Endowments and endowment mortgages have received a lot
of bad press in recent years, amid concerns over falling
policy values and accusations of endowment misselling.
This article attempts to answer some of the questions and
concerns you may have about the way endowments work, what's
happening to them, and what you can do to ensure your mortgage
is paid off at the end of the term if you have an endowment
mortgage.
What is an endowment mortgage?
There are two basic types of mortgage. The first is a repayment
mortgage, where you make one monthly payment to the lender
which is part interest and part repayment of the original
capital.
Then there are interest-only mortgages, where your monthly
payment to the lender is just the interest on the original
loan and the mortgage debt remains unchanged. You then make
separate payments into an investment scheme (such as an
endowment), with the idea being that at the end of the mortgage
term this
investment will have grown sufficiently to repay the mortgage.
An online mortgage calculator can give you an idea of the
difference in payments
to your lender between an interest-only mortgage and a repayment
mortgage.
Interest-only endowment mortgages were very popular in
the 1980s and 1990s and were often chosen in the belief
that the endowment would end up being large enough to clear
the mortgage and still leave a tidy sum of money left over
as a bonus.
How do endowments work?
An endowment is a long-term savings policy, typically running
for ten to twenty-five years. An endowment plan has what
is known as a "sum assured" value. If the policyholder
dies during the life of the endowment, it pays out the sum
assured. In the case of endowments linked to mortgages,
the sum assured is equal to the size of the mortgage. The
payout in the event of the death of the
policyholder is guaranteed but, if the policyholder survives,
the final value of the endowment at the end of its term
is not guaranteed.
Endowments can be unit linked, which means that you buy
units in a fund, or they can be "with profits".
How does money grow in a with profits endowment?
There are two ways in which a with profits endowment can
increase in value. Firstly, the insurance company may add
a bonus to your policy each year. This is known as a reversionary
bonus and is usually a percentage of the amount of profit
made by the fund over the previous years.
The amount added in this way may only be a small amount.
However, once added, these bonuses cannot be taken away
- hence the name reversionary bonus - and will belong to
you when the policy matures.
Then there is the terminal bonus. This is a separate sum
of money which the insurance company can add to your endowment
policy when it matures. These terminal bonuses are discretionary
and may not be applied at all.
What are the advantages of with profits endowments?
The idea of a with profits endowment is to smooth out fluctuations
in the stockmarket.
With a non-with profits endowment, your investment is linked
100% to the stockmarket. Therefore, there is always the
possibility that the investment value could fall just at
the time when you need the money.
By using with profits endowments, insurance companies get
round this problem by giving you a slightly smaller percentage
of any fund growth as an annual bonus and try to smooth
out future annual bonus declarations.
The point of this is to try to ensure that, no matter what
happens to the returns of the fund, you are guaranteed a
certain minimum amount when then endowment policy matures.
Why don't you get the entire year's gains as a bonus?
On the one hand, the insurance companies and their fund
managers want you to have as much security as possible -
hence the reversionary bonuses which cannot be taken away
at a later date.
On the other hand, they are also trying to maximise long-term
growth by investing your money in stocks and shares, property,
gilts, and cash. All of these involve a degree of risk.
What is the problem with endowments?
Anyone taking out an endowment policy, whether on a with
profits or unit linked basis, has to be given a written
illustration by the insurance company of how much the policy
might be worth at maturity. When providing these illustrations,
insurers have to make an assumption as to the rate of growth
per annum that will
apply to the money you are paying into the endowment. This
assumed rate is known as the projected rate, and there is
no guarantee that this rate will be met in reality.
Until a few years ago, the projections were usually based
on a mid-range growth rate of 7.5% per annum. In the early
1980s, the assumed growth rates used in the illustrations
were even higher. Therefore, the monthly endowment premiums
were low by today's standards, because they were set to
reflect these high projected growth rates.
Interest rates and other economic factors, such as stockmarket
growth and interest rates, are much lower now than they
were in the 1980s and 1990s, so it has now been necessary
to reduce projected rates of growth for people taking out
a new endowment policy today. As a result, the monthly premiums
for a new
endowment policy today will be higher than they were in
previous decades.
How does this affect existing policyholders?
Because actual growth rates have been lower than the projected
7.5% rate, an endowment policy taken out in the 1980s or
1990s may now not be worth enough at maturity to pay off
the interest-only mortgage to which it is linked.
Insurance companies are therefore assessing the state of
people's policies and contacting them to advise what action
they should take now to avoid a potential shortfall at the
end of their mortgage.
How will I be affected?
In most cases, if you took out a with-profits endowment
in the mid-1980s or earlier, the fund should be sufficient
at maturity to pay off the mortgage. This is because the
money in your endowment policy will have benefited from
the higher rates of interest and better stockmarket growth
of the 1980s.
But, the shorter the length of time your endowment has
been running, the greater the potential for a shortfall
at maturity.
It is impossible to predict exactly how large this shortfall
may be, as so much depends on future fund performance between
now and the time when your endowment matures. Insurance
companies are trying to assess the issue by looking at how
much has been accumulated in your fund so far and making
more conservative estimates about future growth.
What can I do now?
There are a number of options:
1. You can increase payments into your existing endowment
policy (subject to Inland Revenue rules), or take out additional
endowment policy with the same insurer or a different insurer.
However, you may decide you don't want to be tied into another
endowment.
2. You can ask to extend the term of your endowment policy,
subject to your mortgage lender agreeing. This is probably
not a good idea if it means your policy would continue beyond
your retirement age.
3. You can set up an additional investment, such as an
individual savings account (ISA). An ISA may be cheaper
and can offer a wide range of investment choices to suit
your attitude to risk.
4. You can ask your mortgage lender to switch part of your
mortgage (equivalent to the projected shortfall on your
endowment) to a repayment mortgage. You can get an idea
of the costs of the new repayment part of your mortgage
by using an
online mortgage calculator.
5. You can use any other spare lump sum to pay off part
of your mortgage. You will need to check first to see if
this would make you liable for any early redemption penalties
from your lender.
Which is the best option?
Everyone's situation is different, and everyone has their
own particular preferences. If you are unsure what to do,
you should take professional mortgage advice to help you
review your options and come to a decision as to what to
do.
Should I just cash in my endowment?
This would almost certainly be a mistake. Many endowment
policies are structured such that the management charges
are highest in the early years. If you surrender the policy
early on, the amount you get back may well be less than
the amount you have paid in up until now.
Also, you need to bear in mind that a large proportion
of the final value of a with profits endowment depends on
its terminal bonus. The size of this bonus will not be known
until the policy matures.
So, the best strategy is normally to keep the endowment
in place. If you need to cut down on your monthly outgoings,
you can leave a policy "paid up" (although you
may incur penalties for doing this). This means that you
do not pay any more money into the endowment, but leave
it to mature on the original date for a
lower amount. If you do this, you will need to make sure
you still have sufficient life cover to protect your mortgage.
It is possible to sell endowment policies on the second-hand
endowment market. The amount you get will depend on the
policy and how long it has left to run. Again, this is an
area where you would be well-advised to talk to a professional
before taking any action.
About the Author
David Miles edits a number of finance websites, including
TheCashClinic.com
- a UK Personal Finance Portal.
