FOOL'S EYE VIEW
60-Second Guide To Endowments

By James Carlisle
October 18, 2002

Endowments have been having a bad press recently and it's no wonder, what with a full-scale "mis-selling" enquiry and the risk that many of them may not pay off the mortgages that they were sold with. Here's the Fool's 60-Second Guide to what they're all about.

0:58 What is an endowment?

Endowments are a form of life assurance with a savings element on top -- basically meaning that they pay out a sum of money, after a set number of years, even if you survive. It sounds quite good, but remember that it's your money! Building up money in something over a period of years is just what an investment does and there are much better investments out there. Traditionally endowments have been sold alongside an interest-only mortgage, to pay back the capital at the end of its term.

Some are structured as with-profits endowments, so that you get awarded bonuses at the end of each year (annual bonuses) and at the end of the term (terminal bonuses). The theory is that the investment (comprising what you've contributed plus any bonuses so far) can't go down, but since so much of the investment returns are kept back for the terminal bonus at the end, this doesn't count for much .Your endowment can go down anyway, if the fund exercises something called a 'market value adjuster'. If this is sounding a trifle confusing, then that's because with-profits investments suffer from an extreme lack of transparency.

Other endowments are 'unit-linked', which means that they basically just track a particular unit trust -- both upwards and downwards. That makes them more transparent than their with-profits bretheren, but it makes you wonder what the point is of wrapping the thing up in an endowment!

0:49 Are they any good?

The short answer is no! The added complexity of an endowment opens the way for what are often obscene charges. Every pound that goes in charges is a pound that's working hard to pay off your fund manager's mortgage, not your own! Endowments also tend to be very inflexible – once you've started one, it might cost you if you change your mind about it.

If you want a mortgage, then the default option should be the repayment mortgage. With these you repay a bit of the capital each month so that, if you keep up the payments, the mortgage will be gone after 25 years -- no ifs and no buts. If you really want an interest-only mortgage, whereby you pay back all the capital in one chunk at the end, then you're likely to be far better off backing it up with a real investment -- perhaps a cheap index tracking ISA.

0.41 What's the mis-selling thing about?

Because of the large commissions to salesmen, they had quite an incentive to sell them to people alongside their mortgage. Unfortunately, in some cases they were economical with the truth when selling them, in order to get the sale. The crucial point is that endowment mortgages involve more risk than a repayment mortgage. If this wasn't properly explained when the endowment was sold, there might have been a 'mis-sale'. If you think this might apply to you, then the place to start is the section of the Financial Services Authority's website that is dedicated to endowment complaints.

0.33 Endowments falling short

Aside from the extra risks, and the mis-selling, endowments have had further problems, because interest rates have fallen and projected returns from the stock market have been adjusted downwards. That basically means that endowments aren't expected to do as well as they were – and in come cases might not do well enough to cover the mortgage that they were sold with at the end of their 25-year term.

Of course these are just projections and we're looking a long way into the future, so they could be way off. It may be that the endowment does better than the new projections, though it could do worse as well. That's the risk of a stock market investment and it's what should have been explained when the endowment was sold. Another point to make is that part of the reason that stock market projections are lower is that interest rates are lower, so the problem with the endowment may be balanced by your paying less interest on your mortgage -- a good plan is to put the saved interest towards paying off the mortgage.

Anyway, the FSA got worried that people might not be aware that their endowments aren't on track, so they've made the endowment companies send out letters to everyone letting them know roughly where they stand. They're called 'reprojection letters' and come in three varieties – green, amber and red. A green letter means you're currently on track to meet your mortgage, an amber letter means there's a significant risk that you won't meet the mortgage, and a red letter means that there's a high risk that you won't meet the mortgage.

0:18 What to do about it

If it looks like your endowment might not pay off your mortgage, then you need to think of doing something else to help pay off the mortgage. The simplest, most obvious and least risky option, would be to add a little to your mortgage payments each month, thereby repaying some of the capital, so that there's less left at the end for the endowment to cover. Because the reprojections have been caused by lower interest rates, your monthly mortgage payments have hopefully gone down a little, leaving some headroom to increase the payments. So you could speak to your mortgage company and ask them about your repayment options.

The alternative, riskier, approach is to do some extra saving in the stock market, but then you might be a bit cool on that idea since it's what got you into hot water in the first place. If you are happy to take the risk and do more with the stock market, then we'd make the humble suggestion that you might not want to do it through your existing, or any other, endowment – after all, that really is what got you into hot water in the first place. Most likely, a straight-forward, cheap and flexible index-tracking ISA would suit.

There's more about all the different options in the FSA helpsheet 'Your Endowment - Time To Decide'.

0:03 Where next?

Endowments are a knotty old business, so it would hardly be surprising if you had further questions. The place to go with those is the Endowments Discussion Board, and for starters, its frequently asked questions section. You'll find links there to all sorts of other resources on this site and elsewhere.