FOOL'S EYE VIEW
Why Your Endowment May Fail

By Cliff D'Arcy
July 27, 2004

During the Eighties and early Nineties, millions of homebuyers were encouraged to buy endowment policies along with their home loans. In return for, say, 300 monthly premiums, these savings plans were designed to pay out a tax-free lump sum after 25 years that would be big enough to pay off the mortgage debt. Endowment policies are life assurance plans, because they include life cover that will pay out a minimum 'sum assured' if the owner dies during the duration of the policy.

Most endowment policies were with-profits (WP) plans, which means that they invested in a life assurer's with-profits fund. By holding a balanced portfolio of shares, property, bonds and cash, with-profits funds are designed to produce good long-term investment returns. Returns were paid to investors in the form of guaranteed annual bonus, plus a terminal bonus when plans matured.

As for investors in unit trusts (or unit-linked endowments), they experience the full exhilaration and despair of the stock market's ups and downs. Conversely, returns for with-profit investors are 'smoothed': some of the profits made in bumper years are held back or 'reserved' to boost returns in the lean years. Hence, WP funds offer a significant exposure to stock markets without the usual volatility of direct investment in shares.

As for returns from different WP providers, these vary according to:

• Asset allocation - what proportion of the fund is invested in each asset class, such as shares, bonds, cash, etc.
• Financial strength - how much excess capital the company has to meet its liabilities and cope with further stock-market uncertainty.
• Investment philosophy - the style adopted by the company's fund managers (do they adopt a long-term value approach, or are they swayed by the latest investment fashion?).
• Inflation - often, low inflation goes hand in hand with lower investment returns.
• Charges - individual investors' returns will be reduced by the charges that apply to their policies.

So far, so good for WP funds, which sound like an ideal way to make superior long-term returns and yet still sleep at night. However, the three-year bear market of 2002 to 2000, during which the UK stock market plummeted, has hit WP providers hard - with some hit harder than others. Even the excellent returns produced during 2003, during which the FTSE All-Share returned 21% during 2003, with income reinvested) did little to undo this damage.

What's more, in the past, some life assurers attempted to win market share or desperately cling on to their prized position in the top performers' tables by over-declaring bonuses. Unfortunately, as the markets weakened, the financial watchdog decided to tightened up regulation of life companies by changing the basis on which their financial strength is measured. This means that some firms were forced to sell shares in order to increase their stable assets.

The net result of all of the above factors was a severe reduction in the proportion of shares held by WP funds. Back in 2000, before the bear market began to bite, life companies held, on average, around two-thirds of their capital (66%) in shares. Four years on, this has halved to an average of one-third (33%) in shares.

Hence, some companies now hold an unacceptably low stake in equities for what is, after all, a long-term investment product. In particular, weaker life offices have slashed their exposure to equities, with several holding less than a third of their capital in shares. These funds are highly unlikely to recover sufficiently to produce decent returns in the future.

So, thanks to a combination of astonishingly high charges, reducing investment returns and a reduced exposure to shares, endowments are likely to continue to disappoint in the immediate future. Nevertheless, not all WP funds are in the same boat, as an article in this month's Money Management revealed.

Money Management calculated one useful measure of the solvency* of the leading life offices. Here are the ten strongest and ten weakest life offices, based on this measure (thanks to Money Management for supplying this data):

* The 'with-profits surplus/required minimum margin liabilities ratio'

The ten strongest firms
Ecclesiastical	24%
NFU	23%
Wesleyan	19%
Teachers	17%
Liverpool Victoria	16%
AXA Sun Life	16%
Legal & General	11%
CGNU Life	11%
Norwich Union	10%
CIS	10%

The ten weakest firms
London Life	-17%
National Provident Life	-12%
Scottish Provident	-8%
Scottish Equitable	-6%
Scottish Mutual	-6%
GE Pensions	-5%
Sun Alliance & London	-2%
Equitable Life	-1%
Clerical Medical	1%
Friends Provident	2%

Policyholders in closed life funds, such as those from Equitable Life and Sun Alliance, should be more worried than most, because these funds must be run ultra-conservatively, since no new money is coming in. It's fairly likely that policyholders in these funds will see a shortfall in the amount needed to pay off their mortgage when their policy matures.

Historically, shares have produced higher returns than cash, bonds and property over long periods. Thus, a significant stake in shares should be an indicator of the health of a WP fund. Conversely, funds with low equity stakes are likely to produce poor returns in the future. Indeed, the proportion of assets held in equities has fallen to an average of under half (48%), according to Money Management. Here are the worst offenders and the smartest managers:

Lowest proportion of WP assets in shares, 2003
Scottish Mutual	26%
Scottish Provident	31%
Norwich Union Life & Pensions	32%
Britannic Assurance	33%
Friends Provident	34%
The Children's Mutual	37%
Clerical Medical	38%
Scottish Widows	38%
Scottish Equitable (Cautious)	40%
AXA Sun Life	41%
Royal London	41%

As things stand at present, investors in the above WP funds can expect returns little better than cash, i.e. in the low single digits. These investors stand little chance of having their mortgages paid off by their endowments.

Highest proportion of WP assets in shares, 2003
Scottish Equitable (Growth)	85%
Ecclesiastical	71%
Wesleyan	69%
Liverpool Victoria	62%
MGM Assurance	62%
Standard Life	60%
Teachers Provident	58%
NFU	57%
CGNU Life	51%
Commercial Union	51%
Legal & General	51%

Over time, investors in these WP funds can expect to receive superior returns when compared to other WP providers, since these funds have above-average stakes in shares.

So, if your endowment provider has low financial strength, together with a low stake in shares, you can expect years of under-performance. These companies include Scottish Provident, Scottish Mutual, Clerical Medical and Friends Provident.

Finally, if you need help with tackling an under-performing endowment or other savings plan, check out these articles:

• The £37-Billion Mortgage Time Bomb
• More Endowment Cuts, More Mortgage Worries
• Ditching Dodgy Endowments
• Tackling Failing Endowments

More: Visit our Mortgage and Investing centres.

Cliff has an under-performing mortgage endowment with Standard Life.