While with-profit bond providers are defending their products after Canada Life's withdrawal, they agree further cuts in annual bonuses are inevitable, writes Laura Slattery

With-profit bonds have come under attack of late. Canada Life recently closed its bond to new investors with the warning that anyone buying now would only end up subsidising losses created by over-generous bonuses already awarded to existing policyholders in a turbulent market.

Companies still in the market for new customers understandably have been defending their products, affirming that with-profit bonds are still as good an option now as they ever were.

A with-profit bond is a capital-guaranteed investment product that smoothes out returns over the term of the investment, protecting the investor from bumps in the market.

Each year, fund managers will announce a bonus rate. This annual bonus is then added to the lump sum invested and cannot be taken away. Policyholders will also be promised a terminal bonus on maturity of the bond.

The first concern for with-profit investors at the moment is that annual bonuses have already been cut to reflect the falling equity markets over the last two years. For example, this year's bonus rate for Hibernian's Celebration Bond is 5 per cent, down from 6 per cent in 2001. Friends First reduced its rate from 6 per cent to 5.25 per cent and Scottish Provident went from 5 per cent to 4.75 per cent.

The danger is that bonus rates will fall so low they will start to make some deposit accounts and other types of capital-guaranteed investments look more attractive. Already, once management fees of between 1 and 2 per cent are built in, there is little difference between the returns on with-profit bonds and the better deposit accounts.

Companies offering bonds will point to the terminal bonus but these are not guaranteed and, as Equitable Life investors discovered, can be undermined by circumstances.

According to Ms Brenda Dunne, appointed actuary with Canada Life, unless markets recover significantly before the next bonus declarations early in 2003, bonus rates will need to be 3 per cent or lower to make up for losses already made.

While the remaining with-profit bond providers broadly agree that further cuts are, as Ms Dunne claims, inevitable, none are quite so pessimistic about how much they will fall.

"Based on current market sentiment, we would expect a reduction in bonus rates, but I don't think it will be by more than 1 per cent. People have been talking about bonus rates collapsing altogether, but we don't think that will happen," says Mr Munroe O'Dwyer, product development manager at Scottish Provident.

"We would anticipate that the bonus rate would come down next year, but only marginally," says Mr Karl Symes, investments marketing manager for Irish Life, which this year maintained its 2001 bonus rate of 6 per cent. A spokesman for Hibernian says that "in all probability" bonus rates will come down next year, perhaps to between 3.5 and 4.5 per cent.

Hibernian offers new investors in its Celebration Bond a special introductory first-year rate, which this year ranged from 5.5 per cent to 7.5 per cent, depending on the amount of money invested. "The way most companies would like to do it would be to have more flexibility for the managing of the bond and not build up expectations on the terminal bonus," says the spokesman.

But it is important not to attach too much significance to first-year introductory offers and higher-than-average annual bonuses.

A high bonus rate could simply mean the life assurance company has brought part of the terminal bonus forward: the returns will be smoother, but they won't necessarily be greater.

Irish Life says in its brochure for its Secure Investment Bond that it expects to pay about two-thirds of the profit the11 investments generate in the form of annual bonuses and pay the final third as a terminal bonus. But if the annual bonuses already set aside for the investor equals his or her share of the fund profits, the investor will not receive any terminal bonus.

Annual bonuses are "only a means to an end", argues Mr O'Dwyer of Scottish Provident, which, at 4.75 per cent, has a lower-than-average rate.

"It's not the bonuses that are declared in any one or two years that count, it's how the underlying assets perform in the medium to long term," he says.

Regular withdrawals can be made from with-profit bonds up to certain limits, but if an investor exceeds these limits before the end of the investment term, an early exit penalty called a market value adjustment (MVA) may apply, depending on when the bond was taken out.

For example, at Friends First, an MVA of 15 per cent applies to early exit if customers took out the bond between January 1st, 1998, and May 31st, 2002.

An MVA is designed to protect continuing policyholders by ensuring that the fund does not suffer unduly from early exits when markets are depressed. Not applying an MVA would mean using policyholders' money to subsidise these customers at the expense of longer-term returns in the with-profit fund.

MVAs are subject to ongoing review of market conditions and can be applied or increased at a later date. So it is important that investors be prepared at the outset to have their lump sum tied up in the bond until the capital guarantees kick-in, usually on the fifth or tenth anniversary of the bond.

One exception is Irish Life's Secure Investment Bond, which provides guarantees after seven years and every year thereafter. This product has an annual management charge of 2 per cent, about half a per cent above the average.

With-profit bonds are a cautious investment at the best of times, but some providers are now treading even more carefully, cutting the proportion of the funds normally invested in equities. Irish Life has just announced that, following a review of its with-profit bond, it has decided to reduce the amount of the fund invested in shares from 80 per cent to 70 per cent, with the rest invested in fixed-interest securities.

"We feel it's a slightly more prudent approach to take," says Mr Symes.

Friends First has much less exposure to equities, at 39 per cent. Hibernian's equity content is 46 per cent, down from 58 per cent last year, while Scottish Provident has between 40 and 45 per cent in equities, down from 70 per cent.

"Our fund manager has reduced our equity content in response to the market conditions. We haven't sold any equities, but any new business in the fund is not invested in equities," says Mr O'Dwyer, adding that "a little more clarity" is needed before boosting equity investment upwards.

So in comparison to other providers, Irish Life is still keeping the faith with equity markets, and Mr Symes points out that the higher the investment in equities, the better the ability of the bonds to recover from their partially underwater state. "Equities will provide better long-term returns," he maintains.

Companies want to maintain a higher level of returns, he says, but they also want to be able to give a higher level of guarantees.

For the with-profit bond investor, however, the promise of returns that are both guaranteed and high might sound a little too good to be true.

"Personally, I think they're good products for the cautious investor," says the spokesman for Hibernian. "The rate of growth has never been very high."