UK: Standard Life Post-Demutualisation Who’ll Get the Profits?

Last Updated: 30 August 2006

Standard Life finally demutualised in July, listing its shares on the London Stock Exchange and opening its doors to shareholder capital.

This was the culmination of much hard work by the management team, which followed many years of debate about the rights and wrongs of transferring ownership away from its members. The question shifted inexorably from ‘if’ to ‘when’ through the years as it became clear that the risks, rewards, costs and management requirements of a multi-faceted international savings and investment business did not sit well with shared passive ownership by a pool of historical UK-based with-profits policyholders.

All debates about ‘ifs’ and ‘whens’ are of course now irrelevant. What is relevant is the question of what, if anything, existing policyholders should now be doing with their Standard Life policies? In particular, will the with-profits policyholders continue to get their fair share of profits?

Non with-profits policyholders

Firstly let’s consider the position of the non with-profits policyholders. The answer here is a simple one. Such policies did not confer membership pre-demutualisation, and the position has not changed since. They received no shares in the new company in compensation for loss of ownership, and their investment returns are represented by movements in the value of the underlying assets of the funds in which their policy is invested.

Any policyholder concerned about their non with-profits policies should ask their financial adviser to review them. A review would be relatively straightforward and involves comparing the charges, contract terms and the value of any guaranteed benefits under the existing policy to the charges, contract terms and the value of any guaranteed benefits of an alternative policy. There may be other consequences of transferring or cancelling a policy that should be taken into consideration, such as financial penalties.

Little, if any, useful information can be gleaned from the past investment performance of one company’s funds compared to another, as this uses historic data and will not predict the future consequences of changing. However, the number and scope of investment funds under the current policy and the alternatives would usually be relevant. As a general comment, we are not aware of many Standard Life policies with wholly inappropriate charging structures, although terms can sometimes vary from contract to contract.

With-profits policyholders

Will the answer for with-profits policyholders be quite so simple? Those familiar with the complexities of with-profits funds will know that the answer is a firm ‘no’.

To briefly recap, the theory of with-profits funds is that some returns are held back in years of good investment performance (as reserves) whilst some are reflected immediately in the policy as annual bonuses. The eventual payout or transfer value should include an additional payment or final bonus paid from the reserves. This should reflect the investment returns of the policy over its entire term. In adverse short-term market conditions the payout or transfer value may be reduced by a market value adjustment (MVA) to reflect those conditions.

The theory – smoother returns

The idea of with-profits plans is to produce a smooth return over time. With-profits policies also confer ownership of the mutual company on policyholders, so that investment returns also reflect the fortunes of the business – hence the title of ‘with-profits’. In return, the fund’s reserves are used as the capital of the business and help to run it. In most cases, and of course for all Standard Life with-profits policyholders, going forward the with-profits fund will benefit from less of the firm’s profits as they will now have to be split with shareholders, as with the working capital risk.

The practice – reduced bonuses

So much for the theory. Recent practice has been to reduce annual bonuses whilst placing more emphasis on the final bonus, with the result that whilst returns continue to be smoothed, the graph will be flatter. As final bonuses are not guaranteed, whereas annual bonuses are supposed to be, subject to any MVAs, actuaries can exercise more control over payouts from policies, putting more emphasis than ever on the market timing of the encashment of the policy.

The move away from annual to terminal bonuses effectively removes one of the original intentions of with-profits – to provide a smoothed investment return over the period of the policy. As the other main benefit of with-profits – ownership of the company – has also been removed, it must be right to question whether with-profits funds are appropriate going forward.

Standard Life’s investment returns

Returning to Standard Life, the overall investment return of the with-profits funds was 16.1% for the calendar year to 31 December 2005. Based on this, most unitised with-profits pension policies will receive annual bonuses for the year to 31 January 2006 of 2.5%, whilst most unitised with-profits life policies received annual bonuses of 2%. The intention for the current year is to reduce these annual bonuses by 0.5%, to 2% and 1.5% respectively. This means that of the 16.1% of investment returns for 2005, policyholders who remain invested at the end of that year have had 2% or 2.5% locked in and must wait in hope for the remainder to be credited to their policies as part of their final bonus.

The complexities of with-profits

The reasons Standard Life and other life office actuaries have applied so little of the with-profits fund’s investment return to annual bonuses can be partly explained by the highly complex nature of the with-profits funds. As a starting point, we need to consider their liabilities as well as their assets. The reserves not only have to fund annual bonuses in years of negative investment returns and final bonuses, they must also meet promises previously made by the company.

These include, for example, the guaranteed annuity rates included in some pension policies, as well as annuities which have been in payment for a long time. Many of these exceed current market annuity rates and the reserves within the fund must meet the shortfall between the underlying value of the policy and the full cost of purchasing the annuity. Let’s take a simple recent example where the current open market annuity rate is 6.1%, whilst the guaranteed annuity rate on offer is 9.1%, and the fund value is £100,000. Here, £49,180 must be added to the policy value from the with-profits fund’s reserves in order to meet the annuity promised based on open market annuity yields. This represents an effective final bonus of nearly 50% for the policyholder, and of course reduces the reserves available to fund the annual and final bonuses for everybody else.

Guaranteed returns

Some insurance companies must also use their reserves to help fund the annual guaranteed returns included in a certain number of with-profits policies. In Standard Life’s case they are up to 4% for pensions and 3% for life policies. These guarantees have led to the segmentation of the Standard Life with-profits fund in order to group these policies in one sub-fund (there are six in total) so that each one can be managed to take account of the guarantees attaching to the policies in it. The segment with these guarantees is invested 63% in fixed interest securities, with only 19% in equities, in order to try to produce the returns required to meet the liabilities each year without taking too much risk. This must be viewed as a sensible approach, but intuitively it is difficult to envisage returns on these policies ever significantly exceeding the guarantees on offer, given the asset mix of the funds.

With all these issues in mind Standard Life with-profits policyholders should be weighing up their options fully armed with the relevant information. It is difficult to generalise given the differing nature of their contracts and the sub-funds that they are now invested in and whilst many holders of policies with guaranteed returns might be happy to receive 3% or 4% each year, some may prefer to take their chances in a slightly more aggressive fund. Of course, an additional factor that may have a significant impact on any decision to move away from the with-profit fund will be the possible application of a surrender or exit penalty on the plan. An experienced independent financial adviser will be able to guide you through this difficult area.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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