Secrets Of Success: Keep it simple and check those costs

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The first point to make, out of fairness to the life companies themselves, is that in considering stopping or switching from a with-profits endowment, you need to take account of the life insurance that is attached to the policy. It makes sense to factor in the cost of replacing, or replicating, the cover attached to your policy over the remainder of its term.

Even in today's more open and commoditised life cover market, this can represent a not insignificant sum. Fortunately, it is now relatively easy to get competing quotes (try and there is often some provider willing to pay particularly low rates in order to build up its life cover book. Shopping around was much harder in the distant days when endowments were being sold to all and sundry.

The second point concerns the transparency of the costs associated with endowment policies. This, to my mind, has always been the Achilles heel of the packaged product business in this country, where for years the game for providers was all about concealing the true cost of policies from those who bought them.

How many people would knowingly have bought many of the savings policies they did had they really known and understood how much of their money was being taken out up-front in the shape of commissions?

With a relatively complex product such as an endowment, the issue has not just been about finding out what the true costs are. We also need to point out the potentially huge impact that compounding those costs can have on the future returns of a policy.

Not that disclosure itself is the only answer. Look at any unit trust "key facts" document and you're likely to see the warning that a projected 7 per cent annual return is likely to fall to somewhere between 4 and 5 per cent a year after taking account of charges.

But this warning appears to have had very little impact on consumer behaviour, just as publishing interest rates seems to have little impact on the amount of consumer debt.

As Cazalet points out, one of the big cost issues with life companies in recent years concerns the way that they now provide for the cost of the guarantees that were so liberally given out in the past. Any savings policy with a guaranteed return is by definition of greater value to the holder than one that does not have the same level of guarantee, as well as representing - by extension - a potential cost to the provider.

Paying for guarantees that had been promised but not provided for is what, of course, brought Equitable Life to its knees. After the House of Lords verdict in the Equitable case, most life companies have had no choice but to face up to the need to manage the guaranteed return liabilities on their books.

In a low inflation world, even a 3 per cent guaranteed annual return (quite common with older savings policies) becomes a potentially significant burden that has to be met.

The way life companies deal with that varies hugely. The wholesale reduction in equity exposure is part of the phenomenon. Prov-iders have jettisoned the potentially higher returns from stocks in favour of assets (such as bonds) that they know will be capable of meeting their future guarantees with certainty, even if their upside is traded away in the process.

But there are other, less obvious, ways in which providers have responded to the guarantee issue. According to Cazalet, some, such as Clerical & Medical, have used derivatives to hedge their already much-reduced exposure to the stock market still further. They use a mixture of call and put options to ensure, in effect, that the return they achieve falls within a certain set of parameters.

Other companies, typically the ones with the weakest financial positions, make explicit charges to cover the cost of the guarantees they have provided. While the stronger companies charge the cost of guarantees to their inherited estate or excess capital, companies such as Royal & SunAlliance now make a specific charge of 0.5 per cent a year for guarantees.

This fee is deducted from the investment return available to a policyholder on maturity. Others now charge with-profits policyholders for the fact that they have to tie up capital to keep their policies going through weak markets.

In one sense, none of this is a surprise: it merely underscores the fact that in investment there is no such thing as a free lunch. In retrospect, it also shows how many life companies, not just Equitable, were unwise - going on reckless - in the way they overdistributed to policyholders whose policies matured during the latter stages of the bull run on the stock market.

Nobody complained at the time, of course, but that is the way of the world. Now it means that many investors are left with policies that have a quite different risk-return trade-off to the one they thought they were buying at the outset.

Looking forward, however, also means that future returns on endowments are likely to be even more constrained than you thought. On Cazalet's estimates, the average with-profits fund has about a third of its assets in equities, 10 to 15 per cent in property, and the rest in fixed income and cash. Taking a medium-term figure of 7 per cent a year for equity and property returns, and 5 per cent for a mix of government and corporate bonds, that implies an overall return for the average fund of 5.5 per cent a year.

Knocking off the charges will reduce that by between 1 and 1.5 per cent a year, and guarantee charges (if they have been put in place) by a further 0.5 to 1 per cent a year. That leaves something like 3 to 4 per cent only to be applied to policies by way of investment return. That is not as high as even the lowest of the three projected rates of return in the standard regulator-approved warning letter about endowments.

Not a pretty picture, though it is worth stressing that experience varies widely between providers and that there is only value in switching if you can find a better home to go to. Take into account the small text and charges attached to any alternative home.

Readers know my view that guaranteed products appearing to offer protection against unwanted market movements score no higher on the transparency or value-for-money stakes than the worst kind of with-profits policies. Best is to be highly selective and keep it as simple as you can.

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