An Equitable Assessment of Rights and Wrongs

by Dr Michael Nassim

10.  Critique of the Society’s own assessment of its damage

10.  Critique of the Society’s own assessment of its damage

The Society has concluded that there is a deficit of £ 3.2 billion pounds in the With Profits Fund, which estimate is very close to that of independent outside accountants, such as Burgess Hodgson^22,23.  It is now seeking to recover the whole of this sum from former officers, directors and its erstwhile auditor.  The sums sought from the individuals are punitive, and some face ruin from the legal costs alone.  Having proclaimed the worst links in its chain, the Society is making them solely and wholly accountable, which is not inconsistent with the conclusions of the previous section.  Because of its import we are all obliged to take this exercise at face value, and disregard any public relations, political or diversionary aspects.

We may therefore also take the view that the Society should not seek to be judged by others any less fully than it judges its former self.  On this basis former as well as present members of the Society are entitled to their share of full compensation pro rata.  It must therefore be a matter of astonishment and regret that the Society proposes to offer former members less in compensation than it seeks on behalf of its present ones.

The matter does not end here.  The deficit which Burgess Hodgson has identified, and which the Society alleges that auditors Ernst and Young overlooked, is the cumulative disparity arising from a dual standard of reporting non-discounted policy values for members, but discounted values for its own management and the regulator.  A memorandum from Equitable actuary Catherine Payne addressed to Christopher Headdon came out in the Ernst & Young case, and it showed that total with-profits policy values exceeded assets in the years 1995-99 inclusive.  This enabled Burgess Hodgson to firm up previous estimates¹⁹, and to surmise that a similar situation had obtained in the years 1990, 1991, 1992 and 1994. (It is also of interest that footnotes to the Payne memorandum reveal that the GAR reserve had been kept at £50 million from 1998 into 1999.  This may explain the origins of the misleading estimate of the GAR liability referred to earlier, which was apparently held constant despite legal advice by then received.  It is also likely to reflect the approximate size of the absolute solvency gap within the GAR segment of the fund as computed under Second Order Sophistry Item 5, which further emphasises the impropriety of maintaining that this was the maximum liability that the Society would incur if it lost the House of Lords Appeal.)

Though the Ernst and Young case is centred upon the reverses of more recent years, it is unlikely to allow even partly for an earlier loss of the Society’s estate.  This we have previously identified as a crucial question.  Until there is definite knowledge of its fate no attempt can be made to recover it, but the likelihood is that this will largely be impossible.  Reason enough, perhaps, for the Society not to advertise the matter.  Yet as has been seen previously in comparison with other offices, a preserved estate or its equivalent provides a valuable smoothing and strengthening buffer, and is part of the inherent characteristics of a healthy With-Profits Fund.  If at the height of the bubble the total valuation of the With Profits fund was £30 billion, and it had been backed by a relatively spare estate comprising only 10% of this (15% is more usual), then we can see that the true loss to the fund is at least 3 billion pounds more than has previously been stated¹¹. And if the Equitable With Profits Fund is ever again to function as such, this estate must first be restored.  Meanwhile whatever allowance or recompense for its loss later policyholders should be made requires formal debate.

As yet the Society has ignored the effects of a growing tide of complaints about the GIR issue, which though analogous to the GAR one in many ways, could not by its nature have been laid off fully in dual accounting standards.  This issue has previously been summarised as Second Order Sophistry item 6.  The background to this has been explained in detail by Peter Scawen¹² as part of a more general exposition of how Equitable With-Profits annuities are calculated.  When the Society stopped policies with the GAR option, from 1988-96 they awarded a guaranteed interest rate of accumulation of 3.5% per annum (GIR) to policies until they matured.  This was mentioned in the product particulars, but in practice it could be arranged to cost the Society little or nothing. In the first place, an initial deduction of 4.5% was taken from each premium, and there was an annual management charge of 0.5%.  In the second, although the accumulation rate was guaranteed, the proportion of this allotted as guaranteed and un-guaranteed annual bonus was at the Society’s discretion. In retrospect, the first indication that this might be important came from the bonus statements for 1997, when both GIR and post July 1^st 1996 non-GIR bonus rates had to be declared, and the guaranteed portion of GIR bonus was 3.5% lower than for non-GIRs.  And what the GIR product particulars did not state was that, that once a GIR annuity was taken, the hurdle rate of overall return to ensure it remained level was also raised by 3.5%, such it suffered an automatic below-the-line compound drain rate 3.5% to 4% p.a. on both its guaranteed and un-guaranteed elements¹².  As a result, most GIR annuitants had overall rates of return to keep their annuities level 3.5% higher than they understood them to be.

The situation is further worsened because, during the successive years of the annuity the proportion of annual bonus added in guaranteed or un-guaranteed form to the remaining asset share is also at the Society’s discretion.  As a result, the proportion of a GIR annuity that is in basic guaranteed form can erode rapidly, as is now the case.  All this amounts to a guarantee that functions more like a penalty, and one that can be charged for in full twice over; i.e. both before and after the annuity is taken.  Retrospective perusal of R & H⁸ sections 3.1.4 –6, which describes the overall GIR charging structure, and section 3.2, which outlines the discretion involved in allotting the guaranteed and un-guaranteed bonus elements, is also useful in understanding the degrees of freedom which allowed this situation to develop.  Even so, the R & H paper was written before non-GIR policies were introduced, and so does not deal with the further inequities that resulted from their admixture. As a result the GIR policyholders (i.e. the rump of the With-Profits Fund) are selectively disadvantaged in comparison with the both the older GAR policyholders and the newer non-GIR policyholders, because the GIR annuities erode 3.5% p.a. faster overall. We may also anticipate that now the fund is closed to new business the Tontine effect will also disadvantage GIR policyholders selectively versus newer policyholders. This will be further accentuated if the life expectancy of the newer members is greater than older ones, a factor that might place additional demands on the remnants of the With-Profits Fund in any event. Unfortunately, despite the wishes of some, this issue was not addressed in the Compromise Scheme, which is why further troubles now threaten.  In view of the outcome of the GAR issue, the Society may additionally be liable for the GIR one in future, perhaps to the tune of several billion pounds.

On this basis the Society could be as much as £10 billion short, of which it is actively seeking to recover 3.2 billion.  The amount recoverable from former directors is likely to be very much smaller.