The arrival of another warning letter from the good folk at Scottish Life, now part of the Royal London group, prompts some further observations about the prospects for mortgage endowments, a subject which - as I know from my postbag - remains dear to many people's hearts and engenders some fierce opinions. The important issue at stake here is what those who receive warnings that their endowment policies may fall short of their original mortgaged sum should do now.
In my case, the issue is hardly a matter of life and death. The only policy I have that could fall short of its target sum is for a small sum, £5,000, and represents, as I recall, the cost of repairing and insulating the roof of a house we sold more than a decade ago. As I no longer have a mortgage linked to the policy, the fact that I continue to pay premiums into the endowment as a de facto savings policy bears testament mainly to two things: my indolence and how little I really knew about financial instruments 16 years ago.
The warning letters that hundreds of thousands of endowment holders like myself are now receiving from life companies are, however, a useful trigger for reappraising the wisdom of maintaining their policies, a decision that will unfortunately be of more significance to many than it is to me. As I see it, the steps involved in analysing the situation are as follows:
1. Work out from the projection figures sent to you what the "implied" valuation of the endowment policy now is.
2. Discover from the life company what the current surrender value of the policy is.
3. Get some quotes from companies that trade endowment policies what you could sell your policy for today.
4. Compare these figures with what you think realistically you will achieve either by cashing in the policy and reinvesting the proceeds or by holding the policy through to maturity.
Only after you have done these steps - none of which except the last is inherently difficult - should you try to decide what remedial action, if any, you should be taking. Once you get to this stage, the important thing is to make sure you apply a common set of assumptions to all the various cases in order to make sure that you are genuinely comparing like with like.
Finding out the surrender or second-hand values of an endowment is straightforward: contact the life company in the first instance and get some quotes from the several companies that deal in traded endowments on the other.
Calculating the implicit value of the endowment is not that difficult either. You need to work back from the projected end values quoted in the warning letter to establish what the current implied value of the policy is, given the three projected rates of return (4 per cent, 6 per cent and 8 per cent per annum) you will have been quoted.
In my case, as my £5,000 policy has six years to run to its original maturity date, its "implied value" comes out at around £2,900. Once you have the implied value, you can compare it to the figure you would obtain either by surrendering the policy or selling it at auction. The latter will almost invariably be higher than the surrender value, but less than the implied value. In some cases, including my own, the surrender value (£2,312) is too high for it to be worthwhile for any traded endowment company to take it off my hands.
Now comes the difficult part of the exercise, which is deciding whether you are more or less likely to do better than the life company over the remaining years of the policy by investing the money somewhere else. The factors involved include your personal tax position, assumptions about the likely terminal value of the policy and what confidence you have in your (or your adviser's) ability to find a more rewarding home for the money.
To ensure that the comparison is genuinely a fair one, you need to bear in mind that endowment policies have some clear advantages going for them, including the fact that the money you receive on maturity comes to you tax-free. The premiums you currently pay also include an element of life cover (sometimes critical illness cover too) that you could not replicate as cheaply today, because of your greater age.
In my case, to get to the original maturity value of £5,000 over the next six years if I surrender my policy, I would need to earn 10.6 per cent compound per annum - assuming that I continue to invest the future premiums I save by surrendering the policy. On the assumption that the implied value of £2,700 fairly reflects the underlying assets associated with the policy, then the required rate of return the life company has to achieve is 6.8 per cent.
The biggest unknown is actually not whether I can beat the life company by 2.8 per cent per annum after tax, but whether the life company is likely to pay out more or less than the final value. As the Scottish Life fund currently has 60 per cent in bonds, at current yields that suggests it will struggle to do much better, if at all, than the required rate. Yet as a recent survey in Money Management demonstrated, despite all the bad publicity, only a very few endowments have in practice failed to pay out more than the required sum if held to term.
Against that again, policies that matured at the end of 2003 paid out an average realised rate of return of just 6.6 per cent over 15 years and 8.1 per cent over 20 years. That is two thirds or less than the sums being realised at the peak of the stock market four year ago.
Even allowing for lower inflation, prima facie that appears to suggest that life companies have been overdistributing on their endowments in the past few years and need now to catch up. If that is the case, although final payout ratios should start to rise again in due course, the immediate prospects for raising final payout ratios is limited.
That may tilt the equation more towards selling your policy (if you can find a good price) and reinvesting the proceeds elsewhere, even though you will have to suffer an immediate hit in the shape of the gap between the price you can obtain today and the implied current value of the policy. Professional advice is clearly important before taking this step.Reuse content