FOOL'S EYE VIEW
Endowment Shortfalls Are A Warning For Us All

By Stuart Watson (TMFTiger)
May 14, 2002

It's been hard to miss the various headlines about shortfalls in endowment mortgages over the last few days. The headlines have returned as another round of re-projection letters for these policies are being sent out. Letters are being sent to all policyholders over a three-year period up until June 2004, although some companies will send out new letters every year or two years.

Depending on the growth required in the endowment fund, policies are graded red, amber or green. The numbers receiving the first two categories has increased significantly since last year and now some 60% of the letters being sent are warning that there is a significant risk that their funds will fall short. 35% of the letters being sent now are red, those at the greatest risk of falling short, whereas only 15% fell into this category last year. These percentages may change as more letters are sent out though.

What If You Have No Endowment....

If you haven't got an endowment mortgage, you may breathe a sigh of relief and think that this doesn't affect you. But you'd be wrong. If these funds are falling short, it means other stock market-linked funds like your pension could fall short too. The same applies to any other specific investment plans you might have. School fees, for instance.

Unlike endowments, most of these other schemes have no set targets and therefore there are no such warning signs along the way, unless of course you monitor and reappraise the plans yourself. You could use the same red, amber and green coding. The colour of the notice you receive is based upon the growth rate required to hit your target.

•  A red code means annual growth of 8% or more is required (action is encouraged);
  
•  An amber code signifies annual growth of 6% to 8% is required (consider taking action);
  
•  A green code implies annual growth of less than 6% is required (currently on track).

Some experimentation with our compound interest calculators can then show you how your investment plans are bearing up.

Any investment plan like this needs to be monitored regularly and the payments varied if a shortfall looks likely. This is difficult for the policyholders to calculate by themselves and the inflexibility of endowment policies complicates matters still further. The potential shortfalls haven't been highlighted as early as they could have been, meaning there is less time to take corrective action. In addition, with endowments, varying the payments can be costly and you can also lose out should you decide to switch investments.

This is offset by the fact that interest-only mortgages have benefited from the fall in mortgage rates over the last few years. When this happens, the monthly payments on an interest-only mortgage fall by more than the equivalent repayment mortgage. For example, say you have a £100,000 mortgage repayable over 25 years and the mortgage rate falls from 7% to 6%. The monthly amout for a repayment mortgage would fall from £706.77 to £644.30, a reduction of £62.47. On the interest-only mortgage, it drops from £583.33 to £500.00, a decrease of £83.33. Obviously, mortgage rates have come down a lot more than just 1% in the last few years. See the mortgage calculators in our homeowning centre if you want to do similar sums for yourself.

This difference, or at least part of it, really ought to be ploughed back into the investment side of the interest-only mortgage to compensate for lower expected returns that accompany lower interest rates. However, in most cases, this has not happened and has resulted in endowment holders unknowingly underpaying on their mortgage over the last few years and therefore building up these potential shortfalls.

Don't Panic

Whether it's your endowment mortgage or other investment plan that is falling short, the first thing to remember is not to panic. Investment returns do vary and so adjusting the level of payments you make down the years is a necessary part of the process. In the case of an endowment, if you think you have been mis-sold your policy then the FSA's guide will show you what to do next. The FSA's factsheet that accompanies the re-projection letters is also well examining in detail.

Also bear in mind these three key points:

• The earlier you take action, the less money it will cost you in the long run. That doesn't mean you should rush in and increase your payments straight away, but that you shouldn't just assume that the problem will fix itself. In fact, left unattended, it will most likely get worse;
  
• You don't necessarily have to make up any potential shortfall in the same manner. You can use other investment products to plug the gap;
  
• Always err on the side of caution. Remember that any additional money you finish up with at the end of it all is yours to keep. Better safe than sorry!

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