Investing financial intermediaries

In earlier parts of this unit we concentrated on deposit-taking financial intermediaries which, in general, take deposits and onlend them, rather than buy­ing and selling assets. However, there are exceptions:

- Banks and building societies buy and sell gilts and Treasury bills:

- Banks buy and sell the debts of third world countries (the so-called 'Brady' bonds);

- Investment banks buy and sell assets in the financial markets, rather than take deposits.

In the final part of this unit, we focus on intermediaries which buy and sell for them lending and deposit-taking are minor activities. Unfortunately, the market term for them is 'the institutions' and, as was stressed in section 1, they are more than just brokers and agents. Also, they are more than providers of advice.

The investing intermediaries are dealt with in order of size.

 

Insurance companies

The assets of all insurance companies are grater than those of pension funds, but for the purposes of the Insurance Companies Act 1982, a distinction is made between the short-term and long-term insurance business of insurance companies. Broadly, short-term business is renewable annually, e.g. house or motor insurance.

Together, the two 'footings' (balance sheet totals) come to £466bn, much larger than the total for building societies and slightly larger than the £44 3.5bn for pension funds. When we include the investment trusts and unit trusts, the aggregate size of these 'institutions' exceeds £1,000 bn., most of which are assets located in the UK.

General Insurance

This comprises insuring such items as:

- Houses - contents and structure;

- Motor vehicles;

- Aviation;

- Marine;

- Public liability;

- Personal accident;

- Unemployment.

This is usually short-term business, with policies renewable annually and often up-rated annually. However, there are two classes of long-term insur­ance which are included here, i.e:

- Permanent health insurance - say for 20 years from the age of 30:

- Critical illness — or 'dread disease'- cover.

 

Life assurance

Here, the word 'assurance' is used, because death - unlike theft or accident - is a certainty, so that the policy will always be the subject of a claim - except when it has been lost and the deceased's executors are unaware of its exist­ence. There are several main types of life insurance products:

 

Whole life assurance

Whole life assurance pays a lump sum at death.

Term assurance

Term assurance pays a lump sum if death occurs before a date stated in the policy (say) before 20 years of the date of the policy. If death occurs after that date, then nothing is paid because the policy has expired. However, the as­sured has had the protection for that period. Mortgage protection policies are term life cover

 

Endowment assurance

Here the sum assured is payable at a certain date, e.g. 13 October 1998 or prior death.

Annuity

An annuity is the reverse of an assurance policy which pays a lump sum after a stream of annual or monthly premiums. With an annuity, the pur­chaser pays a lump sum now⁷, and receives a stream of income payments until his/her death. Joint annuities for husbands and wives or for partners can be bought but they are more expensive because payments will continue until the death of the second survivor. For people's peace of mind - 'what if I die the month after I bought the annuity?' - most annuities can be guaran­teed for five years, so that if early death occurs then payments will continue for five years after the date of purchase.

Prices of annuities - the yield per year per £1,000 spent - depend on the age of the purchaser and current levels of interest rates. The older the buyer and the higher the yields on fixed-interest rate securities, the more income each £1,000 will buy

Personal pensions

In 1988 great changes took place in their legal basis. Those pension con­tracts taken out before July of that year are termed 'retirement annuities' and many of these will continue until their owners purchase special kinds of annuities from which they will draw their pensions. This could continue until 2030 or later.

Personal pensions replaced the older products and began to be sold in 198S. They are particularly suitable for self-employed people and those workers with no occupational pensions. Most providers of personal pensions are life assur­ance companies rather than pension funds.

 

Additional voluntary contributions (AVCs)

These, before 1988, could be provided by pension funds for their members to 'top up' their pensions to the maximum possible level. Since 1988, new AVCs must be 'money purchase' schemes, usually provided by life assurance com­panies, rather than allowing members to buy extra years of service for their pension schemes provided by their employers.

Profits

Apart from term life assurance, holders of whole life, endowment policies and annuities can share in the profits of the company or organisation providing the cover. Traditionally, profits have been declared annually or every three or five years, and added to the sum assured in what are known as reversionary bonuses. These cannot be taken away, so that assurers adopt a very conserva­tive attitude when 'declaring' (announcing) them. A second type of bonus is paid on maturity - the terminal bonus - and this fluctuates in line with conditions in the stock and property markets. In the 1990s, many companies have been reducing their terminal bonuses, while others have even been un­able to declare reversionary bonuses at the level of previous years.

These uncertainties of the trend of profits have caused some companies to cease to sell 'with profits' endowment policies. Instead, they have begun to sell 'unit-linked' endowment policies, which are divided into units whose value fluctuates in line with market trends. In other words, their value can fall, unlike the traditional 'with profits' endowment or whole life policy.

Types of insurance company

Some companies specialise in life assurance, e.g. Scottish Widows. Others concentrate on general insurance, e.g. Norwich Union (which has a separate life assurance company). Yet other are composite insurers, providing both life and general cover from the same business.

There is also a very strong 'mutual' element in the industry, with the Firms being owned by their policy holders and not their shareholders. Scottish Wid­ows is one of these, as is Standard Life, the largest of the mutuals. Norwich Union is, at present, a mutual but plans to become a pie in 1997 or 1998. Another mutual - Clerical. Medical and General - has been bought by the Halifax Building Society.

 

Pension funds

Pensions can be financed in two ways: unfunded or funded.

Unfunded pensions

Unfunded pensions are, in effect, 'pay as you go' schemes. Examples are the state retirement pension, financed by the National Insurance Contributions of today's workers, and pensions for civil servants, the police service and firefighters. The latter group of pensions is financed by taxation and borrow­ing. (Because they are not true funds, contributed by the pensioners during the period when they were working, and in which are held identifiable assets, we shall not consider them further.)

Funded pensions

Funded pensions come in three types:

- Defined benefit schemes;

- Defined contribution schemes; and

- Hybrid schemes.

All have their own funds, with identifiable assets.

Defined benefit schemes

Defined benefit schemes are the standard schemes of this century. Contribu­tions are made by employees and (usually) by their employees, who earn themselves a benefit (pension, of which part can be taken in a lump sum) of either ¹/₆₀ or ¹/₈₀ of their final salary (or the average of the last three years' salaries) for every year in which contributions are made. Thus, 40 years' service gives a pension of ²/₃ or ¹/₂, of final salary if the benefit is ¹/₆₀ or ¹/₈₀ respectively. The assumptions are that employees stay in their jobs for a long time and that salary changes are upwards. However, it is now a fact that job changes are more frequent, so transfers have to be made between funds. Second, the 'upward salary' assumption makes it hard for older workers to move to part-time or less remunerative work with their employers as they approach retirement age.

A severe problem can arise with these schemes if there is a period of substan­tial inflation (as there was) because the earlier contributions are unable to finance the higher final salaries caused by the inflation. As a result, [he em­ployers are required by the trustees of the schemes to make up the contributions and this can be a drain on their profits and cash flows. Moreover, if inflation then slows (as it did), the schemes may become 'over-funded' instead of 'un­derfunded', so that a 'pensions holiday' is declared. In some funds, the over-funding has allowed employees, as well as employers, to pay lower con­tribution rates. These 'defined benefit' schemes have been virtually universal in the largest companies and typically are run by trustees advised by mer­chant banks in their investment decisions. A more common term for them is 'final salary' pensions.