With Profits

With profits funds are a type of pooled investment fund, normally run by insurance companies or mutual societies. The funds are invested in equities, bonds, gilts and property – although this varies depending on the fund and its objectives. With-profits can be used to save into endowments, life insurance, pensions and bonds.

Many people have chosen to invest in with profits funds in the hope they'll earn a higher return than they would receive with a traditional savings account. Customers pay a monthly premium for a set term and the money is invested in a with profits fund and pooled with payments from other customers.

At the end of the term, the insurance firm pays out a lump sum. Investors should also receive regular bonuses over the period of their investment and a final bonus at the end of the policy's term. The policy may also offer some level of life insurance cover.

The idea behind with profits funds is that they give customers a taste of the stock market but at a reduced level of risk as they smooth out fluctuations. Smoothing means that when there is good investment growth, companies should hold back profits and use them to top up bonuses in years when the economy isn't doing as well.

The problems

Anyone who decides to withdraw their money from a with profits fund early will be hit by penalties – known as Market Value Adjusters (MVAs). These are applied to ensure that if you do decide to leave you won't leave with more than your fair share. MVAs can be as high as 18%.

All is not lost however. Most funds have a short period where you can get out without paying the MVA, this often comes after you've had the fund for ten years. A vast number of people invested in with profits funds at the turn of the century, so many policies should have already reached or should soon reach their MVA-free day.  It's well worth checking your policy and waiting for this date if you do want to withdraw your money.

There is also an issue surrounding the performance of with profits funds. Many were severely hit with the dot-com crash of 2000 and as a result, funds that were too heavily invested in these stocks had to switch to less risky investments. The trouble with that strategy is that these funds then struggled to make up the losses as they were now investing in safe fixed-income investments rather than riskier stock markets.

Tying in with this, there has also been a lot of criticism about the lack of clarity about the risks involved when investing in with profits funds. Many investors who have taken out policies have felt the risks were not sufficiently explained to them at the time and many mis-selling cases have been reported to the Financial Ombudsman Service.

And the problems don't end there – there is also a lack of transparency when it comes to fees. Because returns are 'smoothed', it's difficult for policyholders to work out the fees they are being charged, as well as understand whether their returns are being held back due to smoothing or due to mis-management, management costs and adviser commissions.