With-profits policies made clear

A with-profits policy is a long-term investment offered by insurance companies. People usually invest in them to get a lump-sum payment at a known date in the future or to get a yearly income with the possibility of investment growth over time. You may have a with-profits investment via a pension, endowment, bond or annuity. With-profits policies often include some life cover.

What happens to your money

Money from all with-profits policyholders is combined, or pooled, into a with-profits fund. The insurance company uses the money in this fund to invest in different types of assets, normally shares, commercial property, gilts, corporate bonds and cash deposits. Different insurance companies invest different amounts in each type of asset; some have mainly gilts and corporate bonds, others have more shares or property.

How much money you will get back

Most policies pay out a guaranteed amount at the end of the policy. This guarantee will be subject to the conditions set out in your policy documents, for example you may have to continue to pay all your premiums. The payout might be in one lump sum, or a series of payments. The insurer may also add bonuses to your policy each year. This increases the amount of money you are guaranteed to get back at the end.

Bonuses

Bonuses are a way for your insurer to add investment growth to your policy. Typically, there are two types of bonus: the annual bonus (which may also be called a regular or reversionary bonus) and the final bonus (which may also be called the terminal bonus).

• Annual bonus
  
  Once a year the insurance company will decide the amount of annual bonus it will add to your policy – the way in which these bonuses are added will vary depending on your policy. Insurers do not have to add a bonus each year. But once an annual bonus has been added it cannot be taken away – provided that you continue to meet the terms and conditions set out in your policy documents. If you decide to cash in your policy early you may lose any annual bonuses that have been added.
  
  
• Final bonus
  
  A final bonus is calculated when your policy matures and it is used to top up the value of your policy so you get your fair share of the with-profits fund. If you decide to cash in your policy early you may also receive a final bonus, but it is likely to be less than the bonus you would receive if you kept your policy to maturity.

How bonuses are decided

The amount of bonus, and whether a bonus is added at all, mainly depends on how well the investments in your fund have performed and how your insurer expects them to perform in the future. But instead of sharing out the profits the fund makes each year, insurance companies use a process called smoothing.

This means that they hold back some of the investment returns in good years and use it to top up bonuses in other years. This gives you some protection from poor market conditions, particularly if your policy matures in a year of low investment returns. But if investment returns are poor year after year, this can result in very low annual or final bonuses – or none at all.

Are bonuses guaranteed?

No. Bonuses may not be added if investment returns are poor year after year or if there is a large market fall in one year followed by a slow recovery. But once any annual bonuses have been added they cannot be taken away, provided that you continue to meet the terms and conditions set out in your policy documents.

Ending your policy early

The guarantees that were promised at maturity may no longer apply. Guarantees can be very valuable so before ending a policy early you should check whether your policy includes any of these. If it does, consider whether these are so valuable that you would be better off keeping the policy.

If investment returns have been low the insurer may also apply a market value reduction or adjustment (MVR or MVA) to ensure you do not leave the fund with more than your fair share of its assets. This is to protect policyholders who remain in the fund, but it may mean that you receive less than you expect.

If you decide to end your policy early, and if your policy includes some life cover, you will lose that protection. So you should think carefully about any security you need to provide for your family. If you still need life cover find out how much it will cost to replace it; the cost of taking out life cover can go up as you get older, and if your health situation has changed, a new insurance company may charge you more to replace your life cover.

If you are thinking about ending your policy early see What to do with your policy.

Other guarantees or options your policy may include

Some pension policies have a guaranteed annuity rate (GAR). This means that when you retire the insurance company will pay your pension at a particular rate, which may be much higher than the rates available in the market when you retire. GARs only normally apply on a particular date, normally your expected retirement date, which would have been specified when you took out your policy. If you retire before or after this date you may lose this guarantee.

Some polices may also have MVR-free dates when you can end your policy early without paying the MVR. These dates are often at particular points, like five or ten years after you started the policy, or at a particular retirement age. Your insurer should tell you when these apply.

More information

Look in your policy documents or your insurer's guide to with-profits. Your insurer should also be able to answer factual questions about your policy, but it may not be able to advise you what to do.

If you are unsure what to do you should speak to a financial adviser – see Getting financial advice.