Few people understand the workings of with-profit schemes. Nick Gardner guides you through the basics

10 tips for investing in with-profits funds 

AT THIS time of year, insurance companies announce the annual returns on their with-profits funds. But few investors understand how the funds work - and whether they can pull out if dissatisfied. Here are 10 tips to guide you. 

1. What is a with-profits investment? 
Most people invest in a with-profits fund through an endowment policy linked to their mortgage. But with-profits funds are used for all types of investments, including pensions, savings plans, bonds and Isas. 

2. How do they work? 
Savers' money is pooled in a fund that invests in the stock market. The funds are supposed to reduce the risk by "smoothing" stock-market returns - gains made in good years are held back to boost returns in bad ones. The annual gains are paid out in bonuses, which, once given, cannot be taken away. When your policy matures (most with-profits schemes have a fixed life) you get a terminal bonus that can account for nearly half your total returns. 

3. What is the advantage of smoothing? 
The bonus system should mean that the performance of your investment does not vary wildly from year to year. Also, if the stock market were to crash when your policy was about to mature, the locked-in gains would theoretically offer you some protection. In practice, however, the company managing the fund can simply cut your terminal bonus to make up for money it has lost. 

4. Can I cash in the investment at any time? 
Yes, but it is unwise to surrender a with-profits plan before the end of the term, when the terminal bonus is paid. If you cash in very early - in the first few years - you may not get back what you put in. Even if you wait a few years, you will probably have to pay a penalty. Such inflexibility is one of the biggest flaws in a with-profits plan. There have even been calls for endowments to be banned because of their punitive rules and high charges. 

5. What if I need the money? 
You have two options. You can surrender the policy to the manager, who will give you back whatever your policy is worth, minus charges and any penalty fees, or you can call a second-hand endowment trader. According to Lee Portnoi, chairman of the Association of Policy Market Makers (APMM), about £1 billion worth of policies were surrendered last year that could have been sold on the second-hand market. If your policy is suitable, the firm can usually pay you up to 15% more than your existing company. Call APMM for details of local traders on 0171-739 3949. 

6. How much do with-profits schemes cost? 
For most savers who invest regularly, charges are far too high. On a 25-year policy, investors usually have to keep payments going for eight years before they can cancel and get all their money back. On lump-sum investments, the charges are a more reasonable 5% or so. 
7. What investments work best as with-profits plans? 
With-profits annuities tend to pay more income on retirement, but they can be risky. If stock-market performance is bad, your income will fall. Otherwise, there is nothing with-profits policies can do that most other investments cannot do better. 

8. What is the worry about endowment mortgages? 
The gamble with endowment mortgages is that your policy may not grow enough to clear the mortgage debt. When you take out an endowment, the salesman or adviser calculates your monthly premiums based on an assumed growth rate. In the late 1980s, this was typically 8.5%, compared with 6% today. Each year, your policy must pay out an annual bonus at least equal to the assumed growth rate in order to stay on track. But bonuses have been falling consistently in recent years and the first bonus announcements of this year even fell short of the more conservative 6% figure. Many homeowners will have to raise premiums to make up the shortfall. 

9. Is an endowment home loan ever appropriate? 
Only if you are prepared to gamble your property on the stock market. Most sensible advisers regard endowment mortgages as unsuitable for all but a tiny minority of homeowners. 

10. Are with-profits savings schemes better than unit trusts? 
It depends on your attitude to risk. Unit trusts tend to perform better, especially if wrapped inside the tax shelter of an Isa. But they can also drop dramatically in value in the event of a stock-market crash. If you have a with-profits plan, the annual bonuses credited to your policy are guaranteed: once given they cannot be taken away. 

The Sunday Times January 23 2000