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APPENDIX (to letter dated 21 November 2001)

Equitable Life With-profits Fund ~ Should members surrender?

This note has been provided for the Administering Authority as a guide to some of the factors which may make individual surrender of Equitable with-profit funds more attractive in certain circumstances.  Neither William M Mercer Limited nor the Administering Authority can give you advice about what decision you should take, since they do not know anything about your personal and financial circumstances and attitude to risk.  These are crucial factors which affect any decision an individual might reach.  Therefore you must make your own decision on whether to surrender or not, and, if you are in any doubt, you should obtain your own professional advice.

1.  How bad could it get at Equitable?
The worst case is that Equitable becomes insolvent, in the sense of not being able to meet the policy guarantees and the necessary tests of its ability to do so laid down by the authorities.  Based on the information available from Equitable's published returns, it is not in this situation.

Were there to be a further significant deterioration in the markets, or some other major adverse development, solvency could become an issue. If Equitable were to become insolvent, there are provisions for other insurers to launch a rescue under the Policyholders Protection Act.  These are intended to secure 90% of guaranteed funds (including the 3.5% guaranteed return) at retirement or death, although they have never been applied before in this type of situation.  Surrender terms in the meantime would not be protected and all final bonuses would be lost.

If Equitable were to collapse - eg as a result of further stockmarket falls - other institutions would not be immune, and alternative investments in equity-type funds such as a managed fund would be suffering.

2.  What are the influences on future returns under the with-profits fund?
Although we have described the worst case scenarios above, more likely is that Equitable will continue, but investment performance in relative terms will be impaired by its weakness in terms of low reserves and the conflicting interests of policyholders.  Because of the problems with GARs (Guaranteed Annuity Rates) and subsequent events, the Equitable with-profits fund is now a closed fund with a relatively low inflow of cash and an increasing number of maturing policies. This makes it more difficult for Equitable to take a longer term view of the stock market and weather any short term fluctuations.

This is an important reason why falling markets have had such a dramatic impact, and it means that there can be expected to be far more volatility in payouts in future, relative to the past and other with-profits funds.  The Equitable fund no longer offers the conventional with-profits attractions of a smooth progression in return from year to year and this is unlikely to return.  Indeed it is anticipated that any success in their investment policy will only very slowly translate into improved payout levels, whereas any further problems will produce rapid reductions in payout.

No one can predict future returns on any type of investment - even the return on a simple investment such as a building society account varies significantly over a period of a few years (although it is always positive).  What is more important here is performance relative to that of alternative pension fund investments.

The most likely scenario for the next few years would appear to give with-profits returns at levels similar to those of government bonds or cash, close to the current 6% per annum being credited (but not guaranteed) by Equitable.  For those expecting to retire in this period, these are the likely alternative investment choices, and hence the chances of making up a penalty of 5-10%  are not particularly high. However, the risk of further cuts in with-profits payouts in a falling equity market is avoided by a switch into bonds or cash, and this might be seen as a price worth paying.

An important exception is if an individual member has a relatively high guaranteed fund at retirement, so that Equitable has not in practice been able to reduce their policy value by the full 16% headline figure, or has done so but leaving almost no non-guaranteed bonus in the process.  This is now likely to be the case if the "guaranteed fund" on the member's last benefit statement is around 80% or more of their "total fund", although the individual position varies.  If the member were to switch, then the balance of the 16% reduction would be applied as an additional penalty.

If someone is further away from retirement, most advisers would recommend an exposure to equity investments because these are expected to out-perform bonds or cash over the longer term - perhaps only by 2% to 4% per year on average, but this mounts up over many years. The price of this outperformance is greater volatility in the value of the member's investment from year to year. If this level of equity outperformance were to be achieved, Equitable with-profits would be likely to underperform direct equity investments by 1% to 2% per year, because of the relatively low proportion of the with-profit fund held in equities and the need to reflect the most recent market falls by being cautious with future distributions.  This would suggest recovery of a 10% penalty over perhaps 5 to 10 years or so in circumstances where the guaranteed proportion of the fund is relatively low - the period is longer if the guaranteed fund is higher as described in the previous paragraph.

If equities were to "boom", as was the case in the 1990's, they would overtake more rapidly.  The main rationale for remaining with with-profits is to retain the guaranteed policy value (plus the guaranteed 3.5% per annum return) which applies provided the policy is held to retirement.   In circumstances where equities underperform for a sustained period, this guarantee could prove to be valuable.

There is still a range of formal inquiries being conducted into the circumstances leading to Equitable’s closure.  In particular, an internal investigation conducted by the Financial Services Authority has led to a review by the Parliamentary Ombudsman which, if it upholds a finding of failure by a Government agency, may lead to some Government compensation for Equitable policyholders.

At this stage it is impossible to assess whether such compensation may be paid, and, if so, how much, and to which groups of policyholders.  For members considering surrender, the main issue is whether this might disqualify them from any compensation paid.  This is equally unclear - there is an argument that compensation should extend to any individual who is deemed to have suffered a loss, not just those who remain some years after the event, but it may be considered that the focus should be on those who have chosen to remain with the with-profits fund.

There is still an opportunity for the GAR problems to be reduced by a compromise deal between the various policyholder groups later this year, which would be a positive factor for those remaining.  Proposals were announced on 20 September 2001 and the effect of these on non-GAR members is summarised below.

3. The compromise proposal
A major cause of the Equitable Life's difficulties is the valuable GAR guarantees offered to certain policyholders. It is proposed that these policyholders agree to give up these guarantees in return for an increase in the value of their policies of around 17.5%.  At the same time most other policyholders would receive an uplift of 2.5% in return for their consent to the deal which will include giving up any claims of mis-selling in relation to their non-GAR policies.  The new Equitable management believe that this would remove the legal and financial uncertainties facing the company, increase its financial strength, and allow a more flexible investment policy, which should increase returns.

For those with internet access, the full proposals and Equitable's explanation are published at www.equitable.co.uk.

No members of the Scheme have any GARs.

For non-GAR policyholders, a potential 2.5% policy value uplift might be allocated around January/February 2002.  However, this is a small amount relative to the overall uncertainties in the returns from any AVC policy, as described above, and surrender values may not reflect the increase immediately.  Surrender values might also worsen at that time if the compromise does not proceed. So this does not affect the conclusions below.

It is intended that the proposals will be finalised in November, following a period of consultation, and then put to a policyholders' vote in December. Assuming a vote in favour, the policy value uplifts would be applied in January/February 2002.

4.  What are the factors which might make surrendering attractive to a member?
Surrendering is now likely to be attractive if one or more of the following relate well to a member's individual circumstances:

• the member is some years (10+) from intended retirement, is comfortable with moving AVC monies (less the surrender penalty) to a fund investing largely in equities and anticipates further outperformance from equities

• the member believes there is a significant prospect of further bad news to come, either because the capping deal cannot be concluded or because the member's expectations are for markets to fall further (and the member would be looking to invest so as to avoid this market fall)

• the member would like to lock into the reduced fund value because it could meet their needs and the member wishes to avoid any further bonus reductions and switch to a conservative investment such as bonds or cash.

5. What are the factors which might make surrendering unattractive to a member?
Surrendering is not likely to be attractive if either of the following relate to a member's individual circumstances:

• the member is close to retirement (say within 5 years), because they would suffer a further loss of at least 5% and possible 10% on surrender and there is little opportunity to make it up, other than by successfully adopting a much higher risk investment strategy

• the member is reasonably close to retirement (say 5-10 years) and the bulk of their policy value is made up of guaranteed funds (80%+ by reference to their last benefit statement)1 since the surrender penalty is effectively more than the apparent 5-10% and the chances of making it up are low.

• the member believes that Equitable will secure substantial compensation from the Government or another external party but believes that only those individuals who have not transferred out of the with-profits fund will be eligible to receive it.

Note that we have consciously referred to the expected period to intended retirement, not normal retirement under the scheme.  A common use of AVCs is to fund for early retirement, and the Administering Authority is not party to the plans of individual members.  A key feature of the Equitable Life policy is that benefits can be taken without penalty on early retirement.

www.equitable.co.uk

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