Endowments and Endowment Shortfalls - What You Need To Know

Endowments and endowment mortgages have received a lot of bad press in recent years, amid concerns over falling policy values and accusations of endowment miss-selling.

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 stock market 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 stock market 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.

Please note that this article is for general guidance only and does not constitute financial advice. You should seek professional advice with respect to your own specific circumstances.

------

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.

David Miles is the editor of a number of personal finance websites including UK Mortgages & Remortgages and The Cash Clinic - a UK Personal Finance Portal.

Starting With Smaller Goals First And Work Your Way Up Until You Achieve Financial Freedom

While you need to have a lot of positive-thought and confidence in order to be... Read More

Why You Need To Buy and Sell Gold Coins (Part 4)

Top Investment PerformanceThroughout history, many coin collections have produced substantial long-term profits for their owners.... Read More

The 9 Critical Steps To Success In Demolishing Your Money Worries For Good!

Articles on 'How to make money' come a dime-a-dozen. How about a fresh, new perspective?... Read More

Who Else Wants To Know Oprahs Secrets To Wealth & Success?

Before I had a lot of money, I was really quite happy," said Oprah Winfrey.... Read More

Compounding: The Science Of Exponential Money Generation

It all begins with a simple calculation.You are home on a rainy Sunday afternoon, looking... Read More

Easy Ways to Save $1,000

Vacation season is upon us and it can be tempting to pull out the plastic.... Read More

What Are Your Beliefs About Money and Wealth?

What is your attitude towards having wealth? Do you believe it is possible to have... Read More

Why Get Rich When You Can Be Wealthy?

"Any fool can rich, the wise get wealthy." Chris WidenerGetting rich is the main goal... Read More

Financial Planning For Singles

Financial planning often gets a bad rap. Part of the problem is self-inflicted, since some... Read More

Profit from Your Own Information Empire!

Would you like to profit from your own information empire? Here are a few ways... Read More

Top 10 Secrets of Getting Rich!

As many people have observed, "Success leaves clues." If you want to achieve extraordinary success... Read More

The Mathematical Formula For Making Money

No matter what markets you serve; what products you sell; or what marketing tools... Read More

Money Myths Of The Poor

From tender age, we were exposed to myths about money and myths of being rich.... Read More

Plan For Wealth

One very important wealth creating habit is to set up a concrete plan that you... Read More

Controversial Wealth Audit Reveals Over 90 Percent of Us Could End Up Working Forever...Are You One

Results from a new tool developed by UK based firm, Lean Marketing, confirm a worrying... Read More

Building Wealth: A Wealth Building Strategy Is More Than Simply Diversifying Your Investments

Wealth - an abundance of values. Each of us determines what is or is not... Read More

Turbocharged Financial Planning

Financial planning is an ongoing process individuals and businesses should implement by organizing all aspects... Read More

How Should I Create Passive Income?

If you're wondering where to create passive income, then you are likely not alone. There... Read More

From Debt to Financial Freedom

The vast majority of working people are in debt. The vast majority of people who... Read More

10 Ways To Find The Money Hiding In Your Paycheck

No matter how tight things are financially for you; no matter how bleak you think... Read More

Q and A: Financial Independence Tips For Women From Coni Cecil

As a woman Netpreneur, I sat down via e-mail with article-announce regular contributor, Internet marketer... Read More

Lesson 1 - Why Arent You Wealthy?

We will start the Financial Fitness System with the assumption that you are out of... Read More

How To Get Investors And Bankers To Part With Their Money For Your Business

Time and time again entrepreneurs are losing out on getting the capital they need because... Read More

Before There Was Wall Street, There Was Gold.. & when Wall Street is gone, there will still be Gold

Paper burns and large companies can go bankrupt, but if you want a piece of... Read More

Cost Averaging - It Makes Sense (Dollars & Cents)

It's no secret that the market goes UP...the market, goes DOWN. That's the basics of... Read More

Pennies From Heaven

I want to share an experience I had in common as a child with Dr.... Read More

6 Proven Wealth Building Strategies

Building wealth is as simple as saving a little bit here and a little bit... Read More

Your Money Or Your Life

Have you stopped to realize that although you go to school to learn about... Read More

7 Power Habits that Build Financial Independence

Financial independence is having the freedom to support yourself through your own efforts. Here are... Read More

Budget Tips

To budget, to have a budget and to be on a budget is not a... Read More

Retirement ? Can You Afford It?

Every day you work is one day closer to your retirement. But can you afford... Read More

You Deserve To Retire Early

The fact is that most people continue to work for a living, because they don't... Read More

7 Golden Rules to Financial Prosperity

Not Enough Money?I believe that most people haven't got enough money for everything they wish... Read More

Principles to Ensure a Fantastic Financial Finish

Most people want to get to the end of their lives and be able to... Read More

Financial Intelligence - Compounding (The Ninth Wonder of the World)

Compounding: The Ninth Wonder of the WorldBy Nicola Cairncross Compounding is often described as the... Read More

A New Economic Policy

Anyone knows that material wealth is measured in goods: apples, cars, shoes, sheep, etc. When... Read More

Five Straight Steps to Opening an Offshore Bank Account

Despite what you may have read or heard, anyone is free to open an offshore... Read More

Who Wants To Be A Millionaire?

Steve Martin once delivered an opening monologue for Saturday Night Live in which he answered... Read More

Who Else Is Tired of Life Punching Them in the Face?

Remember the bloodied face of Randall "Tex" Cobb?He was a boxer who fought in a... Read More

Trustees: Who Can You Trust?

Early in my legal career I represented two young women in their early 20s.Their mother... Read More

Your Wealth Cycle Foundation

The four main steps in building a wealth cycle foundation are:· Pay yourself first ·... Read More

Is Your Money Keeping Up With Inflation?

In today's unpredictable global economy, you obviously never know what is going to happen next.... Read More

Early Retirement The Dream of the Working Classes

Everyone dreams of early retirement. The idea of no longer having to work at an... Read More

Wealth And Your Net Worth

Most people know it's important to keep and organize all of your vital financial information.... Read More

Let Me Inspire You - You Aint Seen Nothing Yet! (PART-1)

You know about compounding right? You understand what pyramiding your result on a weekly basis... Read More

The PDQ? Factor

It's the beginning of a brand new year: a time to set goals, make plans,... Read More

Asset Diversification Is NOT Boring?And Will Make You Money

OK, this article will start with the cheapest piece of advice you will receive this... Read More

Could a Roth IRA be Better Than a 401(k)?

Very few people whom I know are familiar with the benefits of the Roth IRA.... Read More

Financial Freedom, Is It Only A Dream or Just Steps Away?

Almost all of us go to work everyday and do the same routine over and... Read More

The Secret Barrier To Wealth - Underearning

Is the ghost of "Money Past" haunting you? Do you feel like no matter what... Read More