Endowments and endowment mortgages have received a lot of bad press in recent years, amid concerns over falling policy values and accusations of endowment misselling. This article attempts to answer some of
questions and concerns you may have about way endowments work, what's happening to them, and what you can do to ensure your mortgage is paid off at end of term if you have an endowment mortgage.
What is an endowment mortgage?
There are two basic types of mortgage. The first is a repayment mortgage, where you make one monthly payment to lender which is part interest and part repayment of original capital.
Then there are interest-only mortgages, where your monthly payment to lender is just interest on original loan and mortgage debt remains unchanged. You then make separate payments into an investment scheme (such as an endowment), with idea being that at end of mortgage term this investment will have grown sufficiently to repay mortgage.
An online mortgage calculator can give you an idea of difference in payments to your lender between an interest-only mortgage and a repayment mortgage.
Interest-only endowment mortgages were very popular in 1980s and 1990s and were often chosen in belief that endowment would end up being large enough to clear mortgage and still leave a tidy sum of money left over as a bonus.
How do endowments work?
An endowment is a long-term savings policy, typically running for ten to twenty-five years. An endowment plan has what is known as a "sum assured" value. If policyholder dies during life of endowment, it pays out sum assured. In case of endowments linked to mortgages, sum assured is equal to size of mortgage. The payout in event of death of policyholder is guaranteed but, if policyholder survives, final value of endowment at end of its term is not guaranteed.
Endowments can be unit linked, which means that you buy units in a fund, or they can be "with profits".
How does money grow in a with profits endowment?
There are two ways in which a with profits endowment can increase in value. Firstly, insurance company may add a bonus to your policy each year. This is known as a reversionary bonus and is usually a percentage of amount of profit made by fund over previous years.
The amount added in this way may only be a small amount. However, once added, these bonuses cannot be taken away - hence name reversionary bonus - and will belong to you when policy matures.
Then there is terminal bonus. This is a separate sum of money which insurance company can add to your endowment policy when it matures. These terminal bonuses are discretionary and may not be applied at all.
What are advantages of with profits endowments?
The idea of a with profits endowment is to smooth out fluctuations in stockmarket.
With a non-with profits endowment, your investment is linked 100% to stockmarket. Therefore, there is always possibility that investment value could fall just at time when you need money.
By using with profits endowments, insurance companies get round this problem by giving you a slightly smaller percentage of any fund growth as an annual bonus and try to smooth out future annual bonus declarations.
The point of this is to try to ensure that, no matter what happens to returns of fund, you are guaranteed a certain minimum amount when then endowment policy matures.
Why don't you get entire year's gains as a bonus?
On one hand, insurance companies and their fund managers want you to have as much security as possible - hence reversionary bonuses which cannot be taken away at a later date.
On other hand, they are also trying to maximise long-term growth by investing your money in stocks and shares, property, gilts, and cash. All of these involve a degree of risk.
What is problem with endowments?
Anyone taking out an endowment policy, whether on a with profits or unit linked basis, has to be given a written illustration by insurance company of how much policy might be worth at maturity. When providing these illustrations, insurers have to make an assumption as to rate of growth per annum that will apply to money you are paying into endowment. This assumed rate is known as projected rate, and there is no guarantee that this rate will be met in reality.
Until a few years ago, projections were usually based on a mid-range growth rate of 7.5% per annum. In early 1980s, assumed growth rates used in illustrations were even higher. Therefore, monthly endowment premiums were low by today's standards, because they were set to reflect these high projected growth rates.
