With Profits Explained
When you save or invest with a life assurance company you will have a choice of funds that your savings or investment can be linked to. There are typically two types of with profits funds
- Conventional With Profit (sometimes called Traditional With Profit)
- Unitised With Profit.
Conventional With Profits:
Few insurance companies now offer Conventional With Profit funds and they are more likely to be on your older policies. Most older style, conventional with profit policies have an amount set (known as the minimum sum assured) which would be payable on maturity. During the term of the policy, bonuses are added as a percentage of that sum assured and that is how the value of the policy grows. If a terminal bonus is to be added at maturity or on death, it will also be calculated as a percentage of the minimum sum assured.
Unitised With Profits:
Some newer profits funds are set up as unit linked funds, where the fund is split into units and your investment premiums buy shares or 'units' in the fund. As the value of the investment fund grows and hopefully, its profits, either the price of each unit goes up in value, much like a share price, or you receive your bonuses in the form of additional bonus units being added to your policy.
Death Sum Assured for both types of with profits endowment
In addition, and not to be confused with the minimum sum assured or the unit prices and value, some with profits policies have a death sum assured, this is the guaranteed amount that would be paid out on death of the policyholder within the term.
How with profits funds are invested:
Your savings or investment monies are invested by the life assurance company into investments such as equities (stockmarket linked investments), property, cash investments that pay out a fixed interest. The returns that they receive on the monies are reflected in annual bonuses that are credited to your policy. Each year bonuses are declared by the company and are added to your policy.
Conventional With Profits
In simple terms when you start a policy you have:
A Life Insurance Sum Assured
- This is the guaranteed amount that is paid out on death
A Basic Sum Assured
- This is the amount that bonuses are calculated on
- For Example a yearly bonus of 5% is declared. Your policy value will be increased by 5% of the Basic Sum Assured
- These are known as annual or reversionary bonuses
- They cannot be taken away once added
A Terminal Bonus
- May also be added at maturity, death or encashment
- Terminal bonus can be a % of the Basic Sum Assured or a % of the existing bonuses already added
- Terminal bonus can be withdrawn at any time and is not guaranteed
- Terminal bonus is supposed to be an adjustment of the underlying investment fund performance compared to the bonuses already added. For example, if the underlying fund had grown 100% but you had only received annual/reversionary bonuses so far of 50%, you may expect to receive a terminal bonus of another 50% at maturity/death etc.
With Profits Bonus
How are with profit bonuses worked out?
Yearly, annual bonus:
The level of with profits bonus paid will depend on the level of return made by the life assurance company. These annual bonuses are set each year in line with what the life assurance company believes will be the long term return on the funds invested. The bonuses added are not necessarily what has been earned on the investments over the year. This is because bonus payments are not directly related to investment returns. For example:
- If the life assurance company fund made 10% on the investments, they may only pay out 6%, leaving 4% as a reserve.
- If, in the following year the returns were only 6%, the company could use the reserves and could maybe keep the annual bonus at 6%.
- This effectively smoothes out investment fluctuations for the investor.
By offering this type of fund, life assurance companies can offer investors exposure to the equity markets without them having to suffer their investment value moving sharply up and down. This is because once the annual bonuses have been added, they normally cannot be taken away.
When a policy linked to the With Profit Fund matures or on death there may be another type of bonus paid. This is called a Terminal bonus and reflects the actual growth the life assurance company has made on its investments and any profits it has held back in reserves during your investment period.
Terminal bonuses are not guaranteed to be paid and will depend on market conditions at the time.
MVA Market Value Adjustment
Let us imagine that you invest in a with profits fund and the returns are as follows:
- Year 1 - If the life assurance company fund made 10% on the investments and the bonus pay out is 6%, leaving 4% as a reserve.
- Year 2 - If, in the following year the returns were negative i.e down -10% and the company uses its reserves and added another annual bonus to your investment of 6%.
- Year 3 - Returns on the fund are 5% and the company reduce the bonus that year to 5%.
- Actual profits made by the fund over 3 years are 5%.
- The bonuses added to your policy are 25%
- You think that is a fantastic return, I will now cash this investment in.
Market Value Adjustment:
If an investor wants to surrender or transfer a With Profit policy early, the life assurance company reserves the right to change the amount paid out if market conditions are unfavourable. This is called a Market Value Adjustment factor or penalty - sometimes seen as MVA or MVAF or MVAP.
In this example, they have given you more in bonuses than the fund has earned. Just like a terminal bonus, where they add any reserve profits at the end, if they give you too many bonuses in poor times, they reserve the right to adjust this figure if you encash your policy early.
Market value adjustment penalties do not normally apply on death or at the maturity date.
Advantages and Disadvantages of With Profits Policies
- Relatively safe investments with some exposure to equity markets
- Bonuses are smoothed so no sharp rises and falls in your investment
- Once annual bonuses have been added they cannot be taken away
- Possibility of a Terminal bonus at maturity
- Life assurance and other benefits can be included
- Bonuses paid depend on the life assurance company's long term investment view
- Annual bonuses are now generally lower with Terminal bonuses generally the same
- This means that more emphasis is put on the final bonus which is not guaranteed to be paid.
- If the policy is surrendered in unfavourable market conditions, a MVAF may be applied
- These policies generally provide poor returns if surrendered in the early years