Endowments


What is an endowment?
Endowments were very popular through the 1980's and for much of the 1990's. An investment policy and life insurance policy packaged up as one, it was seen to provide the best of both worlds.

Particularly for interest only mortgages this was a very popular product. If the investor passed away at any time during the term of the endowment the life insurance element would pay out. If they live to the end of the endowment then the investment should have built up enough to pay off the mortgage.

The idea of an endowment is that premiums are paid to the insurer who invests the money either in to the funds chosen by the investor, in which case it would be a unit linked endowment, or the insurer’s with-profits fund, in which case it would be a with profits endowment. Each month a portion of that investment is then sold to pay for the life insurance.  

They were typically sold as 10, 20 or 25 year plans. When the plan matures any gains are free of income tax so long as they have been held for a minimum of ten years. However the tax rules are a little more complicated than this and the precise position should be checked with the insurer.

In theory it was a well thought out product that could deliver the client everything they wanted. Well that was the plan anyway.


What is a with profits fund?
A with profits fund holds the profits of an insurance company. Those profits were traditionally held for the benefit of the company's members e.g. policy holders. Insurer's did not have shareholders when these funds came in to being as all insurers were mutuals, like building societies.

By investing in a with profits fund insurers could not only hold their profits but also policyholder premiums all in one fund that could then be invested to grow the fund further and increase the gains for all involved.

Two types of bonus are paid out to holders of a with profits fund. An annual, or reversionary, bonus would be paid each year. A terminal, or maturity, bonus would be paid out at the end of the contract to reward the investor for holding their policy for the full term.

However investing the assets of a with profits fund for long term gains was in hindsight a risky strategy. Three years of stock market falls from 2000 to 2002 saw the value of with profits funds suffer so much that insurer's had to place artificial reductions (market value adjustment or MVA) on to the value of investor's holdings. Insurer's also reduced bonus rates significantly, and some were cut altogether.

The only sensible strategy at that time was thought to be to invest much of the with profits fund in bonds and gilts. These would provide a safe haven for the funds' assets and help them rebuild their values over time. However just as insurers turned to this strategy the value of equities soon began to rise as world stock markets sought to recover from the battering of three successive years of losses.

So not only did with profits funds lose money when the markets fell, they also largely missed out on the recovery that followed from 2003 to 2007.

The recession of 2008-2009 and resultant fall in world markets further compounded the misery for with profits fund and the policy holders that owned them.

All of which leads to the fact that with profits funds may never recover their position and have, in part due to a set of unfortunate circumstances, experienced very poor investment returns.

Policyholders stuck with these funds must decide whether the value of their holdings and perhaps more importantly the potential future growth, and bonus rates, of their holding is worth retaining the fund inside their endowment.


The problem with endowments...
A combination of high initial (front-end) charges and other mostly well hidden, and therefore presumably high, ongoing charges, has drawn much crticism towards endowments and shone attention on the mis-selling of these plans in the '80's and '90's.

Added to the fact that they have experienced very poor investment returns, partly due to poorly performing insurance company funds, and the with profits funds saga outlined above, as well as that charging structure, these plans have generally worked out to be a poor investment.


What to do if you have an endowment?
Investors that do still hold endowments have three options:
  • Surrender the endowment – obtain a surrender value from the provider, then if it seems right, encash it and walk away. If you’re lucky enough to have made a profit then do consider whether income tax would be payable on that profit. However many endowments are known as qualifying endowments, which are usually held for more than ten years and so are free of income tax.
     
  • Sell the endowment – because so many people have tried to get rid of their endowments there is now quite a large secondary market for these products. Traded endowment policies (i.e. second hand endowments), as they are known once they have been sold, are bought on the second hand market via a number of companies that can match sellers with buyers.
     
  • Hold the endowment – if your endowment has performed well or it makes sense to keep it e.g. if you are expecting an attractive bonus, which a financial adviser should be able to show you the calculations to prove the case for, then holding the endowment can be no bad thing. However throwing good money after bad is not what you want either so be sure to make some calculations, or get a financial adviser to do so on your behalf, before you make a decision.