Endowment Mortgages & Endowment Shortfalls

David Miles 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.

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Copyright 2004 David Miles. You are welcome to reproduce this article on your website, so long as it is published "as is" (unedited) and with the author's bio paragraph (resource box) and copyright information included. In addition, all links to external websites must be left in place.

About the Author

David Miles is the editor of a number of mortgage and remortgage websites, including:
The UK Mortgages & Remortgages Website
London Remortgages