Your Money Q & A: Surely but slowly

With-profits policies sidestep the ups and downs of the stock market. But there is a flip side

Standard Life is the latest big insurer to cut the payouts on some of its with-profits endowment policies, despite last year's strong stock market returns. In spite of popular capitalism, privatisation, wider share ownership campaigns and an increased awareness of unit and investment trusts and tax-free PEPs, one of the most widely held stock market-based investments is still the with-profits endowment policy - that of mortgage repayment infamy. But many savers and investors do not understand where their money is going.

Q: What is the attraction of with-profits policies?

A: With-profits policies run by life insurance companies, in the main for endowment mortgages and pension plans, offer savers an unusual promise. They are stock market-type investments, giving the prospect of the higher returns available from shares. But instead of rising and falling in value with the market, with-profits policies grow steadily.

However, despite this steady growth, the rate of build-up can be reduced, and the ultimate payout value of maturing policies can be lower than those maturing previously. That is what is happening now.

The with-profits idea of steady growth contrasts with most stock market investments, includingunit-linked endowments and pension plans, where the value can go down as well as up.

Q: How can life companies make a promise that the value of your policy will not fall?

A: It is the way returns are distributed. With-profits policies invest in a wide range of "risk" assets, including shares, bonds, gilts and property, that can fall in value as well as rise. But insurance companies that run with-profits funds overcome this problem by smoothing out returns. Each year they award bonuses which increase the value of the policy. Once awarded, these so-called "reversionary" or "annual" bonuses will not be taken away.

However, the bonuses may not reflect the rise in value of a fund's investments following a good year. On the other hand, the bonus could well be more than is justified following a poor investment year.

Q: Is that the only way life insurance companies achieve this sleight of hand?

A: Not entirely. The key lies in the conservative way that bonuses are added. Take, for example, a with-profits policy designed to cover a mortgage of pounds 30,000. The policy includes life insurance, which means that if you die during the term of the policy, it would pay out pounds 30,000. However, read the the small print carefully and you will find that the promised payout at the end of, say, 25 years, is much lower, perhaps only about pounds 10,000, the basic sum assured. That could well be about the same as the value of the premiums you will eventually have paid over the period, with no investment return. In other words, the initial promise is very conservative. Annual bonuses are added to this amount. But these bonuses may also be very conservative. A large part of the eventual payout is likely to consist of a "terminal" bonus. So you will not know how well your investment has done until you reach the end of the policy's term.

Q: How can I find out how my investment is doing at the moment?

A: Once a year you are sent a statement showing the value of your policy. This will show the basic sum assured (the original minimum promised payout), the latest annual bonuses, previous years' bonuses and the percentage value of the latest bonus. This may be expressed as two percentage rates. One is a percentage of the original basic sum assured, the other a possibly different percentage of the bonuses already awarded. Add the basic sum assured to the total bonuses awarded and you get the latest value of the guaranteed payout at the end of the policy's term. This guarantee assumes you will keep the policy for its full term and will continue to pay any premiums due.

Q: When do I get the annual statements?

A: Many companies will send out statements in the spring. This is the time of year when companies declare their bonuses. These are reported in the press in terms of annual and terminal bonuses or in terms of the actual return on maturing policies. You might see that policies that have run for 10 years have produced a return equivalent to around 10 per cent a year, while those which have run for 25 years could show an annual return of around 13 per cent. This suggests that investors with longer-term policies are benefiting from better investment returns in the earlier years.

Q: So does that mean returns on these policies are falling?

A: In general yes, but it depends on how you look at it. Investment returns have fallen in recent years and are expected to continue to be lower than the boom years of the 1980s. But inflation has also fallen. What really counts is the real return over and above inflation.

Q: Is that the only reason with-profits returns are falling?

A: No. Another reason for the fall in recent years is that insurance companies paid out too much on maturing policies in the late 1980s and early 1990s. Traditionally, relatively few long-term policies reach maturity. People who cash in early get poor value for money. But this has allowed insurance companies to inflate the value of policies for those who last the course. The companies then look better in the performance league tables and this helps them sell new policies. With more policies likely to be maintained, life companies have to be more realistic.

Q: But will falling returns affect my ability to pay off my mortgage with a with-profits endowment policy?

A: It could do. It is one thing to know that policies can still give real returns over inflation. But home-owners want big enough returns to clear their mortgage debt. A handful of companies have encouraged policy- holders to raise premiums, but most are being sanguine. Anyone worried about having insufficient money to clear the mortgage might consider switching to a repayment mortgage, while maintaining the endowment policy as a savings plan.

q Questions and answers compiled by Anthony Bailey.