Fool's Eye View

[ May 30, 2000 ]

Endowments Explained

By Rob Davies (TMFEssex)

Carburton Street, London -- Over the last few weeks I have been asked to take part in a couple of radio programmes where listeners phone in with their financial problems and worries. The idea is that the assembled panel can help them. That's the theory, anyway.

Apart from the odd question on whether a particular investment club should buy shares in Baltimore Technologies (LSE: BLT) (I kid you not), by far the biggest category of questions concerned endowment mortgages. In particular the listeners have become worried after hearing from their investment company that the endowment may not be large enough to pay off the mortgage when it matures. Clearly, this is a major concern and the issue was the subject of a rather superficial, emotional and tabloid-type Panorama programme on the BBC last Monday.

The Fool's view on endowments is well known to the cognoscenti but it might well be worth examining why we take this view and to explain the exact nature of the problem.

A mortgage is a loan to buy a house. It is called a mortgage because it is secured on the house being bought. That means if for the buyer cannot keep up his mortgage payment for any reason the lender has the right to take the property in lieu of payments. In the beginning, building societies simply lent the money, calculated how much the borrower needed to pay back every month and that was that. Bit by bit the mortgage was paid off, capital and interest, until at the end of the period the debt was extinguished.

But that was far too simple for lenders to make much money on. Besides, rising house prices and inflation in the 1980s made mortgages very expensive. What the lenders needed was something that a) made them more money and b) was easier for the buyer to afford. Note that I said easier to afford, not cheaper.

The classic way of doing that for any form of merchandise is the "buy now, pay later" trick. And this is exactly what the banks did. Rather than asking for the money to be repaid bit by bit, every month for 25 years, they said, "just pay us the interest and then pay off the capital in one lump sum at the end of the period". That way the buyer has to pay less every month and the bank gets to lend the money for longer. Perhaps I should explain why that is good for the banks.

Let's assume you borrow £10,000 for ten years at 6%. On a repayment mortgage you pay the interest every month and a bit of capital. At the beginning it is mostly interest, and at the end it is mostly capital. So the loan goes from £10,000 to zero over ten years. In effect this means that you are only actually borrowing £5,000 for 10 years. Assuming everything stays constant you pay 6% x 5,000 x 10 = £3,000 in interest. But by only paying off the interest every month and keeping the full £10,000 for 10 years your interest payment is twice that: 6% x 10,000 x 10 = £6,000. The miracle of compound interest is working in the bank's favour, not yours, and the banks make twice as much money.

Now of course you still need to pay off the loan after 10 years. So the bank sells you an endowment. This is a complicated instrument, so more fees for the banks, which combines life insurance and a savings policy. The life insurance is to protect the bank from your early demise, this way it makes sure the loan is repaid. Why the buyer has to incur this cost and not the bank is one of the great mysteries of finance.

The other part of the deal is an investment policy that puts your money into long-term savings, i.e. the stock market. This means that in addition to the interest payments on your mortgage you have to invest in a savings policy. Although they are quite separate they are clearly linked. The amount you pay in is determined by the size of the mortgage and the projected returns, and this is where the problem lies.

Until April 5th 1988 there were no guidelines on what rates to use. The whole industry was unregulated and no records of "promises made" had to be kept. In those heady times projected rates of return were in double figures. Even after that date projected rates were typically 10, 12 or 14%. On that basis endowments were selling like hot cakes. Obviously, the higher the figure the faster the investments would grow and therefore make the attainment of the lump sum that much easier. A higher growth rate meant that monthly contributions could be lower. You can imagine how attractive an idea that was to mortgage salesmen.

So the basic idea was to borrow at 6% and invest at 10%, or whatever rate they chose to use. That way the savings account is expected to grow faster than the interest bill. So even though you are paying more in interest you end up with a lump sum of savings that is greater than the mortgage. That sounds too good to be true. And it was.

In the late eighties interest rates rose to close the gap, then a few other problems arose. Well, one in particular. Long-term interest rates, which dictate the general level of the stock market, fell dramatically in 1998 and stayed pretty low in 1999 despite some volatility. The reasons for that would take another article to explain, but part of the blame lies with that chap Gordon Brown. In an act of gross irresponsibility he gave the Bank of England total independence to set interest rates at a level that suited the economy, and not the politicians. Together with tight control of government expenditure, and a slight increases in taxes, this meant that UK government debt, in the form of gilts, was suddenly very attractive. Long-term interest rates fell, and the stock market rose.

All very wonderful you might think. But too much of a good thing can be bad. The stock market rose to discount these new lower rates, so more growth in the future was less likely. Lower interest rates probably mean lower rates of return from the stock market too. So gradually, over time, projected rates of return have been edged down. The Financial Services Authority (FSA) now regulates the industry and issues its own guidelines on what rates are appropriate. The last time it changed the rates was in July 1999 when the existing rates of 5, 7 and 9% were eased down to 4, 6 and 8%. In the past when this happened they simply kept quiet. But, in a new development, the FSA agreed with the ABI (Association of British Insurers) that fund managers should write to all their investors and notify them of the change in rates.

They agreed to three different codes for the letters. Green if there was little doubt that the endowment might not meet the mortgage, amber if there was some risk and red if it was likely that the endowment would not be large enough to fully repay the obligation.

Anyone with an endowment started before the mid-eighties probably has nothing to worry about. Even someone getting an amber letter should not be too concerned, because the fund may actually do better than projected and meet the debt. However, someone in receipt of red letter, where the endowment is unlikely to meet the mortgage, had better have a look at our endowments discussion board to look at ways of solving the problem.

Some Fools will say, and quite rightly, that as the stock market has returned an average of 12% a year since 1918 there really isn't anything to worry about. That may be true. But there have been periods when returns have been much lower than that. If that coincides the maturity of the mortgage then it could be a problem. And, as we say about managed funds, the past is no guide to the future.

Related Links

• Endowments and life assurance discussion board
• Poorly Endowed -- Part One
• Poorly Endowed -- Part Two