The cold, hard truth about final bonuses

The forecast days of 'absolute extreme' are upon us, says Rachel Stevenson. The with-profits agony is spreading, no matter how insurers try to reshape payouts. But cashing in the reduced policy could be a loser, too

Richard Harvey, the chief executive of Aviva, prophesied three months ago an Armageddon for with-profits investors. He spoke of an "absolute extreme" scenario where the effects of falling stock markets had become so severe that final bonuses on with-profits policies would be eliminated.

This week, that absolute extreme case happened, with Aviva scrapping final bonuses for many of its pension and endowment policyholders. The UK's largest insurer also cut annual bonuses by up to 50 per cent and 174,000 pension policyholders will not receive an annual bonus.

The news from Aviva followed a warning from the Britannic Group that it may not pay annual bonuses to any policyholder for last year. Britannic had been regarded as one of the strongest with-profits insurers in the UK, so its need to claw back funds by withholding bonus payments is a sign that the worst bear market since 1974 is taking its toll.

So far this year we have also had bad news from Axa Sun Life and the Co-operative Insurance Society, who brought down bonuses by as much as a quarter. With-profits investors are wondering what to do with their investments: hold on in the hope returns will recover or cash in before things get worse?

Life insurance companies own 20 per cent of the UK stock market and hold billions of pounds of assets. They have ridden high on bumper returns in the stock market over past decades, investing most of their funds in equities in the hope of earning the highest returns. Companies, enjoying rising stock markets, have been paying policyholders more than their fair share of the assets in the fund, relative to the investment performance earned on the fund's portfolio.

But the past three years of equity falls means insurers have been struggling to operate above their solvency margins, meaning policyholder returns have tumbled to the bottom of their priority list. When a life insurer declares annual bonuses, they become an instant liability on its books. It has to set aside money to cover the cost of honouring them, but this puts enormous strain on the company at a time when its assets are dwindling.

Ned Cazalet, an independent insurance analyst, estimates that insurers' free capital has fallen from £130bn at the start of 2000 to almost zero now. This surplus capital is what insurers use to pay final bonuses, sometimes 50 per cent of what you get back at the end of your policy. The ability of insurers to fund final bonuses has been all but wiped out.

But the sector has still been managing to pay £20bn of bonuses a year in the past three years. Aviva this week said it had paid £1.5bn in bonuses to policyholders in 2002. Payouts for many of its policyholders are 18 per cent higher than the value of the assets backing the policy.

Aviva is able to fund this year's bonuses from its substantial spare capital. Its with-profits funds have not made profits to pass to policyholders. In fact, Aviva's largest with-profits fund, CGNU Life, made an 8.6 per cent loss last year and a 9.5 per cent loss in 2001. It has not made a profit since 1999.

So while a 50 per cent annual bonus cut and no terminal bonus may seem, in their own terms, to be calamitous, with-profits investors should bear in mind how their payouts fare against the relative underlying returns made by the insurer.

Looking at it this way, you see that smoothing – the practice of holding back returns in good years to bump up payouts in bad years – is more at work than ever. If a with-profits fund has made an investment loss of 15 per cent (as some will have) and, as in Britannic's case, you do not receive an annual bonus but your final bonus remains unchanged, you are, in effect, being given a return of 0. That's better than minus 15 per cent.

But most Aviva policies are taking a hit of between 12 and 15 per cent on their final bonuses. An annual bonus of between 3 and 4 per cent has been declared, but by wiping out the final bonus, policyholders end up 8 per cent worse off after the bonus declaration.

"You would think Britannic policyholders would be worse off than Aviva's, most of whom are being given an annual bonus," John Turton, at the London-based independent financial adviser BestInvest, says. "But they are clawing back through cuts in final bonuses much more. It is the small annual bonus cut, which camouflages the reality of a huge cut."

He is evaluating his clients' with-profits holdings and says now is the time to take stock of what your with-profits investment is worth. He is looking at the underlying performance of the insurer's with-profits fund and comparing it to the payouts offered to policyholders. If, as in Aviva's case, you are receiving much more than the fund has earned, Mr Turton thinks many with-profits policyholders should move to crystallise their gains.

He believes future returns on with-profits funds will not be high enough to patch the holes already visible in insurers' capital. "If they are paying you £11,000 when they have only made £10,000, where has that £1,000 come from?" he says. "Their reserves. And they will want that £1,000 back. If you are ahead of the underlying fund now, the prognosis must surely be that it is not going to get any higher. And if fund value is less than the underlying value, will your fund recover as equally as markets will?"

Insurers have piled out of equities and in to less volatile investments such as bonds and cash. This means that when the equity market does start to recover, they will not participate in the upside. And reserves have been so depleted that gains in the markets are likely to go to restocking the kitty.

But cashing in a policy is not always an easy way out. Market value adjusters (MVAs) are being applied to policies. These are penalties attached to your fund that adjust your payout to reflect the market conditions of the time, particularly if you cash in early. They depend on how long you have had your policy, and they may counter the effects of bonuses you have been awarded. Other investments are available for cautious investors who agree to some exposure to equities, but want a balance with bonds and cash. The future for new investments in with-profits funds may lie in new versions that should make it easier for investors to see what is happening to their money.

Scottish Equitable's with-profits fund is ring-fenced from the rest of the business, meaning it is outside the business risks and is run for policyholder returns. They are smoothed in these managed funds, but they are more transparent than traditional with-profits.