Bonding with your bonds

What to look out for when you cash in a with-profits bond. By Nic Cicutti

ANYONE WHO has followed our regular series on with-profits bonds - a relatively safe haven for investors' funds - will know that one of their attractions is that once added to a policy, a bonus cannot be taken away.

This is true. Yet what is also true is that there are occasions when a policyholder who cashes in a with-profits bond may receive back less than the amount they invested. How can this happen?

The answer lies in a not-very-well-understood application of something known as the Market Value Adjuster (MVA) on the final payout of investors' policies.

Every insurance company will have a clause in the small print of its bonds' sales brochures, allowing it to apply an MVA on encashment of a policy. The MVA not only allows a provider to reduce the amount payable on encashment, whether in part or in whole. It also includes removing some of the accrued bonuses that were previously thought to be guaranteed.

For unitised with-profits policies, which are not directly tied to the value of the underlying assets (and are not guaranteed), any MVA will reduce the surrender value of the units to the same market value as the assets which back that particular bond.

This is a dramatic move. After all, what is the point of an insurance company telling you its bonuses are guaranteed and unmovable if it does the precise opposite the moment you cash in your bond?

The reality, as always, is slightly different. Generally, the application of an MVA will tend to happen in extreme cases. For example, if UK and world stockmarkets suffered a sharp fall - not just 5 or 10 per cent, but more - as a result of which the bond in question suffered from a flood of withdrawals from the with-profits fund.

This would have a terrible effect on all with-profits investors, because bonuses are paid on the basis of a calculation on the part of the company concerned that returns in the foreseeable future will continue.

Therefore, anyone leaving when bonuses have already been attached on the basis of expectations that are now totally different would be taking more out of the with-profits fund than they are "entitled" to.

So the MVA is a way of protecting reserves and ensuring that payouts can continue in subsequent years. Long-term investors benefit. Nor is it necessarily the case that shorter-term ones lose out: in theory, even if an MVA is applied, they will receive any investment returns gained on their bond to date (including bonuses), minus charges.

Of course, it can be fiendishly difficult to work out how MVAs have been applied. Generally, however, it is extremely rare for an MVA to be applied. When it is, it tends to be on an individual rather than a collective basis. Of much greater use to most investors is knowing whether an MVA might apply in cases where partial encashment involves the receipt of 5 per cent "income" from the with-profits bond, one of the raison d'etres for investing in one. Again, most companies stipulate that they will not apply one in such cases.

Two further points worth noting are that MVAs are not usually applied on encashment at death. Moreover, some companies will select a plan "anniversary" when a bond can be encashed without the application of an MVA.

`The Independent' has produced a free 24-page Guide to With-Profits Bonds. Written by Nic Cicutti, this paper's personal finance editor, it examines arguments for and against investing in bonds. Sponsored by The With-Profits Bond Shop. For your copy, call 0845 2711007