Tax-free but not such great value

Friendly societies fill a small investment niche, but charges are high, says Iain Morse

Talk to marketing people and they will often tell you that a surefire way of selling a financial product is to advertise it as tax-free. Hardly surprising then, that friendly societies are so popular among large numbers of savers.

Friendly societies grew out of medieval guilds and were first established in the 16th century as mutual self-help societies, paying benefits to members and their families in cases of illness, hardship and death. Some still restrict membership to particular trades or professions, others are open to all. The aim was to encourage people to provide for themselves.

Prior to the formation of the Welfare State they were able to extract an important concession from the taxman, namely that their savings plans would be free of any income or capital gains tax.

Their history helps explain why the upper limit on premiums is fixed at pounds 25 per month, or an annual premium of pounds 270, with only one plan allowed per saver. The rules on policies are similar to life company endowments: premiums must be paid for seven and a half years on a 10-year term, or for 10 years on any longer term.

Their tax-free status means that fund performance should be competitive both with insurance company endowments and PEPs. Many societies cater to the less well off, with minimum monthly premiums in single figures. But do they give value for money?

Answering this question is not easy. The limit on premiums gives a clue to the main weakness, for there are fixed costs to administering each policy regardless of premium level.

A comparison of charges and early surrender values among five larger societies gives a clue to future performance. The figures below assume a 10-year plan with monthly premiums of pounds 25 and growth before charges of 9 per cent.

The left hand of these columns shows actual cash deductions from the pounds 3,000 invested over the policy term. These vary a good deal, but the next column shows their effect, firstly in reducing an assumed yield of 9 per cent. The third column shows prospective returns after such deductions, while the fourth gives the differing charges levied by each society.

The way these charges are levied is also important. Some societies load charges at the start of a policy, others spread them more evenly. Front- loaded charges have a greater effect in reducing maturity values. Either way, if you surrender a policy within the first five years, you are unlikely to recover even the premiums paid.

For example, savers would receive no premiums back after the first year if they invest with Tunbridge Wells, Scottish Friendly or Family Assurance. Liverpool would pay back pounds 159 out of pounds 300 paid in, while Homeowners would return pounds 116. By the fifth year, the return of premiums, even assuming 9 per cent growth ranges between pounds 1,260 and pounds 1,550.

These figures also indicate why some societies with high initial charges still deliver good results for savers who pay to maturity: the money taken off those who surrender early is used to swell remaining investors' funds.

None of this says much about actual performance. Tunbridge Wells, with some of the higher charges shown, have consistently good results on its with-profits fund. The same is true of Scottish Friendly.

A different picture emerges if we look at the past performance of managed equity funds run by Family Assurance, with 10 annual premiums of pounds 100 maturing at pounds 1,472 in 1997. This compares to a return of pounds 2,196 from Perpetual's Income Fund, a unit trust PEP which has the same tax advantages.

Friendly society plans cannot be used to secure a mortgage. Early encashment is heavily penalised. Charges remain high. So where do they belong in a savings portfolio? The answer must be that they fill a niche in the market for small savers and can be used to meet specific future needs. As for being friendly - well, yes. But at a cost.