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Fight crime - be an accountant
The announcement by the British Government of a new UK-wide Serious Organised Crime Agency is indicative not just of the reform being implemented in policing in the wake of the increase in the terrorist attacks on the big economies. It is just as significant in the more central role being given to accountants in the fight against crime, the growth in forensic accountancy and the opportunity for accountants to be involved in new developments.
SOCA will integrate the responsibilities which currently fall to the National Criminal Intelligence Service, the National Crime Squad, Home Office responsibilities for organised immigration crime and the investigation and intelligence responsibilities of HM Customs & Excise in tackling serious drug trafficking and recovering related criminal assets. The agency will include forensic accountants, forensic software experts and staff with criminal intelligence and investigative skills. Governance arrangements for the new agency has not yet been determined.
In announcing the setting-up of SOCA, Home Secretary, David Blunkett, said: �Modern organised criminals are sophisticated, organised and well-resourced entrepreneurs. We need to respond to this changing criminal threat, harness the skills of non-traditional investigators like accountants and legal experts and combine these with our world-class detectives and intelligence officers. We must become better organised, more sophisticated and more technologically capable than the criminals. We must not just keep pace but have to get ahead of them.�
John Smart, partner in global investigations and dispute advisory practice at Ernst & Young, said the increased reliance on forensic accountancy was a significant and growing trend. �There are at least two factors working in favour of forensic accounting,� he said. �The focus on corporate governance has raised awareness of criminal detection, whereas in the past it was a risk that people chose to ignore. The other factor is that there are signs that the police are taking financial crime more seriously and putting more money into fighting it. One example is the Assets Recovery Agency, which is using forensic accountants. And the police are doing more to get these skills internally.�
While demand for forensic accountants in the criminal law field is continuing to grow, there has been a decline in the volume of work for forensic accountants who specialise in providing expert witness in civil law suits. In the UK, the Woolf reforms of civil law led to more dispute resolution in the courts. In turn, forensic accountants have been brought in at an earlier stage in legal disagreements to provide informal advice to plaintiffs and defendants, but have tended to be used less as witnesses.
Financial services companies are becoming more willing to hire forensic accountants to investigate possible internal misbehaviour, added Smart. There has been a culture of covering up embarrassing dishonesty, but a new culture of shareholder activism and naming, shaming and fining by the Financial Services Authority has encouraged banks and other finance companies to deal openly with serious problems.
Surprisingly, interest from qualified accountants in moving into the forensic field is moving at a slower pace than the expansion of firms� activities. Smart explained: �We find it difficult to fill the positions. There is a shortage of good, qualified people with three years or more experience.� Not only the Big Four, but also the second tier firms are recruiting heavily.
Recruiting problems were underlined by a report by the House of Commons� Northern Ireland Affairs Committee, The Illegal Drugs Trade and Drug Culture in Northern Ireland, which said that the work of the province�s division of the Assets Recovery Agency - a key plank of the campaign against continued paramilitarism - was weakened by its shortage of forensic accountants.
Without profit
Confidence is everything with investment products. And because of historic over-confidence in the stock markets by investment managers and financial services sales personnel, consumers have now lost confidence in what had been a bedrock of the UK�s personal finance sector - with-profits funds. The report by Lord Penrose into the near collapse of Equitable Life is just the latest hammer blow that could put with-profits products into a terminal condition.
Lord Penrose has concluded that the primary cause of the collapse of Equitable was imprudent management - and indicated that professional bodies should examine the behaviour of members involved in bringing down the mutual society. Penrose found that the society had continued to pay dividends unjustified by investment returns and left it with too little in the way of reserves to meet likely future liabilities. This situation was severely exacerbated by foolhardy guarantees approved by the directors to attract new business, the cost of which undermined the viability of the business.
There is, arguably, a comparable if less damaging issue at Standard Life, the other largest mutual financial services business. Standard Life failed to foresee the depth of the recent bear market and continued to hold onto an excessive weight of equities, while itself issuing guarantees for certain classes of investors. As the bear market worsened, the Financial Services Authority intervened, concerned that the insurer had insufficient liquid capital to meet potential liabilities. Standard Life was eventually forced to sell much of its equity holding into a weak market, worsening the impact of the collapse in share prices on the value of its investments.
The Treasury has now established an independent review into corporate governance at mutual life offices in the wake of the Equitable report, to be led by Paul Myners - who previously conducted a review for the Treasury on institutional investment. It is recognised that in the absence of shareholders, some mutuals may suffer a deficiency in accountability to clients and other stakeholders. A second Treasury review will examine accounting practices by life assurers in relation to their with-profits businesses - an issue highlighted repeatedly by accounting & business.
With-profits funds were designed to protect investors from the sharp falls that occur periodically in the equity market, by �smoothing� the impact of highs and lows from investment returns. But across the industry directors have tended instead to pay out too much in product bonuses in the good years - reflecting competitive pressure - leaving them too little to provide attractive bonuses in the bad times.
The result is a damaging series of announcements by major providers. Most - including Prudential and Legal & General - have cut bonus rates. Abbey (formerly Abbey National) shocked the market by saying it will pay no bonuses at all this year on its with-profits products - except where it has issued guarantees - as has Eagle Star on some with-profits policies. Standard Life has ended the practice of imposing penalties on the increasing number of people leaving its with-profits funds - but instead will only pay early leavers the unsmoothed value of their investments.
About a quarter of people who were invested in with-profits products five years ago have cashed in their investments early, reflecting in particular the reputational damage caused by predicted endowment shortfalls. Many with-profits funds are now closed to new business. Most advisers believe that closed funds are unlikely to provide dynamic investment management, or good returns.
Carl Melvin of the adviser Pension Transfer Solutions said: �Closed pension funds are not a good thing. There is no new money coming in. This can cause the asset allocation of the fund to become unbalanced over time, with existing investments sold to rebalance the fund and provide payment of benefits, which may force the fund manager to sell at the wrong time. Normally, new cash is used to assist in rebalancing. With a closed fund, new contributions can come only from existing clients, and how many existing clients would put more money into a closed fund, especially if poorly performing? Where there is no competition for new business - as with closed funds - there is no requirement to be competitive.�
This view of closed funds was confirmed by research conducted by KPMG. This found that UK life closed funds in run-off - the technical term for closed funds - was over £118bn, equivalent to 4% of the value of the life market. Run-off business is caused for several reasons, including group consolidation following M&A activity, solvency problems caused by falls in equity values, strategic business decisions and margin pressures, including the impact of stakeholder pensions. Life insurers in run-off have a smaller proportion of assets in equities compared with live funds and adopt a more conservative investment strategy, KPMG found.
Darryl Ashbourne, director with insurance solutions at KPMG Corporate Recovery and author of the survey concluded: �As a run-off continues, there is a tendency for administrative costs to increase disproportionately and a risk that liabilities may escalate. Strategies which reduce costs and uncertainty are to the benefit of both policyholders and shareholders.�
The shift in investment focus - under pressure from the FSA - from equities to bonds means that the returns seen from the 1970s to the mid-1990s are unlikely ever to recur. Tom McPhail, head of pensions research at leading advisers Hargreaves Lansdown, predicted that the best to be hoped for from with-profits funds in the coming years is a 4% to 6% return. This would significantly underperform against pension and endowment projection for many policyholders.
But with-profits funds actually continued to pay-out positive returns during the severe bear market that began in 2000. By contrast, unit-linked funds badly contracted in value. Yet the effect of these contrasting returns is, paradoxically, a move away from those with-profits funds whose smoothing effect has benefited hundreds of thousands of investors. The explanation lies, at least in part, in the way newspapers have tended to focus on the weak bonuses paid on with-profits investments, rather than comparing them with the negative returns on unit-linked products.
Paul Paxton-Doggett, national financial planning manager at Grant Thornton, explained: �Market perception of with-profits does not square with their actual performance relative to the unit-linked alternative. Norwich Union�s
25-year with-profits savings policies have, for example, yielded 10.1% per year after tax. However, press coverage has focused on the fact that Norwich Union has reduced its bonus rate declarations. With-profits funds have substantially out-performed similarly invested unit-linked funds during the three-year bear market.�
In the view of Paxton-Doggett, the products have been blamed for the failures of the providers. �Perceptions of with-profits have been driven by high profile events at Equitable Life, NPI, Standard Life, etc,� he said. �But in few of these stories has with-profits been the culprit. However, it has been with-profits members who have had to bear the consequences. Wherever there is loss or injustice, the victims seek to place blame, often in an ill-informed way - and that is what has happened to with-profits. In many of these cases, and Equitable Life is a prime example, it has been poor management decisions that have generated the problems for the life company. But, by definition, the fortunes of with-profits members are inextricably linked to the fortunes of the company.�
Inflated promises
According to Philippa Gee, investment director at advisers Torquil Clark, with-profits have also been associated in the public mind with inflated promises by the product sellers. �With-profits itself is a sound proposition; what turned it into its coffin were factors such as the sales and marketing people who set it out to be something it wasn�t, selling it as a higher return investment and putting pressure on the company to announce bonus rates at an unsustainable level,� argued Gee. �The commission that has also been paid by some companies has been so high that when you combine it with the high bonus rates, the whole with-profit system becomes unrealistic.
�Another nail, for some companies, has been the provision of guaranteed annuity rates to pension policyholders, where they have been promised an annuity rate when they take their pension in a certain way of perhaps double the annuity rate currently available. To make such an assumption means you need to ring-fence a proportion of your assets to meet this cost, otherwise you face a big hit and if your with-profit fund has shrunk due to poor stock market returns, the risk becomes even greater.
�Also, with all the bad news that we have witnessed over recent years, some policyholders naturally want out. However, this means that it has put pressure on with-profit providers to try to curb the outflow and they have had to put in penalties to try to restrict the movement, which have only served to antagonise policyholders. Overall, what started out as a good idea has been raped by zealous promises and expectations, which the product could never deliver.�
What you cannot really get away from, though, is that investors in with-profits actually did quite well out of a bear market - whatever the popular perception may be. But as a bull market emerges, with-profits will produce weaker returns as the smoothing effect works in reverse to blunt the edge of rising share prices. This effect is exaggerated by bonuses being calculated by performance over the term of the investment. Consequently,
25-year policies are seeing bonuses decline as �bad� years replace extremely �good� ones from a quarter century ago. These factors have driven Hargreaves Lansdown to tell clients for the last two years not to go into with-profits funds.
In any case, suggested Hargreaves Lansdown�s McPhail, insurers are asking themselves whether the product is worth it to them. �People are [still] getting the benefits from smoothing,� he said. �But doing this is costing insurers sheds full of money.� Most insurers are consequently not keen to sell more with-profits policies and the impact of old policies is running down their reserves.
In other words, it is not just investors who are turning their backs on with-profits products - providers are also walking away from them. This is especially true because the FSA is adopting a much harder line on accounting practices and solvency margins than in the past.
Grant Thornton�s Paxton-Doggett explained: �Recent announcements from Standard Life have effectively taken them out of the with-profits market - for the immediate future, at least. This means that there are now only three major providers: Prudential, Norwich Union and Legal & General - and L&G have stated that they are uncertain about the future of their with-profits products.�
As far as providers and advisers are concerned, the new sales environment is not conducive. The FSA has responded to media and customer concern over the performance and selling practices of with-profits products by introducing tighter controls and requiring greater transparency. In private, industry insiders say this will erode sales margins and threaten reserves to such an extent that the products are no longer attractive to providers or sellers.
The FSA is motivated by consumer concerns and political criticism that it has been too soft on some providers in the past. But in strengthening its regulatory controls the FSA is making it less attractive for providers to offer and manage such funds. It does, indeed, look as if with-profits have had their day. | 
