Are you well endowed? Don't panic

It's 'bonus announcement' time in the baffling world of with-profit policies. Nic Cicutti guides savers and borrowers through the maze

Like the first cuckoo of spring, mortgage borrowers and others whose savings and pensions are locked into with-profits endowments are traditionally told by their insurers in January how much their policies will be worth when they mature.

The series of "bonus announcements" can be both baffling and compulsive.

Just what are these bonuses and how do endowments work anyway? How are these bonuses worked out and why do they always seem to be going down, despite reasonable stockmarket performances? How does it affect those whose policies still have many years to run? To find out what this all means read on.

What are with-profits endowments?

These are a form of relatively low-risk investment, linked to equities, which have traditionally been offered by insurance companies.

Since the early 1980s, they have been a popular form of savings scheme for millions of home buyers. The theoretical aim of endowments is that when set up alongside interest-only mortgages, they will eventually build up enough funds to meet the cost of the loan, plus a small nest-egg for the investor.

Part of their popularity is determined by the "smoothing effect" applied by companies on the returns paid out, which determines their low risk.

To complicate matters, there is also a unitised with-profits policy on the market, which is more equity-linked and more volatile. The bonus is added direct to the unit price of the policy but there is no terminal bonus.

How does this "smoothing effect" work?

Generally, policyholders who invest start with a fixed insured sum, to which an annual, or "reversionary" bonus is attached. This bonus is generally lower than investment returns in that year. But once it has been attached, it cannot be taken away by a company, which means that the policy cannot suddenly drop in value.

At the end of a policy's investment period the insurance company attaches a further "terminal" bonus. Depending on the bonus philosophy of the company, this can be worth anything between 60 and 300 per cent of the policy's value.

Although you may not see wild gains possible with a booming stockmarket, you will not suffer if it undergoes a sudden fall, as in October 1987.

How is this philosophy worked out?

Every company can decide whether to give more each year and less at maturity or the other way round. The amounts can change at any time depending on a number of factors.

q Investment returns - the performance of the assets in which the with- profits fund is invested.

q Expenses - the charges involved in setting up the fund, paying commission to the adviser who sold it, and managing it.

q Inflation - high inflation often leads to better returns, which leads to higher bonuses.

q Taxation - the less you pay, as with personal pensions, the more you get. Business expenses are tax deductible.

Sounds very confusing.

It is. Much of it relies on trusting the life company you are invested in to treat you fairly. Generally they do, in the sense that over the past decade or more investment returns from with-profits policies have been good.

General Accident, the Scottish insurer, announced last week that the total payout on a 25-year endowment with premiums of pounds 50 a month would be pounds 115,554.

This is almost pounds 2,700 higher than the amount paid out this time last year and equals a net annual yield of 13.9 per cent. The company is one of the better ones. Norwich Union, for example, pays about 12.6 per cent annually on 25-year policies.

What cuts?

In the past five years the value of payouts has been falling. Part of the reason is that for most policies, good investment years (like 1975 for 20-year policies) have been dropping out and lower-return ones (like 1996) have been added instead. Another part of the reason is that in a bid to win more customers in the late 1980s, insurers jacked up their bonuses to make their policies more attractive. Remaining policyholders have paid the price ever since.

What else is wrong?

Charges can take a huge chunk of your investment, particularly in the first few years.

Endowments are inflexible - if you face sudden financial hardship, you will probably halt contributions. Many people stop paying into their policies in the first six or seven years of starting them. The more this happens the more those who are left will get in maturity payouts. But those who stopped paying in, don't.

I have been paying into my policy for many years. If returns are good, what is the problem?

Part of the problem is that the amount paid out is at the discretion of a company. Its strategy will often look like sleight of hand and can leave you vulnerable to cuts in bonuses, as have been imposed in the past few years.

Does that mean that my policy won't pay out?

It shouldn't. In most cases insurers remain confident that policies pay enough at maturity to pay off loans. But for some 10-year policies, a number of companies have issued warnings that returns may not be good enough to pay off the loan. In which case policyholders may have to pay more to make up the difference.

Should I worry?

You should be aware that this may happen. But wait until you are contacted by the insurer. Experts believe the long run of falling payouts is slowing. Continue paying into your policy, even if you no longer have a mortgage. Never surrender the policy if you can help it. And think carefully before you consider an endowment for your next mortgage.