With-profits funds

Stock market return linked but with fewer ups and downs than investing directly in shares

If you save regularly or invest a lump sum using a life insurance policy, you might choose to invest in a with-profits fund. These aim to give you a return linked to the stock market but with fewer ups and downs than investing directly in shares. However, they are complex and are not as popular a form of investing as they used to be.

The money you invest is pooled together with money from other people and invested in the insurance company’s with-profits fund. The fund is managed by a professional investment manager, who puts the fund’s money into different types of investment, such as shares, property, bonds and cash.

Annual bonuses
The costs of running the insurance company’s business are deducted from the fund, and what is left over (the profit) is available to be paid to the with-profits investors. You receive your share of profits in the form of annual bonuses added to your policy.

The company usually tries to avoid big changes in the size of the bonuses from one year to the next. It does this by holding back some of the profits from good years to boost the profits in bad years – this process is called ‘smoothing’.

Terminal bonus
You might also receive a ‘terminal bonus’ when your policy matures. You can ask the insurance company to give you details about its bonus policy before you buy. With most policies, the amount of profit you earn depends mainly on the performance of the investments in the with-profits fund. Usually, once added, bonuses can’t be taken away.

But the insurance company can claw back some or all of the bonuses paid by making a Market Value Reduction (MVR) – or Market Value Adjustment (MVA) – to your policy if you surrender early. This is most likely in times of adverse investment conditions like a stock market crash.

Types of with-profits fund

Conventional with-profits funds
An initial sum assured (guaranteed minimum sum) is increased by the addition of annual bonuses and a terminal bonus. The size of bonuses depends on fund performance, the costs of the insurance business, and the need to smooth bonuses between good and poor years.

The trend has been for bonus rates to fall as the result of difficult market conditions. Although market value reductions can be applied, this would not normally be the case. Instead, surrender penalties would usually apply if the policy was terminated early with no reductions applied on maturity.

Unitised with-profits funds
A unitised fund is split into units – when you pay into it, you buy a certain number of units at the current price. Unit prices increase in line with bonuses declared and do not fall. Or, if additional units have been added, these are not taken away (but market value reductions can be applied).

There might be surrender penalties if you decide to take your cash early. Bonuses are handled differently depending on the type of unitised with-profit fund you have.

A fixed price unit never changes, so bonuses are paid as extra units to your policy as opposed to a variable price where bonuses are given as an increase in the unit price, so each unit you hold is worth more.

Bonuses

There are two kinds of bonus:
Annual bonuses, also called ‘regular’ or ‘revisionary bonuses’
Final bonus, also called the ‘terminal bonus’

Policy terms
Once the bonus has been added, an annual bonus can’t be taken away – even if the fund performs poorly in future – as long as you continue to meet the terms of your policy. A final bonus might be added at the end of your policy. Whether you receive one and how big it is depends on how well the fund does.

In good years, the fund manager can choose to keep some of the profits to help cover losses in bad years. This is called ‘smoothing’. This means that if there are long stretches without a profit, you might get low annual and final bonuses – or even no bonuses at all.

Market Value Reduction
The insurance company can make a Market Value Reduction to your policy if you surrender early, or in times of adverse investment conditions like a stock market correction.

If you leave a policy early, this reduction might claw back a large part – or even all – of any bonuses that have previously been added.

Inherited estate
A fund needs to keep enough money on hand to meet its expenses, run the business and to pay what it owes to policyholders. But over time, some funds build up far more than they need – usually through profits that were held back to cover losses that never happened. This extra value is called the ‘inherited estate’. The insurance company can use the extra money in one of two ways: for a distribution or a re-attribution.