The Smoothing Illusion | Honest Money Now

Smoothed investment products do not smooth. At best, they give you back what was yours in the first place (less fees). At worst, they level down.

What is smoothing?

Smoothing is a feature particularly of with-profits endowment policies or other unitised insurance products. These products invest your money in a general fund. The fund goes up and down. But your own investment return is reported to you each year as a small annual bonus.

You do not receive actual cash. When you withdraw you get your original investment, the accumulated annual bonuses and a terminal bonus.

The big question

In any supposedly smoothed investment, ask yourself: Who is picking up the downside tab? And why?

When times are good....

Now it's pretty clear how this works in the good times. Some money is always held back to cater for the slumps. When you withdraw it becomes safe to reveal your safety cushion and pay a terminal bonus.

But when times are bad.....

Why doesn't it just work the same way? Of course your terminal bonus will be small or zero, but at least you have a small positive return (the declared annual bonuses) in a falling market.

To answer this, you must ask the question: what should an investor do when he has bought a smoothed investment, received a few small annual bonuses and then seen the market collapse?

Clearly he should sell! Because if he stays in, any future gains will be used to offset the losses already made but not yet declared. Whereas if he gets out, he will be able to start afresh somewhere else, free and clear.

Or maybe you think past gains of the existing long term investors in the fund will be used to cover the losses of the new investors? In that case the long term investors should sell, to preserve their gains against the depredations of the new investors.

The fact is that after a bear market everybody should try to sell their smoothed investments.

The insurance companies have to prevent this. So they impose something called a Market Value Adjustment (MVA) on withdrawal. This is an exit penalty. It is no different from a negative terminal bonus. And it prevents the holders of smoothed investments from ever taking real advantage. Because the smoothing is an illusion, you see.

Levelling down

And when terminal bonuses are paid - whether positive or negative - do you think they fully represent the excess returns made? Or do you think something is kept back for a rainy day? Given that the actual performance of the funds is never revealed?

To sum up.....
So it is not too unkind to describe these smoothed products as follows:

You give someone your money.
They put it in a fund.
They charge the fund for their services.
You receive a letter once a year with a fantasy number in it. This is called the annual bonus. It is a fantasy because you cannot cash it in.
When you want to realise your investment the amount you actually receive is adjusted by a positive or negative amount to bring fantasy back to reality.
But not too close to reality. Just in case.

The lesson from 2000/03

Some truths can only be learned in a sustained bear market.

In early 2005 insurance companies announced cuts in bonus rates, despite the market having a very good 2004. And they were perfectly upfront about the reasons: they needed to recover the losses made in the post-2000 bear market. And MVAs (exit penalties, in other words) remained at around 20%. So you remained locked in with low bonus rates until the market recovery erased past losses.

So, as a buyer of a smoothed investment product in 2000 you would not have avoided the bear market; you would just have avoided being told about it.

To sum up...

These products only worked, if they ever did, because a) savers did not have the wish or knowledge or skill to 'trade against the institution' and, b) savers trusted the company to fairly distribute the proceeds of investment - taking (gently) from the lucky to support the unlucky.

Those days are gone.