Bonus prospects look bleak

Equity markets have recovered but the picture remains bleak for holders of long-term endowment policies. Norwich Union - Britain's largest insurer - announced this week that it would slash the annual payouts on policies taken out more than 15 years ago, despite its £57bn fund making an 11.5 per cent gain over 2004. The group said a 25-year, £50-a-month mortgage endowment policy would pay £52,576, compared with £59,444 last year. A 20-year, £200-a-month pension would have fallen to £113,392, from £120,978 last year.

Equity markets have recovered but the picture remains bleak for holders of long-term endowment policies. Norwich Union - Britain's largest insurer - announced this week that it would slash the annual payouts on policies taken out more than 15 years ago, despite its £57bn fund making an 11.5 per cent gain over 2004. The group said a 25-year, £50-a-month mortgage endowment policy would pay £52,576, compared with £59,444 last year. A 20-year, £200-a-month pension would have fallen to £113,392, from £120,978 last year.

Earlier this month, Axa announced it would cut regular bonus payments on with-profit policies taken over as part of its Equity & Law acquisition. Although the group paid 2 per cent bonuses in 2004, these have recently been cut to 1 per cent. These cuts confirmed predictions that payouts would continue to fall for many years, though industry commentators said these were not as severe as initially expected.

There was also some good news from Norwich Union in that it would maintain regular bonus rates for newer policies. And Prudential kicked off the bonus season early, in mid-December, by announcing it would maintain the 3.25 per cent bonus on its Prudence Bond for the third consecutive year.

While the picture has been slightly better for shorter-term policyholders, financial experts do not expect further improvement, even if equity markets remain stable. Certainly, industry commentators are warning that policyholders should not expect to see a return of the high bonuses seen in the 1990s.

Sharp declines in the stock market from March 2000 onwards and continuing low yields on gilt-edged stocks meant many groups had to slash bonuses on with-profits funds, which are designed to smooth out the peaks and troughs of stock market volatility.

These problems were exacerbated by life companies' forced selling of equities over 2002 and 2003 (when the market was at its lowest levels) in order to meet the Financial Services Authority's strict solvency requirements.

The Actuarial Professions Life Board expects there will be lower payouts for several years to come, reflecting lower returns from stock markets and other investments around the world. Nigel Masters, chairman of the board, said: "Investment returns are not expected to reach the high levels of the 1980s and 1990s in the near future, and payouts from with-profits policies can be expected to continue falling until the policies affected by the good returns of those earlier decades have all matured. Customers with policies of 10 years' duration or less may have already seen the worst of the falls, but payouts from longer-term polices are likely to continue to fall for several years yet."

Patrick Connolly, an independent financial adviser at John Scott & Partners, based in Marlow, said longer-term policies will continue to suffer because markets are not returning as much as they have previously. For instance, the investment return from 1979 to 2004 was lower than the return from 1978 to 2003, simply because there is one better year balanced into the equation. This will result in further cuts to 25-year endowment policies.

Mr Connolly said although some providers are better than others (he cites Prudential, Norwich Union, Legal & General, Liverpool Victoria, and Standard Life), with-profits funds have bleak prospects.

He expects new investors can achieve better returns from their money by avoiding with-profits. For existing investors, whether to sell or stay put should be considered on a case-by-case basis. "Existing policyholders should consider the individual terms of their policies, whether there are any penalties, guarantees, and their own individual tax position," Mr Connolly said.

The main disincentive for selling has been the Market Value Reductions (MVRs). Most policies sold in recent years would impose an MVR. Tim Whiting, an independent financial adviser at Best Invest, London, said before deciding to sell a with-profits fund that imposes an MVR, you should check to see if there are any ways you can mitigate your loss. With some bonds, there are specified dates on which MVRs will not apply. Mr Whiting said if one of these dates is looming, it is probably worth waiting for. If this option is not available - and the MVR is steep - you can consider making regular withdrawals of the maximum amount permitted before the MVR is applied, which can be up to 7.5 per cent per annum.

Taxation should also be considered. Mr Whiting said withdrawals of more than 5 per cent per annum cumulatively, or surrenders, could be subject to income tax, even if you have not made a positive overall gain.

What are the alternatives for new clients or those who believe it is viable to replace their existing policy? Darius McDermott, an independent financial adviser at Chelsea Financial Services, based in London, said for those wanting a life contract, a distribution fund is a better option than with-profits. He said distribution bonds are more transparent than with-profits and, importantly, distribute all of the income you are entitled to.

Alternatively, you could construct your own portfolio of unit trusts, with a plethora of equity, fixed-income and commercial property funds to choose from, Mr McDermott added. This latter option is the preferred route for John Scott & Partners. Mr Connolly does not believe packaged products such as with-profits or distribution funds, where one provider has responsibility for managing different asset classes, can produce the best returns.

Mr Connolly believes the sensible approach for investors is an appropriate asset-allocation strategy to meet their requirements. The best providers can then manage the underlying investments. "We choose the best equity managers to manage the equity portion of portfolios, and the best fixed-interest managers to manage the fixed-interest portion," he said.

'I don't like risk; this was a good option'

While many people are disillusioned with their with-profits policies, Jennifer Baker, 62, has benefited from good timing.

A retired potato packer who lives with her partner Alan Formoy in Spalding, Lincs, Jennifer loves gardening and has a quarter-acre plot. Her policy has grown, too. In 2001 she invested £20,000 in Norwich Unions' with-profits bond, using the proceeds from another NU policy. Since 2001 her policy has grown to be £22,367.

"I am a very cautious investor and was not prepared to take risks. Therefore, a with-profit policy which smoothes out stock market peaks and troughs seemed like a good option," she says.

Although there are penalties if she sells within five years, this is not a problem. "This was always intended as a longer-term investment. I don't need the money so I don't see that as a disadvantage," she says.

At the five-year mark, she plans to review her situation and may consider encashing the bond then, depending on her needs.