Confused about Endowment Policies?
Why are endowments often linked to mortgages? | How do endowments work? | How does my money grow in a with profits endowment? | How does my money grow in a unit-linked endowment? | It all sounds fair enough | So how does this affect existing policyholders? | How likely am I to be affected by this undershoot? | So what can I do? | Which is best? | Should I just cash in the endowment and have done with it?
This fact sheet 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 mortgages - borrowers pay back a combination of interest on what they owe plus a percentage of the original debt. After an agreed period (usually 25 years), the mortgage is paid off.
Interest-only mortgages - here, you only repay the interest owed on the debt. To pay back the money originally borrowed, you can start paying regularly into an investment scheme, such as an endowment. After a period of time the investment should be large enough to pay off the loan. During the 1980s and 1990s endowment policies were very popular as a means of paying off an interest only mortgage.
An endowment is a long-term savings policy, typically lasting between 10 and 25 years. They can be used as a tax efficient savings plan to build a lump sum of money for any purpose or they can be used to repay an interest-only mortgage.
Endowments can offer life assurance that can repay a mortgage in the event of death within the term of the policy, which is often a requirement of the company providing the mortgage. In order for the policy to pay out free of all personal taxes a set of Inland Revenue rules need to be adhered to. These state that the amount paid out on death needs to be a minimum of 75% of the premiums paid during the term of the plan.
Endowments can be unit linked which means that you buy units in a fund or can be invested in a ‘with profits’ fund.
How does my money grow in a traditional “with profits” endowment?
There are two ways growth can be added to a with profits endowment policy. First, every year the insurance company may add a bonus to your policy, know as a “reversionary” bonus as it cannot be taken away. This will be a percentage of the amount of growth made by the with profits fund built up over the previous years. In times of difficult investment conditions there may be very little or no annual bonus added but you will be told the amount in a with profits bonus statement issued once a year.
Then there’s the terminal bonus. This is a separate sum of money that the life assurance company can add to your policy when it matures. Terminal bonus is discretionary and may not be paid at all.
How does my money grow in a unit-linked endowment?
A unit-linked endowment offers investment choice as you can invest in one or more of the insurance company's range of unit-linked funds. There is often a choice of over a dozen funds ranging from with profits to equity funds investing in the stock markets of the world through to a managed fund that provides broad coverage of UK equities, fixed-interest investments and overseas equities.
Unlike traditional with profits endowments, where once bonuses are declared they cannot be taken away, unit-linked endowment policies provide no guarantees as to what growth will be achieved. As your circumstances change you may switch funds to benefit from investment opportunities offered by different asset classes or stock markets.
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. This is calculated based upon the amount you have paid and will pay in the future multiplied by an annual projected growth rate.
In the 1990s, the projections could have been based upon a 7.5% mid-range growth rate. The assumed growth rates were even higher in the early 1980s. The endowment premiums are basically calculated using the specified growth rates, the age and gender of the life assured(s) (to allow for the cost of the life assurance) and the term of the policy.
The projection rates are set by the regulators to reflect how the economy is doing and how it is expected to do in the future. But because interest rates, inflation and stock market growth, are lower now than they were in the 1980s and 1990s, it has been necessary to reduce projected growth rates for new endowment policyholders.
So how does this affect existing policyholders?
If averaged annual growth has been lower than 7.5%, which could have been your projected growth rate, your endowment policy may not be worth as much as originally projected. If the endowment was set up to pay off a mortgage, you might not have enough from the matured policy to repay your interest only mortgage. If you are lucky, you could receive more than projected when the policy matures depending on what fund(s) you invested in and when you started paying into the endowment.
Insurance companies are continually assessing what’s happening to your endowment policy now, so you know if you are likely or not to achieve the projected maturity value.
How likely am I to be affected by a maturity shortfall?
Generally, if you took out a 25-year 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 stock market 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. The insurance company will let you know how much growth has been accumulated to date and they will send you projection using conservative assumptions about future growth showing any projected shortfall.
If you are using an endowment to repay an interest-only mortgage you have 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 or your entire loan from an interest-only to a repayment mortgage.
- You can use a spare lump sum to pay off part of the mortgage or overpay your mortgage 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 savings plan to make up the endowment shortfall. An IFA will give you personal advice to ensure you select the most suitable additional investment to sit alongside the endowment. The advice you receive may be to take out an Individual Savings Account (ISA). An ISA may be cheaper than an endowment and can offer a wide range of investment funds to suit your risk outlook.
- 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. You will also end up paying more interest.
- You can increase payments into your 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.
Everyone has his or her own preferences. If you aren’t sure, you should talk to an Independent Financial Adviser, who will help review your options and help you decide what to do.
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 cash in 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 an endowment policy as “paid-up”, although you may incur penalties. This means you don’t pay any more endowment premiums but the policy is left to mature on the original date for a lower amount. You will also need to ensure that you have sufficient life cover to cover your mortgage. You can sell many endowment policies on the second-hand market. How much you get as a lump sum for your policy depends on the provider of the policy, the terms 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.
A person authorised and regulated by the Financial Services Authority (FSA) has approved this fact sheet. 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 fact sheet is for information purposes only. IFA Promotion can accept no liability for any action that 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.
APRIL 2005
