UK Closed Life Funds – A Secret Returns Goldmine?

More than 200 years ago, Equitable Life, the now defunct UK mutual life insurer, realised that they were making excess profits and started distributing them to policyholders via reductions in the following years’ premium. This profit distribution evolved into making annual increases to the sums insured; the next evolutionary iteration was to deliberately load premiums to allow for scope to intentionally generate “profits” by diverting the additional margin into riskier but hopefully more profitable assets. Finally, insurers were doing so well, especially from a buoyant stock market, they began adding a further “terminal” bonus to pay-outs funded from the excess returns they achieved that had not already been distributed through annual additions.

This style of product, so-called “with-profits”, became a commonplace savings vehicle in the UK and spread around much of the Commonwealth. UK Prime Minister Margaret Thatcher’s private personal pensions revolution in the mid-1980s created yet more demand for this form of hybrid investment – guarantees but with equity driven upside – as did a tax relief on mortgage interest in 1983 that created a boom in life assurance-based saving.

However, with-profits was not a perfect panacea in all economic climates. When inflation, and consequently interest rates, began to fall, the cost of providing a guarantee in nominal terms became increasingly expensive. It also got regulators twitchy because high guarantees mean an increased risk of insolvency. So, ironically, it was the failure of Equitable Life in the early 2000s that led to a rapid tightening of solvency reserving. That, the cost of guarantees impairing returns, and the cancellation of tax relief on mortgage interest, all turned against with-profits and by 2004, large funds began closing and consolidating. Today, there are only a handful of funds still writing new business – and those that are, do so at much reduced levels.

Many hands were wrung over the plight of these so-called “zombie” or “orphan” funds – closed to new business and in a state of run-off that nobody loved and nobody seemed to want to manage. Would policyholders’ expectations be curtailed by over-cautious investment strategies?

Some funds were undoubtedly in a terrible condition, and no amount of nursing would fully turn them around but, following the end of the dotcom bubble in 2004, and with careful guarantee management, a lot of these funds have not only returned to good health once again, but are now flush with surplus. Some funds may have been required to distribute the surplus to shareholders but most of them are contractually required to distribute the majority of the surplus to policyholders.

There was concern, especially amongst regulators, that a huge iniquity would develop: the insurer holding back the surplus for far too long, until just a handful of policyholders would be eligible for a massive payout – the so-called tontine effect. The regulator urged insurers to pay out as much surplus as they could, as soon as possible, to ensure a fairer pay-out to all policyholders that were still in the fund at closure. This has led to the build-up of some substantial additions to policyholders’ basic accrued asset shares.

The method and style of distribution was left to insurers and each of the many approaches favours certain policyholders such as long-stayers or those with distant maturity dates. Two of the main methods are to either bulk up the annual investment returns through an annual addition, or to simply divide all the surplus at any time amongst all policyholders and apply an equal share to all policies that become a claim (the so-called “terminal bonus addition”).

Much of this started in or around 2010 and the purchaser of a second-hand policy at that time has achieved a supra-return through these additions. A 30% terminal bonus addition emerging equates to roughly 3% per annum being added to underlying returns over a 10-year period. The table below shows the returns for the past 12 years of two funds which have chosen to go through the annual additions route:

Figure 2: Progression of Enhancements to Basic Asset Shares (8 Selected Companies), 2014 – 2022

*Adjusted for enhanced annual additions also made.

Source: W L Consulting (collation from life office’s own data)

Compounding the annual performance of these funds leads to some substantial “free” additions from surplus of 63% and 25% of policy assets, respectively. This is on top of the returns achieved on the underlying assets, which are broadly comparable with other mixed asset funds and give total returns of more than 7% or 8% per annum in an era when base rates were nearly zero.

Figure 2 below shows the equivalent additional return represented by the increase in the uplift in the terminal bonus addition between 2014 and 2022. National Mutual of Australasia had, for example, been enhancing pay-outs well before 2014 but by lower amounts than in 2022 and the 2%pa annual return uplift is equivalent to the terminal bonus addition rising from 75% to 105% only.

Figure 2: Progression of Enhancements to Basic Asset Shares (8 Selected Companies), 2014 – 2022

*Adjusted for enhanced annual additions also made.

Source: W L Consulting (collation from life office’s own data)

Is this of benefit to the ILS investor? Well, yes and no. Clearly, the tontine effect much talked about in the mid-2000s seems to be occurring, albeit much diminished by regulatory guidance. Access to surpluses is also significantly curtailed because of the decline to near zero of policies qualifying for these rewards. There do remain opportunities, but very much on a cottage industry level, unlikely to be of interest to the institutional scale investor. However, it is worth bearing in mind that there may be other pockets of untapped reserves that emerge in other markets, just as they have in the UK.

Roger Lawrence is Managing Director at WL Consulting