Back in the bad old 1980s, four out of five new mortgages were interest-only endowment deals. Shoddy financial salespeople persuaded just about everybody buying a home that an endowment was the key to paying off the mortgage and then retiring with a hefty tax-free lump sum left over from the proceeds of this stellar investment.
A decade later we have wised up. Some homeowners may end up with an endowment which will not cover them for the full amount of the capital outstanding on their home loans.
The life insurance companies have been busy covering themselves by sending out warning letters suggesting policyholders should consider raising their monthly contributions or making alternative investments to cover any potential shortfall at the end of the term of their endowment policies.
If you have kept an endowment running, you are lucky. Many people bought endowments who should not have done; they lost most or all of their investment when they found that could not keep up the payments on the scheme. An old-fashioned endowment is often worth less than you have paid in for about the first seven years of its term.
The new super-regulator, the Financial Services Authority, is looking into the pushy sales practices of the past to see whether there is a case for mis-selling to be answered. Keep an eye out for announcements on this subject, as they could affect you or your clients.
And yet these peculiarly British life insurance-cum-investment schemes are still big sellers – a third of new mortgages are endowment-backed – and they have legions of fans who see them as pure investment vehicles.
The top-performing with-profits endowment policies have returned an average of 11.7% a year over the last decade (Money Management, November 1998).
There is now a huge second-hand market in unwanted endowment policies: trading volume has grown from less than £10m in 1990 to £300m last year.
Canny investors swoop on policies after a few years, when most of the charges have been paid by the original owner and they are free to mop up the growth.
Tim Villiers, director of the Association of Policy Market Makers, the industry trade body, says demand for endowments – from personal and institutional buyers – far exceeds supply.
‘In the context of similar investments, endowments are still providing attractive returns – 70% of life funds are invested in equities,’ Villiers points out.
With-profits funds pool investors’ cash and put the balance into property, fixed-interest investments and cash deposits.
At the end of each year, the managers share most of the proceeds of each year’s fund growth through annual ‘reversionary’ bonuses – currently around the 6% mark. Unlike pure stock market investments, with an endowment scheme when the investor receives the annual bonus it is there to stay.
What the life company has given cannot then be taken away. Because some of the profits are held back, investors will still get a bonus in bad years, when there has been no growth or an outright loss in the fund.
Volatility will continue
All the signs are that the volatility which has characterised the markets in the 1990s will continue into the next century, which will make the ‘smoothing’ effect of the life company payment system appear even more attractive t many investors.
But if you are taking out a new endowment or buying a second-hand policy, don’t expect future returns to remain in double digits.
The rump of the old regulation system, the Personal Investment Authority, has just asked life companies to lower the growth estimates they show on their investment-linked policies, including endowments.
Currently the potential returns are shown at 5%, 7.5% and 10%. The new figures you will see from July onwards are 4%, 6% and 8%.
These are much more realistic, according to David Riddington, product support manager at Norwich Union. ‘The level is much more reasonable,’ he says.
‘Our best estimate over the long term may be slightly less than 8%, but year to year there will be fluctuations.’
There has been some press comment about the increasing trend among life companies to keep annual bonuses low in favour of paying out a huge terminal bonus when the policy matures.
Riddington says this is a misreading of the situation: ‘The main driving force is not a move from annual to terminal bonuses as such. That may be the end result but not the motivating force.
‘Annual bonuses are pitched at a level which looks to the future. Because our expectation of total return is reducing, the annual bonus is coming down.
‘When you pay the terminal bonus you are looking back at what we have earned and what we have given in annual bonuses. The terminal bonus is what is left to make up the full earnings over the term.’
There are also tax advantages to investing in an endowment policy – although most of the attractive tax reliefs of the past were eroded in the 1960s and 1970s.
The underlying funds are taxed and higher-rate taxpayers will find endowments useful as there is no extra income tax to pay on maturity if you are the original owner of a ‘qualifying’ endowment.
This assumes the scheme has a term of at least ten years – holding a policy for at least seven and a half years of a term of ten years or more makes it a qualifying policy for tax relief.
Capital gains liability
If you invest in a second-hand qualifying policy you won’t have any income tax to pay but may be liable for capital gains tax on maturity.
A third of new mortgages are still backed by endowments. If people are still buying them, despite the bad press about hefty commission payments and inflexibility, then there indeed may be something to recommend in these schemes.
Robert Guy is technical director of John Charcol, the chain of independent mortgage brokers. Such is the backlash against these contracts that he is wary of ‘endorsing’ endowments – and is careful to hedge his words with caveats.
But he is adamant that some of the bad press levelled at endowments is extreme. ‘The standard criticism is that these policies have heavy charges in the early years, but there are a number of policies that don’t do that,’ says Guy.
‘You can have a level allocation contract and from the first month onwards 95% of your investment goes into the policy. If you want to surrender it after four or five years you will get a reasonable amount of that investment back.’
He suggests looking at five-year surrender values as a way of determining value for money – Money Management publishes regular surveys.
Guy cites CGU, Clerical Medical and Standard Life as life companies which have made an effort to restructure charges and which offer steady returns.
If you have a policy with a mutual life insurer you may also stand to gain from a windfall if the company is taken over or opts for a stock market flotation.
Rumours intensified recently around Scottish Widows, with reports that the mutual could pay out a windfall of £2,000 to its with-profits customers if it becomes a quoted company. Four of the five most consistently top performing companies are mutuals (see table).
If you were one of the millions of people sold an endowment in the late 1980s and early 1990s, make sure you keep paying into it, and ask the life company for projected returns based on the new standard figures.
You can increase the monthly payments into a policy – but the current tax rules only allow increases of up to double your current monthly payments.
If this doesn’t appeal, you should consider using stock market-based individual savings accounts (ISAs) to build up a fund (you can invest £7,000 this year) which can be used to pay off some capital early, or to top up any shortfall in an endowment policy when it matures.
TOP TEN ENDOWMENT PROVIDERS
1. Royal London
2. Friends Provident
3. Tunbridge Wells
4. Standard Life
5. Wesleyan Assurance
6. Scottish Widows
7. General Accident (now CGU)
8. Norwich Union
8. Clerical Medical
10. Scottish Mutual
10. Scottish Amicable
The Association of Policy Market Makers: provides a list of members and details of how to buy and sell endowments. Call: 0171 739 3949.
Table based on the number of appearances in the Money Management top ten with-profits performance tables over the decade 1988 to 1998.
Isabel Berwick is personal finance editor of the Independent on Sunday
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