Its-YOUR-money looks at Endowments
An endowment policy combines term life insurance with a form of saving. You pay a premium during the term of the policy and at the end of the term the sum assured is paid to you (or to whom you specify). If you die before the end of the term, the sum assured is paid. If it’s a ‘with-profits’ policy, in addition to the sum assured you receive additional bonus sums that depend on the investment performance of the insurance company. Typically, some of the bonus sums are declared annually and these are effectively guaranteed once declared. The remainder comes in the form of a terminal payment that is not guaranteed. It is the bonus element that has given rise to accusations of mis-selling in relation to endowment policies in some circumstances.
Much of the fuss surrounding endowments is connected with the use of an endowment policy to repay a mortgage. With an endowment mortgage, you borrow the money to buy your home from a bank or building society as usual. However instead of your monthly mortgage payment being a combination of interest and capital (that is known as a repayment mortgage), your payment to the building society covers only the interest. You take out an endowment policy for the same term as your mortgage, and when the endowment matures, the money you get from the life insurance company repays the loan from the building society. If you die prematurely, the insurance pays off the mortgage.
Endowment mortgages are fine (but expensive) as long as the sum assured is enough to pay off the mortgage. However, to make them more attractive, some insurance companies and mortgage brokers were encouraging people to take out a policy with a lower sum assured in the expectation that the bonus payments would make up the shortfall. Since bonus payments are linked to the performance of the insurance company’s investments (mostly shares), this is acceptable when the markets are rising. But when markets turn down, as they did at the start of 2000, bonus payments are cut back. Many homeowners found that their endowment policies were nothing like enough to repay their mortgages and have been faced with either having to find a lot more money or risk losing their homes.
The accusations of mis-selling arise because it is argued that those selling the policies should have known that an investment product primarily linked to stock market performance is not suitable for paying off a mortgage. We will look at the pros and cons of investing in shares in a lot more detail later. For now it is enough to say that shares are relatively volatile investments and their value can go down. The investment performance of funds that have a large proportion of their assets in shares will always be pretty bumpy. During a long running ‘bull’ market (for example for much of the 1980s and 90s) you will be tempted to think that relatively high rates of return are here to stay. They won’t be. If the stock market is rising faster than the economy then at some point it will turn down as sure as night follows day. Insurance companies that paid out bonuses based on the high returns they were enjoying at that time were benefiting maturing policyholders at the expense of those whose policies were due to mature after the stock market crashed from 2000 onwards.
If you believe you may be a victim of endowment mis-selling then take action now. (See our links page for specialist advice).
Should endowments be avoided then?
Not necessarily. They do provide life insurance (which you will almost certainly need at some time in your life) and a way of saving money that you might not save in other ways. Once you've taken out an endowment policy and arranged for the premium to be paid from your bank account each month, you will adjust your spending accordingly. It isn't exactly pain-free, but it is a relatively easy way of making sure you are saving something. It takes a lot more discipline to set aside the same amount of money to put into a fund of your own, and of course you then have to take the investment decisions.
Insurance companies are massive investors. This means that their risks are highly diversified, but it makes it almost impossible for them to produce higher returns than average for the markets as a whole. After taking account of their management expenses, and the pretty generous commissions they pay to those who sell them, endowments are virtually certain not to beat the markets. However, they are still likely to prove a better bet than doing it yourself unless you are prepared to work quite hard at it. Unless you are lucky enough to win the lottery or have the prospect of making a lot of money very quickly, the important thing is to save regularly and start early!
How well are endowments doing at the moment?
Taking a couple of recently published figures, a typical endowment policy of 25 years, into which the policy holder has paid in £50 per month, and which matures now will pay between £51,000 and £58,000. That represents an average rate of return of up to 9.1%.
The same policy maturing five years ago would have delivered £110,000 – a rate of return of over 13%. The total returns on the FTSE All share index for approximately the same period were just over 15%. As you can see, returns have fallen and it is important to remember that even for policies maturing now, much of the investment period includes the bull market conditions of the 80s and 90s, and a period of relatively high inflation. (The real rate of return on the FTSE All share index is around 7% a year for our comparison period). With inflation around 2%, we can expect market returns in money terms to remain in single figures for the foreseeable future, and that endowment returns will be slightly below the markets. Real market rates of total return are unlikely to be more than around 7% or so before management costs. In fact the Institute of Actuaries estimates that the nominal (money) rate for pension projections should be 7%, implying a future real rate of around 5%.
Your savings in an endowment policy build up over time, and before too long the policy acquires a ‘surrender value’. After that stage the insurance company will give you some money back if you surrender the policy. However, they will almost certainly offer you far less than the policy is worth then, and you have the option of selling to someone else. Whoever buys it will continue to make the payments and receive the benefits when it matures (or if you die in the meantime). There are several companies that specialise in trading second-hand endowment policies, and if you are faced with having to sell a policy then shop around for the best offer before surrendering it to the insurance company. Naturally enough, the policy is worth more than you will be offered for it (why else would anyone want to buy it off you?) but if you really can’t afford to continue it, or you need the money then keep in mind that it does have a value.
Endowments: the disadvantages
The main disadvantage is that an endowment is not very flexible. You are locked into the policy because surrendering it is usually a very poor option, and selling it will still get you less than it is worth. You don’t know the returns you will eventually get (although you will know the sum assured, the bonuses are an unknown factor). If you save the equivalent amount each month (and have a term life insurance policy if necessary) then you have the flexibility to invest it however you wish and have access to the money if you need it. However, saving that way takes a lot more discipline and time, and you may find it difficult to diversify your investments as easily or as cheaply as the insurance companies can.
We will look at investing in a bit more detail on the next pages.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|