SUMMARY AND RECOMMENDATIONS

At regular and unfortunately frequent intervals we suffer from financial disasters such as Barlow Clowes, the pensions mis-selling scandal, the Maxwell pensions scandal, which shakes us out of our complacency that all things are for the best of all possible worlds with the provision of financial services to people in the UK. By providing proof positive, these episodes invariably show up weaknesses in governance and regulatory procedures that were there for all eyes to see before, but had been invariably smothered by the vested interests of those in the financial services industry. The difficulties that beset the Equitable Life Assurance Society from the guaranteed annuity rate policies are not (unlike the others cited) due to criminal intent or to marketing scam, but rather to mis-judgement and possibly back luck. Nonetheless on a fundamental level the affair provides a timely warning to highlight three weaknesses in the British life assurance industry which I hope the Committee will take the opportunity to enquire into so that there will not be another mess which could be avoided. In my view:-

1. There are serious shortcomings in the concept of the pooled with-profits policy including hidden risks, which contributed to the Equitable affair. The product is generally non-transparent and obscure; the with-profits funds are routinely manipulated by life assurance companies; and the product is not particularly suitable for younger people. The Equitable affair highlights as an extreme example the obscure and risky character of the with-profits fund. Namely the non-GAR policyholders unwittingly joined a fund that had embedded within it potential open ended call options in favour of GAR policyholders for which the House of Lords ruling determined non-GAR holders would be liable. Also the holders of with-profits policies are liable for any shortcomings in the unit funds, such as underestimating the costs or success of products.

   I recommend that the Financial Services Authority (FSA) undertake a proper study of the suitability of the with-profits product, and that those who are selling it are obliged to inform prospective purchasers of groups for whom it is more suitable and groups for whom it is less suitable.

   I furthermore recommend that the FSA require all life offices to disclose fully and on a standardised basis in the annual accounts:-

   * the liabilities within the fund on an analogous basis to the requirement under accounting standards for companies to report on risk from derivatives

   * the expenses allocated to the with-profits fund with an explanation of the basis of allocation

   * the asset structure of the fund, and the performance of each class of asset

   * the basis of allocation of bonuses and the (say) seven year rolling average of returns and bonus distribution

2. It is unacceptable that life assurance companies do not report the performance of their unit funds in an objective way, and most do not report the investment performance of their with-profits funds at all

   I recommend that all life assurance companies should be legally required to set up an independent audit committee to report on investment performance annually to investees. The report should compare the performance of funds with their peer group and with relevant indices. To this end the reporting of the performance of the with-profits funds to the Financial Services Authority (FSA) should be significantly improved.

3. The weak governance of mutuals can disbenefit members. Although mutual funds were originally formed to act in the interests of the members who formed them, their governance is weak and the board of a mutual can easily become a self-perpetuating oligarchy or a compliant club for the chairman's business acquaintances, lacking the pressures to which the boards of publicly quoted companies are subject from shareholders and the financial press. Linked with weak governance there has been a tendency for mutuals to be hijacked by managerialist interests at the expense of the interests of the mutual owners. There has also been significant criticism of the Equitable for not communicating adequately with its members.

   To this end I recommend that the composition of the board should be required to include an appropriate balance of skills, to include representation from "ordinary" members, and to be separate from the executive:-

   * analogous to the provisions in the post war nationalisation statutes the board should include a mix of specified relevant skills. In the case of a life assurance company those skills might be investment management, finance, actuarial, information technology, customer relations, possibly human relations, and representative member involvement

   * several of the board members should be nominated by members who are not board members (which is analogous to the provision in section 16 of the Pension Act of 1995 which requires that a third of the trustees of a company pension fund should be members of the fund), and furthermore the board should be precluded from making any comment on the merits or otherwise of the candidates. The candidates should be required to have a significant investment (e.g. £75,000) in the mutual. Companies would be required to circulate the members with details of the candidates who had been put forward for board vacancies together with their statement of why they should be elected, and each could prepare a video that could be played from the websitee. In order to reduce the risk of manifestly inappropriate candidates self-promoting themselves, there may be a case for an appeals procedure run by the FSA.

   * all board members should be non-executive, as should the appointed actuary. (It is a recent trend for executives of mutual life companies to be on the board). It is important to have a bright line between the board members and the management, who should clearly be seen as an agent of the members. This approach is approximately analogous to company pension funds who subcontract investment management (except that under this approach the management is "in-house" - nonetheless the management should be clearly seen to act as an agent, and not as a pseudo-principal)

   Furthermore to ensure that a mutual not only acts to the benefit of its members, but is seen so to act:-

   • a summary of board minutes and summaries of policy papers should be made publicly available except where matters affect individuals (i.e. personnel issues) or where publication would genuinely prejudice the financial interests of the members

   • the board should use appropriate modern means to ensure that it kept in touch with the members both by advising them of relevant issues and also by seeking their views on significant issues

INTRODUCTION

I welcome the Committee's "Examination of the regulatory environment and the management of risk in the life assurance sector following the Equitable Life affair", and hope that the committee will take a wide view of its remit. The issue on which the courts ruled was whether to favour financial equity as between two groups of participating members, which was the approach the Equitable adopted as did The Treasury², or to rule in favour of contract law, which was the approach the House of Lords adopted. A point the Committee may wish to consider is that in contrast to the all or nothing approach of English law, which has resulted in a mess and possible disadvantage to some guaranteed annuity rate (GAR) policyholders and to all non-GAR policyholders (there are many people with both) of which the judges had no inkling. Within the framework of continental law judges might well have attempted to understand the consequences of what they were ruling on and to have brokered a compromise.

The problem had its origins in the marketing enthusiasms of the life assurance companies during the late 1960s, when understanding of risk management was much less developed than now and there was an unfounded belief that long term interest rates and annuity rates would remain high by historic standards. The Equitable was not alone in offering GAR policies, but because of the high number ir sold, the flexible terms of its contracts, and its approach to distributing profits it is the only life assurance company to have run into serious difficulties. Namely unlike many other life funds running with-profits policies:-

• it has paid to clients who surrender their policies their "asset share" (i.e. what the invested premiums had earned). The transfer values offered by many life companies is below policy asset share in order to boost maturity values and to increase reserves

• smoothed across a number of years it has payed out as bonuses the profits made on the fund rather than create the reserves which have built up into £30bn worth of orphan assets in other life funds, and which are now a contentious issue

My concern about my future financial prospects started me looking not only at the Equitable's investment policy, but at the character of the life business in this country, and I would like to raise for the Committee's consideration three issues of long term and fundamental importance for many people in this country who are saving for their retirement through life funds. The first two issues apply equally to proprietary and to mutual funds, while the third is particular to mutual funds such as the Equitable. The issues are:-

• the unsuitability of with-profits policies for many people saving for their retirement in future. In particular Equitable's GAR difficulty was in significant measure facilitated by the obscurity of the with-profits pooled life fund concept obscuring the risks in the fund

• the need for independent reporting of fund performance

• the need to strengthen the governance of mutual societies to ensure that they do in fact represent the interests of their members, and furthermore they are seen to represent their interests

WITH-PROFITS LIFE ASSURANCE POLICIES

The with-profits approach to providing long term savings for retirement is particularly strong in the United Kingdom, still accounting for nearly half of the life and pensions business, and life companies continue to spend significant sums in promoting the product. The basis of the approach is to pool investments in one fund, to declare annual bonuses which are "guaranteed" and consequently represent a liability on the fund which has to be secured, and to smooth returns provided from the underlying investment returns over years. But there are some significant shortcomings of the concept, namely with-profits policies:-

• are obscure and ill defined products that have been subject to extensive manipulation and can be risky

• are not generally appropriate for younger people

• appear to be expensive

The product is obscure, manipulated and can be risky

Even apart from the extreme situation created by the GARs, with-profits policies with most life offices obscure risks, obscure expenses, obscure charges, obscure investment performance, incorporate obscure terms, and the return is ill-defined and subject to the discretion (which can amount to little more than manipulation) of the life office:-

• Risks. The Equitable affair has highlighted in extreme form the risks arising from obscurity of the with-profits product. Namely none of the non-GAR policy holders who joined the fund after mid 1988 knew they were joining a fund that had (to use financial jargon) embedded within it what are in effect open ended³ potential call options on annuity (i.e. long term interest) rates in favour of the GAR policy holders for which the House of Lords ruling determined they would be liable if the options came into the money (i.e. became valuable), which they have now done. Also it is not widely understood that with-profits bear the risks (and the profits) of any shortcomings in the unit funds such as excessive costs or failure of products to sell well

• Charges are presented in bewildering ways. There are usually initial charges, reduced allocations, annual fund charges and escalating monthly fees. In addition, there may be a variety of penalties for transfers, early retirement, etc., and it is virtually impossible for investees to work out the cumulative effects of such charges. Like the mobile phone industry, life assurance companies are masters of legal obfuscation

• Expenses for administering existing businesses (separated between the with-profits fund and unit funds), and the expenses for getting new businesses (again separated between the with-profits fund and unit funds) are rarely shown in the accounts of life offices. Many life offices are reluctant to disclose expenses because they cross subsidise some of their unit linked products (which are more transparent) to make them look more attractive in their marketing literature

• Investment performance: although The WM Company undertake an annual analysis of performance by asset class for with-profits funds the details are confidential to the participating life offices. Equitable is one of very few life funds that publish the investment performance of their with-profits funds (I am pleased to report that recently Equitable has been helpful in providing figures for the performance of its with-profits fund compared with basic indices and with the aggregate performance of life funds as a whole). The failure by other life offices to publish investment performance facilitates manipulation of bonuses. Discussions with the FSA has revealed that at least one of its officials does not regard the statutory returns as adequate for analysing performance

• Obscure terms: for many people with-profits policies have been something of a scam because the transfer value for those who surrended their policies prematurely was frequently below the "asset share" represented by their investment⁴. The same was true (but to a lesser degree) for those who stopped contributing and their policies became "paid-up". Policyholders were given specious reasons for this approach along the lines that with-profits policies were long term products and they involved risks that were spread over the term of the policy, and those risks would have to be paid for if a policy were surrended. The consequence of this approach was to subsidise the bonuses of those who stayed the course to maturity, which satisfy them and make it easy for the managements to show high performance in the ranking tables. Although the life companies may not admit it, if all policies were held until their maturity dates, the returns paid out would fall

• Returns are ill defined and discretionary: returns from with-profits are presented in a complexity of bonuses and guarantees that appear unrelated to anything and no attempt is made to explain the link between returns and the bonuses paid. In consequence policyholders do not know whether they have been treated fairly by a company. The allocation of annual (so called "reversionary") and terminal bonuses is discretionary, if not quixotic, as can be seen by the following figures taken from Money Management March 2000 for the value of the basic fund including reversionary bonuses and the terminal bonuses if one invested £200/month for 10 years (i.e. a total invested of £24,000) for several life offices:-

terminal bonus as % of:-

Although there is a financial rationale why life companies have generally moved towards lower annual bonuses and higher terminal bonuses⁵, the range shown by the two pairs of companies where each of the pair pays a similar total sum is unlikely to have any tangible financial rationale. Another example of a practice that had no financial rationale was that of a company which paid terminal bonuses of about 50% on policies of less than 20 years and 160% on policies, of 25 years. Although this practice might have looked good from a marketing perspective allowing the company to proclaim its performance over 25 years, it had no financial rationale. Again a Scottish mutual life office declared a "centenary bonus" which was not justified by its underlying finances, and this subsequently led to the company's sale.

Equitable has been good in stating the returns on its investment and allocating bonuses so that over a run of years they equal the returns made. Some other offices have built up large reserves which have become "orphan assets", which are essentially unfair to earlier generations of investors who have been underpaid.

Not generally⁶ appropriate for younger people

From an economic/risk perspective the with-profits policy is often not appropriate for younger people. Although the security of annual bonuses which are guaranteed may be desirable for people who are approaching retirement age and would suffer financially if not "hedged" against a possible sharp fall in equities around when they are retiring, the security requires the fund to invest in fixed interest instruments which are less risky but over the years provide a lower return that more risky equities. As a general rule, younger people should be more heavily invested in equities than older people and thus they may disbenefit from the proportion of a with-profits fund invested in generally lower yielding fixed income investments.

With-profits policies appear on average to be expensive for what they provide

Mr. Kevin James of the FSA⁷ found that in order to obtain £1 worth of market return then (ignoring different tax arrangements) on average one had to invest the following sums in different products:-

with-profits funds £1.60

actively managed UK unit trusts £1.45

actively managed US mutuals (unit trusts) £1.33

UK index unit trusts £1.25

US index mutual funds £1.10

* * *

I recommend that the FSA undertake a proper study of the suitability of the with-profits product, and that those who are selling it are obliged to inform prospective purchasers of groups for whom it is more suitable and groups for whom it is less suitable.

I furthermore recommend that the FSA require all life offices to disclose fully and on a standardised basis in the annual accounts:-

• the liabilities within the fund on an analogous basis to the requirement under accounting standards for companies to report on risks from derivatives⁸

• the expenses allocated to the with-profits fund with an explanation of the basis of allocation

• the asset structure of the fund, and the performance of each class of asset

• the basis of allocation of bonuses and the (say) seven year rolling average of returns and bonus distribution

THE NEED FOR INDEPENDENT REPORTING OF FUND INVESTMENT PERFORMANCE

Equitable, like many life funds, proclaims the benefits of being - or becoming - a member by drawing attention to the investment awards it wins. Thus for example the 1999 Annual Report included a table comparing investment in Equitable products with investment in a Building Society, which is a completely irrelevant comparison, and also reported "awards" for several of its unit funds. Last October (e.g. The Sunday Telegraph, 29 October) the Equitable took out full page advertisements which proclaimed "The Equitable wins Five Star Award six years running: a personal best" and stated that "Every year since 1995 Money Management have chosen the Equitable to win a 5 star Best Buy award for monthly contribution Personal Pensions?The Equitable achieved above average results on 78% of its unit linked funds over 5 and 10 years".

The facts as stated are true, but for the majority of its clients⁹ who are invested in the with-profits fund (value £25bn at the end of 1999), information about the unit funds (value £4.5bn) is irrelevant. Furthermore the picture on the unit funds is not straightforward. The Money Management survey reported that the Equitable has done poorly for investors who made single contributions to unit funds over the last five and ten years with 60% of its funds performing below average, while figures from the Combined Actuaries Performance Services of the Pooled Pension Fund Survey appear to show modest performance.

Last May I sent figures to the Society's President and to the then Managing Director drawn from Standard & Poor's Micropal Services which reports on the returns achieved by a wide range of funds over different periods, from Money Management, and from Combined Actuarial Performance Services (CAPS), and which did not show many of the Equitable's unit funds in a good light. I then raised the figures at the Annual General Meeting. The response of various board members to the figures quoted by me and another member were variously:-

• "lies, damn lies and statistics"
• "the data is not comparable because policy terms and conditions differ"

• "critics are using selective data"

Equitable's then Managing Director subsequently responded in various letters arguing that:-

• "the Micropal data are for single premium contributions and so reflect performances for investments made on specific dates. We do not consider that this properly reflects the Society's overall investment performance?Performance figures for single premium investments apply solely and exclusively to investments made on a single day at a particular point in time?The performance of monthly contribution policies is more indicative of the performance of annual contribution policies than is the performance of single premium policies". Yet Equitable was pleased to advertise other figures from Micropal which showed some of its funds in a good light

• "Money Management's survey was not comparing like for like" because of different terms and conditions. Yet Equitable was pleased to advertise other figures from Money Management which showed some of its funds in a good light

• "I simply do not believe that the CAPS figures compare like with like?The "numbers" relating to the funds are supported by relevant management groups and not obtained from published information, and there seems to be a lack of consistency as to how charges are dealt with. The resulting tables?should therefore in our view be treated with some care". Yet the Equitable Annual Report for 1999 uses CAPS figures to claim that "the main [asset] categories within the Society's with-profits fund?outperformed the relevant medians?"

The purpose of this analysis is not to invite the Committee to consider whether the performance of the Equitable's funds were good, poor, or indifferent, nor whether the then Managing Director was correct to dismiss the sets of figures (which may be the case), but rather to indicate the unsatisfactory situation facing an investee who wishes to discover how his or her investment has performed, particularly the with-profits fund which for most investees is the most significant.

I recommend that all life assurance companies should be legally required to set up an independent audit committee to report on investment performance annually to investees. The report should compare the performance of funds with their peer group and with relevant indices. To this end the reporting of the performance of the with-profits funds to the Financial Services Authority should be significantly improved.

STRENGTHENING THE GOVERNANCE OF MUTUAL LIFE ASSURANCE SOCIETIES

Nominally the board of mutual societies are selected by their members in a vote at the annual general meeting (AGM). In practice until the guaranteed annuity issue arose few members attended the AGM of the Equitable, and this was equally true of other mutual societies. Most members either did not vote for directors or nominated the chairman as proxy for their vote. Last year, however, Mr. Edward Doogan, a member of the Equitable who expressed dissatisfaction with its investment performance, put himself forward for election to the board. The President wrote a letter to members (28 April 2000) which stated "Your Board strongly recommends that you vote to re-elect the existing directors who are retiring at the meeting?Your board urges you to vote and strongly recommends you to vote as follows in favour of [names of people already on the board¹⁰], and Against the resolution to elect Mr. Edward Doogan". We were advised that "the facts quoted in his candidate's statement are correct but are in our view selective". In the event, Mr. Doogan won 241,939 votes for and 246,619 against, which was an achievement in the circumstances. To give another example, the Chairman's statement in the Friends Provident Annual Report and Accounts 1999 states that "Members will be asked, following his appointment by the Board, to elect Mr. X as a Director at the Annual General Meeting?[and] will be asked to re-elect to the Board three independent, non-executive directors and two executive directors Mr. A, Mr. C. Ms. C, Mr. D. and Mr. E".

The board of a mutual can easily become a self-perpetuating oligarchy or a compliant club for the chairman's business acquaintances, lacking the pressures to which the boards of publicly quoted companies are subject from shareholders (especially major institutions, but the behaviour of small shareholders of British Gas several years ago raised their concerns to some effect) and the financial press. Linked with weak governance there has been a tendency for mutuals to be hijacked by managerialist interests at the expense of the interests of the mutual owners. For example:-

• the Equitable ran a highly bonused sales force whose incentive was to sell policies regardless of whether they were in the interest of the members. (The Equitable's provision of £132m for pensions mis-selling, which although fortunately modest compared with some other life offices, illustrates the incentive to sell)

• in the early 1990s the Nationwide Building Society pursued a managerial objective of growth by offering new investors higher rates than existing investors, yet (along with mortgagees) the later were notionally the owners of the Society
• last year Standard Life reportedly spent £10m of its members' money persuading them that the Society should remain a mutual. A report of the annual general meeting by the Financial Times (28 June 2000) quoted one member referring to a "biased and inflammatory campaign that put one point of view and not the other"

In the recent difficulties, a survey of Equitable members found that many were critical of the Society for not informing them what was going on with their Society.

To redefine mutuality in a modern context it is important to reduce the risk of the board either becoming a self perpetuating club of friends of the chairman or of being hijacked by managerial interests, and to increase communication with members. To this end I recommend that the composition of the board should be required to include an appropriate balance of skills, to include representation from "ordinary" members, and to be separate from the executive:-

• analogous to the provisions in the nationalisation statutes the board should include a mix of specified relevant skills. In the case of a life assurance company those skills might be investment management, finance, actuarial, information technology, customer relations, possibly human relations, and representative member involvement

• several of the board members should be nominated by members who are not board members (which is analogous to the provision in section 16 of the Pension Act of 1995 which requires that a third of the trustees of a company pension fund should be members of the fund), and furthermore the board should be precluded from making any comment on the merits or otherwise of the candidates. The candidates should be required to have a significant investment (e.g. £75,000) in the mutual. In order to reduce the risk of manifestly insensitive candidates self-promoting themselves, there may be a case for a procedure to prepare a list of suitable persons similar to the Occupational Pensions Regulatory Authority's list of independent trustees - admission to the list would be controlled by the FSA. Companies would be required to circulate the members with details of the candidates who had been put forward for board vacancies together with their statement of why they should be elected, and each could prepare a video that could be played from the website

• all board members should be non-executive, as should the appointed actuary. (It is a recent trend for executives of mutual life companies to be on the board). It is important to have a bright line between the board members and the management, who should clearly be seen as an agent of the members. This approach is approximately analogous to company pension funds who subcontract investment management (except that under this approach the management is "in-house" nonetheless the management should be clearly seen to act as an agent, and not as a pseudo-principal)

Furthermore to ensure that a mutual not only acts to the benefit of its members, but is seen so to act:-

• a summary of board minutes and summaries of policy papers should be made publicly available except where matters affect individuals (i.e. personnel issues) or where publication would genuinely prejudice the financial interests of the members

• the board should use appropriate modern means to ensure that it kept in touch with the members both by advising them of relevant issues and also by seeking their views on significant issues