Endowment policies assume far too much

Investors should treat projected returns with scepticism, says Melanie Bien

Fretting over whether your endowment policy will actually pay off the mortgage when it matures has become a national pastime.

Mindful of the shortfalls faced by many of the 6.6 million endowment holders, the Financial Services Authority (FSA) is reviewing the way projection rates are calculated. And last week it also introduced improvements in the way life insurers work. With-profits funds should be more transparent as a result, while directors and senior managers of life insurers will also be explicitly responsible for all decisions on their business.

Investors rely on projection rates from their policy pro- vider to give an indication both of what they might get back from their investment over the long term and the effect of charges on that return. They are based on the FSA's standard range of predictions, which have been in place for the past 15 years. These indicate investment growth of be- tween 4 and 8 per cent a year.

But the prolonged bear market shows how useless these projections can be if shares don't play ball. The number of "red" and "amber" reprojection letters sent out by insurers to policyholders - saying there is a "significant risk that their plan won't pay off the target sum" - proves that the system is fallible.

Between July 2001 and December 2002, says the Association of British Insurers, 27 per cent of the 4.3 million letters sent out suggested that customers "consider taking action" to meet a possible shortfall. A further 42 per cent said "investment growth of over 8 per cent a year is needed to keep the policy on track to repay the target sum". Such a growth rate is highly unlikely.

"It is important that consumers appreciate the uncertainties," warns Michael Folger at the FSA. "No one can predict the future. Projected returns are not promises."

Despite the review of projection rates and the number of investors facing shortfalls, the FSA refuses to lower its standard predictions. It made this decision on the back of a report on long-term market conditions released last week by accountants PricewaterhouseCoopers. This suggests that in the long run equities still outperform government bonds by 3 to 4 per cent a year.

However, the FSA has told insurers that they may have to lower their own projections if they have shifted some assets from equities into the relative safety of bonds. The FSA's projections are based on 70 per cent of the fund being held in equities. If this ratio shifts so more is held in bonds, the projections should be lowered to take this into account.

Scottish Widows recently admitted that growth of 8 per cent a year is unlikely and that a maximum return of 6 per cent is more realistic. Other insurers are likely to follow suit. This doesn't make happy reading for policyholders, but it will at least give them a much clearer picture of how their policy is likely to perform. This in turn will give them time to take action so they can pay off the mortgage.