With Profits funds
With Profit funds are, quite simply, funds in an investment bond which attracts regular bonuses in the form of annual bonuses and/or terminal bonuses. It is a method of investing in equity markets while attempting to smooth out the peaks and troughs normally associated with equities. As a result, as long as an annual bonus is declared then the value of the units in a With Profit fund will always move upward (apart from in exceptional circumstances, which are explained below)
A With Profit fund should be viewed as an investment of at least five years duration but in reality it should be seen as longer term than this. If an investor is not prepared to lock-up their capital over the medium to long-term then they should not be investing.
Annual bonus rate
Annual bonus rates have fallen for several years now and economic conditions have dictated that annual bonus rates have been reduced. Some providers, impacted by diminished financial strength, are being forced to make far more drastic cuts by closing their With Profits funds to new business and declaring 0% annual bonus rates.
Annual bonus rates are guaranteed and once added, cannot be removed. However, although annual bonus rates are declared for the forthcoming year, product providers do have the discretion to change them in the interim.
For example – if a 3% bonus rate is declared, then each day 1/365th of 3% is added to the unit price daily. Once this is added it cannot be taken away. If after 6 months the life office declare an interim bonus rate of 2%, then for 6 months 1/365th of 3% will have been added, and as long as no further interim bonus rates are declared, 1/365th of 2% will be added for the remainder of the year.
Terminal bonus rates
A terminal bonus is a bonus that can accrue in addition to the annual bonus. It is closely linked to the product provider‘s underlying With Profit fund. If the fund performs well then terminal bonuses will be added. However, unlike annual bonus rates, terminal bonuses are not guaranteed and can be removed at the discretion of the life company. Therefore, if the underlying fund has a period of poor performance then the life company can remove terminal bonuses.
Market Value Reduction (MVR)
This can be applied at the discretion of the life office and is used to protect the interests of an existing investor when encashment is made by another investor.
The MVR is a reduction of the amount paid out to the investor. It will usually be applied if the performance of the fund has been such that on encashment of a bond the actual value of the fund is less than the original investment plus accrued bonuses. This charge can be a grey area in that the investor may not know if it will apply and how much the charge will be.
For example – suppose we have three investors who each pay £10,000 into a With Profits fund. Now suppose the stockmarkets fall by 10% so the total With Profits fund drops to £27,000. If one of the investors decides to encash his original £10,000, then by not applying an MVR, this leaves £17,000 in the fund to be shared by the two remaining investors.
MVRs are currently being applied by all of the major product providers. This is quite simply due to the poor stockmarket performance over recent years and the fact that if these penalties were not applied investors would leave the fund with more than they should be entitled, to the disadvantage of those left in the fund.
While MVRs are bad news for those investors that wish to encash, particularly with the current high level of penalties in place, the situation is entirely different for those planning to remain in the fund. Investors planning to stay within the fund would have every reason to feel concerned if their product provider was not applying an MVR. Indeed, if that were the case it would probably make sense for them to consider leaving the fund themselves. While MVRs have understandably been applied as markets have been falling, the real test will be how quickly providers act to reduce penalties when markets do begin to rise.
With Profits investments
The return on these investments depends on the profits made by the life offices and on their policy as to their distribution (whether on early encashments or in adverse market conditions or other circumstances).
