What is a with-profit fund?

With-profit funds are an alternative investment to both cash deposits and fund investments. They allow the investor to spread their risk across several investments, leading to a strategy that outperforms cash deposits while being a safer alternative to managed funds.

As such, these investments continue to be a significant part of the UK's investment landscape. The objective is to smooth out the impact of market fluctuations by holding back some profits in good years to subsidise bonuses during a weaker market performance.

With-profit funds are used within savings, pensions, investments, and life insurance products and are designed for the medium to long term.

What are the risks?

With-profit funds are generally for individuals seeking a safe yet potentially risky investment that is likely to outperform cash deposits, as well as offer protection.

With-profits policies are suitable for investors who want to spread their risk or prefer a less volatile option compared to many managed funds.

The level of risk and the expected increases in fund value can be balanced due to diversity and the speed with which the amount invested in each type of investment can be adjusted.

How are with-profit funds paid out?

With-profit investment returns are shared out as bonuses, of which there are two main types: 

• Regular bonuses can be added to your policy each year, and many with-profits policies guarantee a minimum payout on specified dates or events.
• A final bonus may be added when your policy matures or, in some cases, if you move out of with-profits by switching to another fund.

 

Smoothing

What sets with-profit funds apart from other pooled investments is a feature called smoothing. This approach aims to mitigate the immediate impact of market fluctuations, thereby reducing the short-term fluctuations in the value of investors' investments.

The underlying fund value changes daily, but customers' fund values grow at a steady rate (regular bonus), which is calculated annually. 

Typically, regular bonus rates are set below the long-term expected growth of the fund. To bridge this gap, a final or terminal bonus is often paid out at the end of the investment period.

Market value reduction (MVR)

Smoothing helps limit the variation in payouts at policy maturity.

Customers can still access their money at other times, but for smoothing to work, there needs to be a system that protects the entire fund from being depleted by investors trying to exit after a market decline. This is referred to as a market value reduction (MVR). 

An MVR is an adjustment factor that can be applied to members who leave a with-profits fund scheme early or at times other than those specified in the terms and conditions, particularly following a large or sustained fall in the stock market. 

This ensures that those leaving the fund do not receive more than their fair share of the underlying investment and means that all with-profits customers are treated fairly.

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Due to the MVR, it's worth noting that holding with-profit funds for at least five years is recommended for optimal results. It normally offers two types of bonuses that, once added, cannot be taken away and, in some cases, offer a guaranteed minimum return.

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