Cashing in with-profits policies

I have a with-profits policy which was purchased in 1992 with a compulsory five year life. I have noticed that the terminal bonus declared by the company has been falling. It is currently paying 3.5% pa in normal bonuses. Should I cash it in?
John McCormack, Liverpool

There has been much concern over with-profits policies, their falling bonus rates and the market value adjustments that are now applied when investors want their money, and it is not surprising.

It is estimated that there could be as much as £500bn invested in with-profits funds and in 2001 there was over £15bn still being sold.

The attraction of with-profits funds was they would smooth the returns of the equity market and yet provide a better return than bank or building society deposits.

The fact that many with-profits funds held up to 70% of their assets in the equity market was often not made clear so as soon as the equity markets stopped performing with profits funds were always going to struggle.

With-profits funds are not and should never have been bought as a guaranteed investment despite the fact they were promoted as such by some of the largest and best known insurance companies in the UK.

They have never been transparent in terms of their charges, performance or where the actual returns are coming from.

As a guide you could look at the performance of the particular insurance company's unitised managed fund - often this will give you a guide to how good a fund manager the insurance company actually is.

Indeed, had more investors paid attention to Equitable Life's poor unitised performance they may well have encashed their policies long before Equitable Life ran in to trouble.

So where do investors now go if they want or need a better return than cash deposits but are nervous of the equity market?

There are two possible choices - one is relatively new to private investors and the other is well established but often misunderstood.

Covered warrants

While investing in covered warrants can be risky as they are volatile and can offer geared exposure to equity markets, used in the correct way they can also be a safe investment.

For example, if you invested 85% of your money in cash, the interest that you earn would rise to return your original 100% and the other 15% could be invested into warrants so benefiting from any stock market rise.

The maximum loss would be 15% as 85% of your money is in cash from day one so the majority of your investment is accessible.

Structured funds

While these come in many different guises many often work in a similar way to a covered warrants (i.e. most of the money is in cash and some of the money is invested in derivatives).

There is a structured fund currently available where you will get 100% of your money returned after six years and 100% of the rise in the FTSE index over this period.

This understandably makes people think that this should therefore be considered as an equity alternative.

However, structured funds are often misunderstood as this particular investment will also pay out 121p for every 100p after only three years if the FTSE is up by more than 21%.

This equates to 7% p.a. (which is capital gains taxable, so tax free if you have not used your allowance) compared to the 2 to 3% you will get by holding cash.

So despite the demise of with profits, there are other available alternatives for investors in these nervous markets.

I strongly recommend you seek individual advice from an IFA before coming to a decision.

Jonathan Fry, managing director, Premier Asset Management

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.