THE PROPOSED TRANSFER TO THE PRUDENTIAL

As promised and now that we have more details, I am setting out a brief commentary on my understanding of the proposed transfer of the Society’s With-Profits Annuities to the Prudential.

There are certain points, which you may wish to consider before casting your vote on the proposed deal. But it is important for you to bear in mind that your vote is an entirely individual decision, as I cannot advise you how to vote nor would I wish to do so. It is a decision you must make for yourself.

However, in order to assist you, I set out a short summary of my understanding. The scheme is very complex and as a result, this is by necessity an over-simplification to make it comprehensible. If you require further detail, please look at the Equitable website and the further details available there and of course seek professional advice.

Summary of the scheme

1. The Annuitants will cease to be members and policyholders of the Society and will instead become with-profits policyholders of Prudential.

2. An amount, estimated initially to be of the order of £1.7 billion, will be transferred to a separate sub-fund of Prudential and will be used exclusively to provide the “unsmoothed component” of annuity payments. The intention is that the sub-fund will be used exclusively for the benefit of Annuitants.

This sub-fund will be within the defined charges participating sub-fund. I refer to this particular element of the defined charges participating sub-fund below as “the DCPSF” (although technically there are, I understand, other elements of the full sub-fund which will be kept separate).

The express intention is that the DCPSF will be used up over the future lifetime of the portfolio of the Annuitants.

The DCSPF will have no liabilities other than the Equitable’s with-profits annuities.

The investment risk and part of the mortality risk will be retained within the DCPSF but all other risks will be undertaken by Prudential in return for payment made by Equitable to Prudential. None of the risks nor any of the profits of Prudential’s other business will fall upon the DCPSF.

3. The transferred policyholders will have absolutely no recourse whatsoever to Prudential’s inherited estate. The future annuity payments you will receive will depend upon the performance of the DPCSF and there is no intention to provide any subsidy or long-term support though there may be some short term support for the smoothing process.

4. The investment mix of the DPSCF’s supporting assets is intended to be the same as for Prudential’s main with-profits fund which is approximately 50% in equities, 30% in property and 20% in fixed interest investments. Over the long term, most people would expect such an arrangement known as a “50/50” fund to perform better than a fixed interest fund. However, in the shorter term, there is an issue of timing given the cyclical nature of financial and property markets.

There are, however, significant differences between Prudential’s main with-profits fund and the DCPSF:

i)               the main fund is supported by Prudential’s inherited estate whereas the DCPSF has no inherited estate;

ii)              the main fund is a continuing entity which is open to new business and which can expect to receive further premiums in the future whereas the DCPSF is closed to new business, will receive no further premiums and is contracting (as the Annuitants die);

iii)            the main fund represents policyholders who have paid and will continue to pay premiums to Prudential at different times whereas all of the DCPSF will have been paid to Prudential at the same time; and

iv)            Prudential’s main with-profits fund will represent a constant or increasing number of policyholders whereas the DCPSF will represent a declining number of polices.

Given the differences set out above, an investment portfolio, that has been selected to meet the needs of Prudential’s other with-profits policyholders, is unlikely at all times to be the most suitable portfolio for the DCPSF.

If, in the event, the investment return that is credited to the DCPSF is both positive and greater than that which might have been obtained from the Society’s conservative investment policy, the Annuitants are likely to receive future payments that are greater than they might otherwise have been and will benefit from the Scheme becoming operative.  If, however, the returns are less than might have been obtained with the Society, the new arrangements, although they might permit the impact to be smoothed, will not create any additional funds that will fill the gap long term.

Because of Equitable’s weak solvency position, it was not able to take the risk of matching liabilities with equity investments. The transfer to Prudential allows that company’s stronger solvency to support such a position but I cannot predict whether that would mean higher returns and it is only that which would improve the annuitants’ position.

Smoothing

If the scheme becomes operative, you will have the advantage of a clearly stated smoothing policy including the safeguard of a with-profits committee (which is required in non-mutual companies by the FSA). The Prudential’s stated intention is to manage the overall rate of return within a range of 0% to 11% per annum.

Actual Effect

My understanding is that payments will continue to be calculated on the same basis as before but of course subject to the overall rates of return declared by Prudential within the DCPSF.

My experience is that the average ABR for all annuitants is approximately 6.5% (having taken into account real ABR’s – see below) with approximately two thirds of the policyholders having ABR’s in the range 5.5 to 7.5%.

GIR annuities were typically sold before 1997 and for these annuities; the ABR was uplifted by 1.035. Thus an ABR of say 4.0% in practice becomes 1.04 x 1.035 or 1.0764 so equates to a real ABR of 7.64%. As will be immediately obvious, the effect of the multiplier of the uplift to the real ABR is that a much higher rate of return is required to maintain payments.

Non-GIR annuities were typically sold after 1997 until close of business. In these policies, there is no GIR uplift.

The tables below show a selection of results depending on the chosen (real) ABR and the overall rate of return by the Prudential in any one year. The numbers in red indicate that the annuity will decline in value and the actual number is the reduction in value as a percentage of the previous year’s annuity payment. Conversely the numbers in black indicate that the annuity will increase in value and the actual number is the increase in value as a percentage of the previous year’s annuity payment. The figures do not take into account the effect of any guaranteed elements in the polcies that may exist.

Given that the Prudential has to strip out its expenses and create a reserve for the "bad" years (the “smoothing” above), personally, I cannot see the Prudential paying out much above 4 or 5% over the next few years. Of course, I am not qualified to give advice on likely future returns and I do not attempt to do so. This is purely a personal view based on the stated proposed range of overall rates of return, the intention to “smooth” returns and the expenses required in administering the policies.

Combining the spreadsheets and my experience of ABR’s (and real ABR’s) above suggests to me that:

a)      the overwhelming majority of annuitants will see their policy values continue to fall in the immediate future;

b)      even in the longer term it is difficult to envisage any GIR policy increasing in value and the non-GIR policies will only achieve that when the Prudential declares an overall rate of return in excess of in general 6.5%;

c)      annuitants are likely to be better off remaining with the Equitable if the Prudential declares overall rates of return in the region of 4% or lower as this appears to be the "norm" for the Equitable (but conversely better off with the Prudential if the overall rates of return are higher – see below); and

d)      annuities are likely to fall more slowly if the Prudential declares overall rates of return in excess of 4% compared to staying with the Equitable.

Where does this leave you?

In summary

1.      The future level of annuity payments will primarily depend upon the returns secured by the investments backing the DCPSF.

2.      The assets are likely to include a significant proportion of equities chosen with the interests of Prudential’s wider and continuing with-profits portfolio.

3.      It is possible that the net proceeds of the investments backing the DCPSF will be greater than might have been achieved from the Equitable’s more restricted investment mix policy.

4.      However they may be less.

What is proposed is a transfer of the Society’s business model to a new home. The rules are now expressed much more clearly and some of the risks have been replaced by fixed charges. Nevertheless, the fund remains an uncapitalised with-profits fund. The proposed transfer does not supply a new ingredient that mitigates the risks or supplies additional funds. This opinion is very much in line with that of the independent expert (Mr Sarjant) whose report you can read in full on Equitable’s website.

As I mentioned at the beginning of this commentary, I cannot advise you on which way to vote. In many ways this may boil down to a straight choice as to whether in light of the position that you now find yourself (perhaps in contrast to the position at the time of the original decision) you would like an annuity income dependant upon a different investment mix than would be the case if the policies remained with the Equitable. That again may be a matter, which turns upon your own personal risk appetite, age etc as it is now given your current income needs and personal circumstances.

There are two other factors you may wish to consider. The first is that if annuities are transferred to the Prudential, you will be in a fund, which does not suffer the risk of any further mis-selling liabilities that may fall upon Equitable. The second is that nobody can predict whether the Parliamentary Ombudsman will press for compensation and even if it did, whether this would be to individuals or into Equitable’s with-profits fund. Personally, I consider the latter unlikely.

I will not take questions on the contents of this bulletin as I have solely put this information on the ELTA website partly because I made that commitment and partly because members have asked help.

Peter Scawen

17 October 2007