With-profits and unit-linked funds
20 December 2016
13 October 2018
This article was last updated by the author in October 2016.
A brief introduction to with-profits and unit-linked funds.
The returns from endowment and whole of life policies can be linked to investment performance. This can be done in one of two ways:
- With-profits - where benefits are indirectly affected by investment performance; and
- Unit-linked - where benefits are directly affected by investment performance.
Historically, with-profits policies have been the main investment products offered by insurance companies. They are available in both regular and single premium contracts, although the bulk of new investment has been in single premium bonds.
Investment performance is reflected in bonuses that attach to the policy:
- Bonuses, if declared, are added to the value of the policy annually. The bonuses are based on the company's profits from its investments but, over time, bonus rates have been cut severely, sometimes to zero.
- The largest single investment area of with-profit funds used to be equities. In recent years there has been a move away from equities for solvency reasons. Some closed funds (funds that are not open to new policyholders) are now almost entirely invested in fixed interest securities, property and cash, while open funds typically have less than half of the fund invested in equities.
- The annual bonuses are generally set at a rate that the insurance company's actuary believes represents the long-term returns from the funds. Annual bonuses therefore, used not to be particularly volatile, although they have been falling since the early 1990s. In the main, they reflect the income yields on investments in a smoothed, long-term fashion. However, financial pressures have limited the scope for companies to take a long-term view.
- Terminal bonuses are paid when the policy matures or on death and generally tend to represent more of the capital growth that the insurance company has made on its funds. Terminal bonuses are therefore more volatile and more directly affected by changes in the investment markets. As annual bonus rates have fallen, terminal bonuses have become more important. However, some companies suspend terminal bonuses when stock market conditions are difficult.
- Insurance companies usually reserve the right to reduce the amount paid on the surrender (but not on maturity or death) of a policy during times of adverse market conditions. A market value reduction (MVR) is applied to unitised with-profits funds, whereas for traditional policies this will be achieved by changing the surrender value basis.
As intimated above, with-profits policies are available in two main types:
- Conventional (traditional) with-profits - this type of policy has an initial sum assured that is increased by the addition of bonuses. Annual or reversionary bonuses and terminal bonuses are declared as a percentage of the sum assured, or the sum assured plus attaching bonuses; and
- Unitised with-profits - these are with-profits investments expressed as a unit-linked policy, where the premiums buy units in the unitised with-profit fund. The main difference from other unit-linked funds is that the unit price is guaranteed not to fall. Virtually all with-profits policies currently available are written on a unitised basis. The traditional with-profit contract, while still an important part of the traded endowment policy market, has all but disappeared in terms of new business.
The performance of with-profit funds depends on:
- the underlying performance of the investments, which is the most important factor; and
- for some companies, the profitability of their other businesses.
The strength of the company's reserves is often measured by the size of the free asset ratio (the surplus assets held by a life office over the value of its liabilities). This can allow reserves to be maintained, even in those years when the value of investments and the income from them have fallen. The companies generally try to maintain a balance between:
- retaining enough of the profits in particularly good years to smooth out the bonuses in years when investment returns are poor; and
- providing each generation of policyholders with the appropriate returns from their investments.
With a unit-linked policy, the premiums buy units in the fund of the investor's choice. This might be run by the life office itself, or it might be a unit trust or open ended investment company (OEIC) run by the life office or another institution.
It has the following characteristics:
- The value of the policy is measured by the total value of the units allocated to it.
- Immediately a policy is effected, its surrender value will be lower than the premium paid. This will be because of the difference between the buying and selling price of the units, usually 5% and/or because there is an early termination penalty.
- From then on, a policy's value depends on the performance of the fund, or funds, to which it is linked.
There is a big difference between the performance of the best and worst life offices, and the best and worst unit-linked funds within life offices.
- The more specialised the fund, the greater the chance of spectacular rises in value and also spectacular falls.
- The more broadly based a fund, the more likely it is to conform to an average return and the less likely it is to suffer a disastrous fall.
- There is some evidence to suggest that new funds tend to perform better than average in their early years because their small size tends to make dealing easier.
- There have been problems in the past with small funds investing too high a proportion in one single investment.
It is fair to say that unit-linked policies therefore have a higher risk/reward profile than with-profits.
Unit-linked policies maturing when stock market prices are high will normally outperform their with-profits counterparts. However, policies maturing when stock market prices are low may perform badly. For this reason, most policies include an extension option so that encashment can be deferred at maturity date until depressed stock markets recover.
Although not as popular in the past, the majority of life offices provide their policyholders with access to both with-profits and unit-linked funds via their whole of life products, most notably in the shape of single-premium investment bonds.