion in the bad years. In practice, with-profits funds -- especially that of the now-infamous Equitable Life -- ‘over bonused’ by paying out too much to previous investors. In other words, they splashed out too much cash when the good times rolled. Alas, now that the property and stock markets are crashing, there’s not enough left in the pot to smooth out these falls. So much for smoothing!

4. Bonuses can be chopped

Yesterday, Norwich Union, the UK’s largest life insurer, announced reduced payouts for all of its 2.3 million with-profits policyholders. In most cases, payouts this year will be 15% lower than they were in 2008. This will leave many customers facing a mortgage shortfall. Norwich Union’s biggest with-profits fund lost 11.9% of its value last year. Although this is better than a 31% drop by the FTSE 100, a loss remains a loss. Furthermore, we can expect similar announcements of reduced bonuses at rival firms such as Prudential, Standard Life, and so on.

5. High exit charges

Lastly, if you are unhappy with the ongoing performance of a with-profits investment, then don’t expect to escape scot-free. You are forced to pay an exit penalty of between 5% and 20% of the current value of your fund -- which, in effect, locks you into more years of poor performance. This is why many investors sell their with-profits mortgage endowments to firms that buy up such products, rather than cashing them in for a reduced payout.

In summary, my advice would be to steer well clear of with-profits funds of all shapes and varieties. Although they appeared to work in the good times, they are very much ‘yesterday’s products’ and have little to offer to today's investors.

More: Find superior savings accounts | Get Real With Your Savings | Get More From Your Endowment