Is the writing on the wall for with-profits funds?

Would you invest in a product that most independent financial advisers won't touch with a bargepole now that they are no longer being paid to recommend it?

This is the question facing those considering putting money into a with-profits fund - as well as millions of savers who have existing with-profits investments ranging from endowment policies to pension plans.

Scepticism about the wisdom of with-profits has been growing for years, but the decision of Legal & General, previously one of the market leaders, to close its fund to new business earlier this year could be the final nail in the coffin for this type of investment.

L&G's decision was based, the insurer explained, on a lack of interest in the fund since the industry-wide Retail Distribution Review (RDR) of January 2013.

DINOSAURS

The fact that RDR - the reforms that banned financial advisers from taking sales commissions when recommending products to clients - was a trigger for the demise of the fund speaks volumes. It suggests advisers can find no reason to recommend with-profits now they are not being paid to do so.

'With-profits funds are the dinosaurs of the investment world,' says Philippa Gee, the managing director of Philippa Gee Wealth Management. 'No one in their right mind would consider going into these funds as a new investor, and the writing has been on the wall for a very long time.'

Danny Cox, head of advice at independent financial adviser Hargreaves Lansdown is equally unequivocal. 'With-profits should be consigned to history,' he says. 'It's a product of the past, but with none of the fond nostalgia attached.'

The problem is that with-profits funds have all too often failed to deliver what they promise. In theory, the idea is to smooth out the ups and downs of market cycles over a fixed term.

Funds invest in a broad range of assets to manage volatility, and additionally pay returns in the form of annual and final bonuses. These bonuses rise and fall each year depending on how well the fund is performing - but once paid they are locked in, so investors shouldn't see their money fall in value.

In practice, with-profits funds have often produced disappointing returns - insurers have routinely failed to capture the upside of market movements and then not had sufficient room for manoeuvre during the downside. This is why so many endowment-linked mortgages came up short of the funds required to repay loans in full, for example.

Moreover, a lack of transparency in with-profits means investors have very often been paying uncompetitive charges for many years - not least to fund commission payments to all those advisers. Penalty fees for cashing in your money early or taking it elsewhere have compounded the misery.

For all that, the concept still has its defenders. Vince Smith-Hughes, head of business development at Prudential, argues that predictions of with-profits' demise are untimely. 'With-profits investments are hugely relevant to consumers who are looking for consistent, medium to long-term returns and access to a wide range of asset classes,' he argues.

KEEPING THE FAITH

Stephen Shone, managing director for existing business at Aviva, has also kept the faith. 'Our with-profits funds continue to perform well for our customers,' he says. 'With average savings accounts yielding low returns and stock market fluctuations an ongoing concern, the key strength of with-profits is its ability to invest in a wide range of assets while protecting from the full effects of volatile markets.'

To some extent, the figures support these arguments. The latest bonuses declared by insurers, all announced in recent months, have held up relatively well.

Several insurers raised bonuses across the board - including market leaders such as Prudential and Standard Life, as well as closed fund giant Phoenix. Legal & General and Aviva mostly kept bonuses on hold, while Friends Life and LV= cut bonuses for some policyholders but were able to raise them for others.

Still, the long-term record is hugely variable. A Prudential 25-year endowment policy maturing in May will be worth £31,438, assuming monthly contributions of £50. The equivalent policy with Aviva was worth £28,869 when it matured in January, while at Standard Life and Scottish Widows, the comparable figures are £27,304 and £25,842 respectively.

In fairness, these returns are far from terrible. Prudential's performance is the equivalent of an average annual return of 5.3 per cent. That was ahead of cash over the same period, which returned 2.3 per cent a year, and, impressively, actually ahead of equities too, which could only manage 5.0 per cent.

The performance of Prudential's rivals was closer to 4 per cent or so a year, but for an investment vehicle that was always pitched as a middle path between safe-but-dull cash holdings and aggressive stock market investment, these figures look credible.

So why are financial advisers so against with-profits? 'Quite simply, there are usually better-performing, more tax-efficient and more flexible options available,' says Patrick Connolly, a certified financial planner at independent financial adviser Chase de Vere. 'This is especially the case since we've seen more flexibility in individual savings accounts and pensions.'

Connolly argues that it is now possible for most investors to build a portfolio of assets with the same risk and return profile as a with-profits fund - typically with a diversified portfolio of collective investment funds sheltered from tax inside an Isa or a pension - but with much lower charges. The growing sophistication of the investment products market has simply rendered with-profits out of date, he says.

TAKE A DIY APPROACH

The DIY approach also gives investors the option of changing their investment strategy if their circumstances change (or if performance disappoints).

With-profits funds, by contrast, often lock investors in - there may be penalties to pay for cashing in early, while some insurers reserve the right to levy 'market value reductions' on unscheduled withdrawals, taking away some of the bonuses previously awarded.

What should existing with-profits investors do? In an ideal world, says Danny Cox, most of these investors would now move their money into the sort of investments Connolly describes.

'Investors should head for the exit, but they will need to be careful of bonus reductions or exit penalties incurred when cashing in,' he says. It's also possible that withdrawing your money could trigger tax charges.

In addition, points out Philippa Gee, many with-profits funds were set up with the promise of minimum payouts or other valuable guarantees. 'You should investigate both what certainties you would be giving up if you were to stop your investment altogether and what potential benefits you might also lose,' she warns.

It may be that the cost of charges and penalties, or of lost benefits, will be too high for investors to have time to recoup any losses - even assuming they can find better-performing investments to switch their savings into. They may be better off staying put.

Against that, however, investors in funds such as L&G's with-profits plans, now closed to new business, must watch out for another pitfall. The managers of these closed funds - often described as zombie funds - now have little incentive to compete with their peers, which may mean performance suffers.

In some cases, managers may even be tempted to shift investors' money into assets that match their liabilities - likely to be lower-risk investments such as bonds - rather than continuing to focus on growth. In which case, bonuses in future, including the all-important terminal bonus paid on maturity, are likely to tumble.

Broadly speaking, the greater the proportion of the insurer's with-profits fund held in equities, the greater the potential for better returns. But only financially strong insurers can maintain such asset allocation policies. 'There may be perfectly good reasons why existing policies should be retained,' concludes Connolly.

10 QUESTIONS TO ASK BEFORE YOU CASH IN YOUR WITH-PROFITS INVESTMENTS

1. How strong is my product provider?
2. Where is the with-profits fund invested?
3. What bonus rates are being paid?
4. Is it an open or closed with-profits fund?
5. Are there any exit penalties or market value reductions if I withdraw my funds?
6. Is there a date or minimum term after which penalties and MVRs are no longer charged?
7. How long is it until the policy matures?
8. Does the policy have any guarantees?
9. Will I face a tax liability if I surrender the policy?
10. What would I do with the proceeds of the policy? Do I need the money?