|Smoothed investment products do
not smooth. At best, they give you back what was yours in the
first place (less fees). At worst, they level down.
What is smoothing?
Smoothing is a feature particularly of with-profits endowment
policies or other unitised insurance products. These products invest
your money in a general fund. The fund goes up and down. But your
own investment return is reported to you each year as a small annual
You do not receive actual cash. When you withdraw
you get your original investment, the accumulated annual bonuses
and a terminal bonus.
The big question
In any supposedly smoothed investment, ask yourself:
Who is picking up the downside tab? And why?
When times are good....
Now it's pretty clear how this works in the good times. Some money
is always held back to cater for the slumps. When you withdraw it
becomes safe to reveal your safety cushion and pay a terminal bonus.
But when times are bad.....
Why doesn't it just work the same way? Of course your terminal bonus
will be small or zero, but at least you have a small positive return
(the declared annual bonuses) in a falling market.
To answer this, you must ask the question: what
should an investor do when he has bought a smoothed investment,
received a few small annual bonuses and then seen the market collapse?
Clearly he should sell! Because if he stays
in, any future gains will be used to offset the losses already made
but not yet declared. Whereas if he gets out, he will be able to
start afresh somewhere else, free and clear.
Or maybe you think past gains of the existing
long term investors in the fund will be used to cover the losses
of the new investors? In that case the long term investors should
sell, to preserve their gains against the depredations of the new
The fact is that after a bear market everybody
should try to sell their smoothed investments.
The insurance companies have to prevent this.
So they impose something called a Market Value Adjustment (MVA)
on withdrawal. This is an exit penalty. It is no different from
a negative terminal bonus. And it prevents
the holders of smoothed investments from ever taking real advantage.
Because the smoothing is an illusion, you see.
And when terminal bonuses are paid - whether
positive or negative - do you think they fully represent the excess
returns made? Or do you think something is kept back for a rainy
day? Given that the actual performance of the funds is never revealed?
To sum up.....
So it is not too unkind to describe these smoothed products as follows:
- You give someone your money.
- They put it in a fund.
- They charge the fund for their services.
- You receive a letter once a year with a fantasy
number in it. This is called the annual bonus. It is a fantasy
because you cannot cash it in.
- When you want to realise your investment
the amount you actually receive is adjusted by a positive or negative
amount to bring fantasy back to reality.
- But not too close to reality.
Just in case.
The lesson from 2000/03
Some truths can only learned in a sustained bear market.
In early 2005 insurance companies
announced cuts in bonus rates, despite the market having a very
good 2004. And they were perfectly upfront about the reasons: they
needed to recover the losses made in the post-2000 bear market.
And MVAs (exit penalties, in other words) remained at around 20%.
So you remained locked in with low bonus rates until the market
recovery erased past losses.
So, as a buyer of a smoothed
investment product in 2000 you would not have avoided the bear market;
you would just have avoided being told about it.
To sum up...
These products only worked, if they ever did, because a) savers
did not have the wish or knowledge or skill to 'trade against the
institution' and, b) savers trusted the company to fairly distribute
the proceeds of investment - taking (gently) from the lucky to support
Those days are gone.