Understanding Aviva’s With-Profits Funds

What Are With-Profits Funds?
A with-profits fund is a type of pooled investment vehicle, traditionally offered by life insurance companies like Aviva, designed to provide a smoothed investment return over the long term. It aims to reduce the direct impact of short-term market volatility on the policyholder’s investment. Policyholders are entitled to receive bonuses, which are additions to their policy value. The core mechanism involves the insurer holding back some of the investment gains in prosperous years to bolster the fund during market downturns, creating a more stable and predictable growth path compared to direct equity investments. This smoothing process is a defining characteristic, intended to offer a middle ground between high-risk equities and low-risk bonds.

The Structure of Aviva’s With-Profits Funds
Aviva’s with-profits funds are part of long-term insurance contracts, often used for pensions, savings, or life cover. When an investor pays a premium into an Aviva with-profits fund, they are essentially buying units in the fund. The value of these units grows through the addition of two primary types of bonuses:

• Annual (or Reversionary) Bonuses: These are declared once a year and are added to the policy’s guaranteed value. Once applied, they cannot be taken away, meaning the policy’s guaranteed minimum value increases each year a bonus is added. This provides a foundation of secure, locked-in growth.
• Final (or Terminal) Bonus: This is a discretionary bonus added when the policy matures, is surrendered, or upon the death of the policyholder. It accounts for the fund’s performance that has not yet been distributed via annual bonuses. The final bonus is not guaranteed and can fluctuate significantly from year to year, representing the fund’s actual investment experience and the smoothing process in action.

The combination of these bonuses aims to deliver a total payout that reflects the overall performance of the underlying assets, minus costs, while mitigating the peaks and troughs of the market.

The Crucial Role of Smoothing
Smoothing is the fundamental principle that differentiates with-profits funds from unit-linked investments. The process works as follows:
In years when the fund’s underlying investments perform exceptionally well, the insurer does not distribute all of these gains to policyholders immediately. A portion is retained within the fund in a reserve known as the “inherited estate” or “smoothing reserve.” This reserve acts as a financial buffer.
In years when market performance is poor or negative, the insurer can use this reserve to top up policy payouts. This means that even during a market crash, a with-profits policy might still declare a small positive annual bonus or a reduced final bonus, rather than showing a dramatic drop in value. The goal is to prevent policyholders from experiencing the full brunt of market falls, providing a less volatile investment journey.

Underlying Assets in Aviva’s Fund
Aviva’s with-profits funds are typically invested in a diversified mix of assets to generate the returns needed to support bonus declarations. This asset allocation is managed dynamically and may change over time based on economic outlook and regulatory requirements. The portfolio usually includes:

• Equities (Shares): For long-term growth potential.
• Bonds (Gilts and Corporate Bonds): For more stable, income-generating returns.
• Property: Commercial real estate for income and capital growth diversification.
• Cash and Liquid Assets: To meet short-term obligations and manage liquidity.

The precise mix is a key determinant of the fund’s potential return and risk profile. Historically, with-profits funds held a high proportion in equities, but many, including Aviva’s, have gradually shifted towards a more conservative allocation of bonds and gilts as their legacy policyholder base has matured and regulatory capital requirements have increased.

Understanding the Mutual Nature and the Inherited Estate
Many with-profits funds, including those historically managed by Aviva (which merged with Norwich Union), were operated on a mutual basis. This means the policyholders were effectively the owners of the fund. The “inherited estate” is a surplus of assets within the fund that builds up over time. It exists for several purposes:

1. Smoothing: As the financial buffer for applying smoothing.
2. Providing Guarantees: To ensure there are sufficient assets to meet the cost of guaranteed benefits, such as minimum payout levels on certain older policies.
3. Absorbing Market Shocks: To protect the fund from extreme market events without forcing a fire sale of assets.
4. Funding Business Investment: To pay for new business acquisition and fund management costs.

The use of the inherited estate, particularly for purposes beyond direct policyholder benefit, has been a subject of scrutiny and debate in the financial services industry.

Key Features and Potential Benefits

• Smoothed Returns: The primary benefit is the reduction of volatility, offering a steadier investment experience, which can be highly valuable for risk-averse investors saving for a long-term goal like retirement.
• Professional Fund Management: Investors benefit from Aviva’s team of professional fund managers who make decisions on asset allocation and investment selection.
• Built-in Guarantees: Many older with-profits policies contain valuable guarantees, such as a guaranteed minimum annuity rate or a guaranteed minimum payout on a specific date. These can be extremely valuable in today’s low-interest-rate environment.
• Diversification: The fund provides instant diversification across a wide range of asset classes and geographic regions within a single product.

Important Considerations and Risks

• Lack of Transparency: The bonus declaration process is discretionary, and the precise calculation can be opaque. Policyholders do not see the day-to-day value of their underlying units as they would with a unit-linked fund.
• Discretionary Bonuses: Both annual and final bonuses are at the discretion of the insurer. While the aim is to be fair, there is no guarantee that bonuses will be declared every year, and they can be cut or omitted in poor performing years.
• Charges and Costs: With-profits funds have associated charges for management and administration, which are taken from the fund. The structure of these charges is not always as explicit as in other investment products.
• Market Value Reduction (MVR): Also known as a Market Value Adjuster (MVA), this is a crucial mechanism. If a policyholder surrenders their policy or makes a withdrawal during a period of poor market performance, an MVR may be applied. This deduction adjusts the payout down to reflect the underlying value of the investments, ensuring that those leaving the fund do not do so at the expense of the remaining policyholders. The MVR protects the smoothing process but can be an unpleasant surprise for those needing access to their money at an inopportune time.
• Complexity: With-profits policies are notoriously complex financial products. The interplay of guarantees, bonuses, and smoothing is difficult for many investors to fully understand.
• Performance: Over recent decades, the performance of many with-profits funds has lagged behind pure equity investments, particularly as their asset allocation has become more conservative. The smoothing process can work both ways, potentially limiting upside gains during sustained bull markets.

The Evolution and Current Status of Aviva’s With-Profits Fund
Aviva’s with-profits fund is largely a “closed fund,” meaning it is not actively marketed to new customers. The focus is on managing the existing portfolio of legacy policies to maturity. This run-off status influences management strategy; the primary goal is to meet existing obligations safely and securely rather than seeking high growth. The asset allocation has therefore been gradually de-risked over time, shifting from growth-oriented assets like equities to more matching assets like bonds. This de-risking strategy is designed to ensure the fund can reliably meet its guaranteed promises to policyholders as they approach their maturity dates.

Making Decisions About an Existing Policy
For current holders of an Aviva with-profits policy, deciding whether to continue or surrender it requires careful analysis. Key steps include:

1. Reviewing Your Policy Documents: Understand the specific guarantees, bonus history, and any special features your policy contains.
2. Obtaining a Current Projection: Request an up-to-date surrender value and projected maturity value from Aviva. Be sure to inquire if a Market Value Reduction (MVR) currently applies or could apply.
3. Assessing the Value of Guarantees: Older policies may have guarantees that are far more valuable than any potential growth from an alternative investment in the current climate. Surrendering such a policy could mean forfeiting significant benefits.
4. Seeking Independent Financial Advice: Given the complexity, consulting with an independent financial adviser who has expertise in with-profits policies is highly recommended. They can perform a critical yield analysis and compare your policy’s projected returns against other available options in the market, considering your personal risk tolerance and financial goals.