Outlook: Low inflation, low returns and a mountain of red letters

When it first became apparent that many if not most endowment policies would fall short of the projections on which they were sold, life companies were instructed by the Financial Services Authority to send out letters alerting policyholders to the dangers. Policyholders would get either a green letter, which meant they were broadly safe and didn't need to take any action, an amber letter, which indicated a high chance of a shortfall and suggested they might like to take action, or a red letter, which meant there was virtually no chance of achieving the targeted return and warned them that if they did nothing about it, then they wouldn't be able to pay off their mortgage.

That was just over two years ago. By then, the technology bubble had already burst and markets were beginning to head south, but share prices were still on the whole relatively high. As we all know, the stock market has since fallen dramatically. From the peak at the turn of the century to the recent trough, equity values have roughly halved. Life companies were instructed to send out the letters within two years and then update policyholders at least once every two years thereafter. As a result, some policyholders will only recently have got their first letter, while others will already be on to their second.

Wherever you are on the trajectory, the story is one of steady deterioration. Green letters are turning to amber and amber ones to red. Endowments close to maturity should still by and large be in the money, but anything with more than about five years left on the clock may be in difficulty. According to the Association of British Insurers, 39 per cent of letters sent out in the last nine months were still green. But these covered policies accounting only for 11 per cent of the total number in issue. Over the next few months, there will be a surge in second letters coming through the mail, and in the great bulk of cases, they are going to make alarming reading.

When the problem first emerged, some of the better capitalised life offices – notably Standard Life and Norwich Union – said that provided they could keep making a 6 per cent annual rate of return, no one would suffer. Even if your policy required a higher rate of return fully to meet your mortgage repayment, the life office would make up the shortfall. At the time, 6 per cent seemed easily achievable. In the event it wasn't achieved in 2000, it wasn't achieved in 2001, and the chances of it being achieved this year are about zero. It is still possible that the difference might be made up before the policy matures. But if the new paradigm of negative or low rates or return persists, then it won't and even mortgage endowment holders at Standard Life and Norwich Union, who thought their policies were bullet proof, will suffer some form of shortfall.

Life assurers cannot in themselves be blamed for the falling stock market, although as persistent sellers of shares to meet FSA solvency requirements, they are certainly part of the problem. They have become like an infernal machine at the heart of equity markets, sellers of shares for reasons beyond their control even after they thought the stock market had returned to fair value. However, the really interesting thing is that the emergence of the mortgage endowment problem pre-dates the fall in stock markets. In many cases, failure to meet the targeted amount will have been exacerbated by the falling stock market, but won't have been caused by it as such. The life companies were failing to meet their projections for rates of return even before the collapse in stock markets began.

In some cases, the investment performance is so poor as to be risible. One reader points to the case of a 25-year Scottish Widows policy taken out in September 1987 which on the FSA's worse case scenario of a 4 per cent rate of return from now until maturity (the worst case assumption was drawn up more than two years ago and may now look more than a little optimistic) will not even have managed to keep pace with inflation on the final amount now projected. The shortfall is an astonishing 34 per cent of the outstanding mortgage. All mortgage endowment policies contain a life insurance element, thrown in for free as it were, but even so, our reader is unlikely to have been any worse off had his money been managed by a monkey.

That the vast bulk of mortgage endowment plans have failed to live up to the promises made for them is a statement of the obvious. Less clear cut is whether mortgage endowments were another case of mis-selling by life companies, or by the banks and building societies that persuaded their borrowers to sign up to them. The Financial Services Authority has consistently refused to declare mortgage endowments a general case of mis-selling, for which everyone should be compensated. Perhaps the biggest reason for this is that the sums involved are humongous. On some estimates, it would dwarf the size of pension mis-selling compensation, which at the last count had reached £11bn. At a time when life company solvency margins are already wafer thin few could take any further regulatory punishment. The same may be true of banks and building societies. Financial services companies need all the capital they've got right now.

In any case, there are mitigating circumstances. Mortgage endowment holders may have been slammed by the low return environment we now live in, but on the other side of the ledger most will have benefited from falling interest rates and rising house prices. These counterbalancing trends don't excuse the mis-selling that occurred, but financially they may have more than compensated for the shortfalls that now loom. In some cases, notably Scottish Widows, many policyholders will also have received a substantial demutualisation bonus. If they had applied that to reducing their mortgages, some of them wouldn't have a shortfall at all.

The flip side of the low inflation rate story is one of much poorer rates of investment return as well. One way of looking at the collapse in stock markets, then, is that equity prices are simply adjusting to reflect this new reality, a world in which both economic and earnings growth is going to be much harder to achieve than it has been in the recent past. Few of us have yet fully come to terms with these new circumstances, and adjusted our behaviour to match. For instance, nobody in the City doubts that eventually there will be a massive rally in stock markets. There was a bit of that in Wednesday night's astonishing 6.4 per cent leap in the Dow Jones Industrial Average. Scared of missing the bottom, everyone piled in. It seemed to be a case of here we go again. Actually the more likely scenario is that once they have fully returned to norm, equity markets will take years to recover the exuberance of the boom. If nothing else is yielding a decent rate of return, why should equities?

Business leaders too need to make some fundamental adjustments. Many business plans are still drawn up on the assumption of 20 per cent returns, or that the enterprise will repay its capital within five years. No wonder so little business investment is going on with that kind of a hurdle to surmount. If you can find a business idea with a realistic prospect of achieving such a target, then you are doing exceptionally well. There's no such thing as a free lunch. The mortgage endowment crisis has forced us to learn that lesson all over again.

jeremy.warner@independent.co.uk