This factsheet aims to answer questions you may have about how endowments work, what’s happening to them and why. It also provides guidance on what you can do to ensure your mortgage is finally paid off if you have an endowment mortgage.
Why are endowments often linked to mortgages?
Whenever you take out a mortgage, there are two main ways of paying it off.
Repayment loans - borrowers pay back a combination of interest on what they owe, plus the original debt. After an agreed period, sometimes 25 years but occasionally sooner, the mortgage is paid off.
Interest-only loans - here, you only repay the interest owed on the debt. To pay off the money originally borrowed, you can set aside a further sum into an investment scheme.
The idea is that after a period of time the investment is large enough to pay off the loan.
This is where endowments come in. They are a particular type of investment that was very popular in the 1980s and 1990s as a means of paying off a mortgage.
How do endowments work?
An endowment is a long-term savings scheme, typically lasting between 10 and 25 years. It provides a value on death matching the value of the amount borrowed, often a requirement of the lender offering the mortgage. They can be unit linked which means that you buy units in a fund, or can be ‘with profits’.
How does my money grow in a with profits endowment?
In two ways. First, every year your insurance company may add a bonus to your policy, sometimes called a “reversionary” bonus. This is usually a percentage of the amount of profit made by the fund built up over the previous years. You will be told how much is being added in a “bonus statement” issued once a year.
The amount added to the policy each year might be fairly small. But once added, a bonus cannot then be taken away. This is why it’s called a “reversionary” bonus. So whatever has built up to date belongs to you at maturity.
Then, there’s the “terminal bonus”. This is a separate sum of money that the company can add to your policy when it matures. Terminal bonus is discretionary and may not be paid at all.
Why such a complicated structure for With Profits Endowments?
With profits endowments are designed to smooth out stockmarket fluctuations. If you invest in a unit linked endowment linked 100% to stocks and shares, there’s always the possibility that the value of your investment could fall just when you need the money.
Through with profits endowments, insurance companies get round the problem by giving you a slightly smaller percentage of any growth from the fund as an annual bonus and try to “smooth out” future annual bonus declarations.
The aim is to ensure that no matter what happens to the returns of the fund, you are guaranteed a certain minimum amount at maturity.
Why not just add the entire year’s gains as a bonus? That way you always know exactly how much a policy’s worth.
Because on the one hand fund managers want you to have as much security as possible, hence the reversionary bonus which cannot be taken away.
On the other hand, they are trying to maximise long-term growth by investing your money in the stockmarket, in property, gilts and cash, which all involve a measure of risk.
It all sounds fair enough. So what is the problem?
When you take out a with profits or unit linked endowment, the insurance company has to give you a written illustration of how much your endowment might be worth at maturity, where the amount you have paid in was to grow by a certain rate of growth p.a. This is known as a “projected rate” and like the maturity value is not guaranteed.
Previously, the projections you might have been given were based upon 7.5% mid-range growth rate. The assumed growth rates were even higher in the early 1980s. The endowment premiums were set to match this growth rate, as projection rates set by the regulators reflect how the economy is doing and how it is expected to do in the future.
Because interest rates and other economic factors, such as inflation and stock market growth, are lower now than they were in the 1980s and early 1990s, it has been necessary to reduce projected rates of growth for new customers who take out an endowment policy.
So how does this affect existing policyholders?
If the fund growth is lower than the assumed growth rate, such as 7.5%, the policy may not be worth enough when it matures to pay off an interest only mortgage. You could undershoot your mortgage target or you could still receive more when the policy actually matures depending on what fund(s) you invested in and when you took it out.
But, rightly, insurance companies are assessing what’s happening to your policy now, so that you aren’t left in the lurch when it matures.
How likely am I to be affected by this undershoot?
Generally, if you took out a 25-year With Profits endowment in the mid-1980s or earlier, the fund should be enough at maturity to pay off a mortgage. This is because the money accumulated to date has actually benefited from the higher rates of interest and stockmarket growth of that period.
Conversely, the shorter the time period since you took out an endowment, the greater the potential for a shortfall in the final payout at maturity.
How much might my endowment undershoot by?
This is impossible to predict since so much depends on future fund performance over the remaining term which could be 15 years or even longer. Your insurance company is trying to assess the issue by looking at how much has been accumulated to date and making more conservative assumptions about future growth.
So what can I do?
There are a number of options: You can find out how much the endowment is projected to undershoot by and ask your mortgage lender to switch part of your loan or all of your loan from an interest-only to a repayment option.
You can use a spare lump sum to pay off part of the mortgage or overpay each month. Check to make sure that there are no redemption penalties on your loan before doing this. If it makes sense to do so, this option is probably the lowest risk option to make up a shortfall.
You can take out an additional investment which an IFA can help you select. It could be a tax efficient Individual Savings Account (ISA), An ISA may be cheaper and can offer a wide range of investment funds to suit your risk profile although in the long term paying off part of your mortgage is likely to prove to be better value for money.
You can ask to extend the term of the endowment policy and your mortgage loan (subject to your lender agreeing). This is probably not a good idea if it means the policy continuing beyond your retirement. And you will end up paying more interest.
You can increase payments into the existing endowment policy. However there are Inland Revenue rules as to what you can do with endowments in order for the maturity value to be free of personal tax. As a result endowments are not very flexible. You can take out an additional policy, either with the old insurer or a new one. The question of charges applies and whether you want to be tied into another endowment. An IFA can help explain your options.
Which is best?
Everyone has his or her own preferences. If you aren’t sure, you should talk to an Independent Financial Adviser (IFA), who will help review the options and come to a sensible choice.
Should I just cash in the endowment and have done with it?
That would be a mistake. Many unit linked and with profits endowments are structured so that the management charges are highest in the early years. If you “surrender” the policy early on, the amount you get back might not even match the premiums paid to date.
Remember too that a large slice of a with profits endowment’s final value depends on its terminal bonus, which will only be known at maturity. If you need to save money (for example because you have opted to turn part of your loan into a repayment mortgage) you can leave a policy “paid-up”, although you may incur penalties. This means you don’t pay any more endowment premiums but leave it to mature on the original date for a lower amount. You will also need to ensure that you still have sufficient life cover.
It is possible to sell many endowment policies on the second-hand market. How much you get depends on the policy and how long it still has left to run.
Again, to decide on the best option for you, you should talk to an IFA – for details of IFAs in your local area call the freephone Hotline on 0800 085 3250 or log on to www.unbiased.co.uk
Please note: This factsheet from IFAP has been approved by a person authorised and regulated by the Financial Services Authority (FSA). Your tax position will depend on individual circumstances. Tax advantages may be subject to future statutory change. The value of investments can go down as well as up. Past performance is no guarantee of future performance. This factsheet is for information purposes only. IFA Promotion can accept no liability for any action which an investor takes based on this information. The name IFA Promotion® and the Independent Financial Adviser (IFA) logo® are Registered Trademarks of IFA Promotion Limited.
Last updated Mar 2005
