With-profits funds are a type of ‘pooled investment’ fund. This means that you pay into the fund along with a number of other investors and your money, along with that of other members, is put together and invested in stocks, shares, equities, bonds and property over a set period of time. This diversity, and the ability to change the proportions invested in each of these types of investment, helps to balance the level of risk and the expected increases in the fund value in the long-run.
What distinguishes with-profits funds from other pooled funds is ‘smoothing’. Smoothing aims to reduce the direct impact of market changes on the fund investments and means that investors are less directly exposed to rises and falls in the value of their investments over the shorter-term. This is of great benefit especially where a with-profits fund is being used to fund something which happens at a specific date such as retirement.
With-profits funds should should ideally be held for 10 years or more.
Investors in with-profits funds do not get to see the actual value of the underlying assets. The value of the underlying fund changes daily, but customers fund values grow by a steady rate, called the regular bonus rate, which is calculated annually. Whilst your fund value grows steadily with regular bonus, it may be lower or higher than the value of the underlying assets. Generally, regular bonus rates are set at a level lower than the growth expected from the fund in the long run, and to make up the difference a terminal bonus is paid out at the end of the investment period.
This smoothing mechanism helps restrict the variation in payout on the day the customer needs it - ie when the product matures. Customers can still get their money out at other times: but for smoothing to work, there needs to be a mechanism to protect the whole fund from being depleted from investors trying to exit after a market fall. This protection is called a market value reduction (MVR) or a market value adjustment (MVA). If a customer wishes to withdraw from the fund early at a time when the market value of the fund is reduced, the customer may find his pay-out is reduced by an MVR/MVA so that the payout reflects the reduced market value of the fund in a manner which is fair to all customers.
However, to protect customers from market falls just at the moment when the customer genuinely needs the funds (as in a pension maturity), many providers guarantee that they will not apply MVRs upon certain events. That means that fund values paid out will be at least initial investment plus regular bonuses less any withdrawals you have made (including adviser charges).