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Known knowns

By Ian Millward, published 23 January 2018.

There are known knowns … and then there is a guarantee from a Life Office.

As Donald Rumsfeld famously said:
'There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don't know.'

I am not sure where Mr Rumsfeld is these days, but I have a suspicion he has found himself a role working in the With Profits department at Standard Life. Let me explain.

With Profits investments are something of a dying breed these days but they were all the rage in the 1980’s and 90’s. In simple terms the Life Office ran an investment fund (shares, bonds, property etc) but insulated investors from the roller coaster ride of the stock market by instead paying regular bonuses. When markets shot up they paid a sensible bonus and held the excess returns in reserve, so they could continue paying a similar bonus in the tough years. Once added these bonuses could not be taken away plus there was the expectation of a final terminal bonus at the end. However, even though the bonuses couldn’t be taken away the Life Office could arbitrarily impose a penalty if it wanted.

So really the returns relied on the good nature of your Life Office .Yes I did use the words ‘good nature’ and ‘Life Office’ in the same sentence and, of course, therein lies the flaw.

But one thing you can say about actuaries is that they have generally been consistent when it comes to getting their predictions wrong. And when it came to With Profits some of them were so confident in their products that they provided open ended guarantees – never imagining we would live in a world where returns of just 2 or 3% would have us all in a clamour.

We have recently looked at a Standard Life pension that contained 2 different versions of their With Profits plan. Both plans offered a 'valuable' guarantee.

Plan 1 guarantees that the capital value will never fall under any circumstances. The only snag is that the bonus rate has fallen to 0.5% a year. It was also 0.5% last year and 0.75% the year before. Remember this is not a bank account, it is a long-term investment fund supported by shares, bonds, and property. These assets, and shares in particular, have done well over the last 3 years so these returns are nothing short of derisory and certainly not in the spirit of the original product.

Plan 2 guarantees an annual return of 4% p.a. Now we are on to a winner. But hang on. This plan does not guarantee the capital and actually there is a penalty in place – which is about 17% of the value of the plan. So the same plan has a guaranteed return and a penalty. To most of this would translate that the product does not in fact offer a guaranteed return of 4% p.a. but it just goes to show how little we know!

I think this is how Donald may have explained the situation -

'There are known returns, there are returns we know you will receive. We also know there are penalties that were probably unknown to you; that is to say we know there are known returns that we know you won’t get if you actually want your money. But there are also unknown returns – these are the returns that you probably thought you were going to get when you signed up for this product but let’s face it you should have known better.