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Endowment Policy Shortfall FAQ
Q. What is an endowment policy? An endowment policy is a mix of stock market investments and life insurance. Every policy has to have a death benefit, which is the minimum amount that will be repaid should you die during the term of the contract. The greater your age, the more expensive the life cover element and therefore such policies cost more for older people. The policy would be written for the term of the mortgage, which in the UK is usually for 25 years upon the life assured, which would normally be the party to the mortgage deed. Q. Why were endowments sold with mortgages? Initially this was a tax-efficient way to repay the mortgage. People received tax relief on the endowment premiums and tax relief on their mortgage interest. Properly structured, the endowment was designed to not only repay the mortgage, but also give a lump sum on top. Most had guarantees that were very valuable. Endowment mortgages were still sold in later years, even though the product had changed radically and had became much riskier and more expensive due to the loss of the aforementioned tax breaks and guarantees. The principle of using alternative repayment methods had become so ingrained with Financial Services Advisers, we are now finding other high risk approaches such as PEP/ISA mortgages and Pension mortgages, all of which are at the mercy of the stock market and therefore considerably at risk. Q. What happens to my endowment mortgage when I have an alternative repayment product? Nothing, it is more than likely that you will have an interest only mortgage so there will be the same loan amount outstanding throughout its term. Your endowment (or ISA etc.) is intended to repay the whole debt when the policy matures. Q. I have received a forecast that my endowment will produce a substantial shortfall at the time of its maturity, leaving over half of my mortgage loan unpaid. How seriously should I consider this possibility? Obviously, if this forecast is in any way accurate, in the years to come you will owe this shortfall to your mortgage provider at the time when the policy matures. Should the investments held within the Fund, in which your monthly premium is placed, start to improve, then this shortfall/deficit could be less and may possibly be eliminated. On the other hand, if there is no improvement in the stock market, matters could even get considerably worse. There is no point, however, in making a judgement on how the stock market will perform in the future because this is pure speculation. That is why the financial services regulator, the FSA, has introduced the package of measures to enable the problem to be addressed now, even though the shortfall presently is only a “paper loss” at this point in time. The FSA took this decision now because leaving it much longer could prove to be a disaster just waiting to happen. This is unprecedented in regulatory history. One can only surmise that the logic in this thinking is that the link between an endowment policy and the repayment of your mortgage is not to be trusted and therefore the switch to a repayment mortgage with the appropriate guarantee is now the most suitable way forward. If we consider the mathematics for a few moments, it will become clearer just how serious this shortfall problem could be. In a few years time when the under performing endowments start to mature, the mortgage providers will have a decision to make on how best to solve the shortfall situation, both in terms of their own business and in the interests of their clients, particularly as the regulation of mortgages has now occurred. Already at CPH / Endowment Risk, we have seen some evidence of clients who have already taken the decision to sell their home now because they simply could not afford to make the changeover to a repayment mortgage. As more and more endowments with a shortfall mature, the problem will become more acute for the mortgage providers whom, it could be argued would be entitled to take an aggressive attitude because of the reprojection letters, which have been sent out over the previous years. If you are one of the people so affected you must realise the problem is entirely yours and you have to solve the conundrum of what is the best way forward. By doing nothing, you would be joining a percentage of other endowment victims who run the risk of losing their home simply because they may not be able to afford to repay the shortfall at the right time. This is the legacy of using an under-performing endowment to repay the mortgage debt. Clearly, if there are a lot of people left in this invidious position, this is not going to help the housing market and could ultimately even affect the economy as a whole. This risk was unacceptable to the FSA, and that is why it is preferable for you to switch to a guaranteed repayment mortgage now and have the present shortfall paid as compensation (should you have been mis-sold your endowment at the point of sale), thereby eliminating the predicament once and for all. Obviously not every endowment was mis-sold, but this category of policyholder will still need to consider the best way forward in solving their prospective shortfall problem. Delaying, or doing nothing is not an option worth considering. Q. How did the problems surrounding endowment mis-selling start? Banks, building societies, insurance companies and financial salesmen saw a path to quick riches on the back of the boom in housing/home ownership. Before the introduction of the Financial Services Act in 1988, anybody could sell endowments with limited regulation. After this date most building societies signed lucrative deals to sell the endowments of just one life office company, while banks moved to set up their own insurance companies. At this time, more than 80% of all new mortgages granted were linked to endowments, a situation which was unsustainable and was beginning to seriously worry the Regulators , who could not understand why so many people were willing to use a stock market product, with all its attendant risks, to repay their mortgage debt. Either the UK public were very sophisticated by understanding the risks involved or they were being "taken for a ride". Q. Why did people buy endowment mortgages? It has been claimed by endowment policyholders that hard-selling techniques and over-optimistic promises made by salespeople meant that you had to be stubborn or single-minded to get anything else. Indeed, these so-called advisers often summarily dismissed the mere mention of a repayment mortgage by the client as being part of our history. It was only in more recent years that customers began to question the pressurised selling techniques by advisers and their concentration upon a single product. Rather than explaining the other mortgage options available, which is demanded of them under the Rules of the Regulator. Prospective policyholders were shown payouts on endowments that were just maturing. These had benefited from some of the best performing years that the stock market had known. In certain cases little or no explanation was given to the risks attached in making a stock market investment, or that markets could go down as well as up. Often consumers were led to believe the endowment policy was guaranteed to pay off the mortgage loan and were also promised a tax-free surplus on top, which could be spent how they liked. Many consumers were also told that they did not need to worry about the maturity date of their policy, because it would grow so fast that it would pay off their home loan early if they chose not to take the aforementioned lump sum approach. It was therefore a "heads you win, tails you can't lose" explanation of the benefits. Subsequently it has emerged that as a consequence of this many people were sold endowment policies, which stretched on beyond their normal retirement age. Few questions were asked at the point-of-sale about their retirement income and their ability to pay the necessary premiums and interest on their mortgage, should the policy fail to produce sufficient funds at the customer's retirement date. Often borrowers could only get the cheapest mortgage deals if they agreed to take out an endowment, or they were mistakenly led to believe that they had to take out an endowment in order to secure the mortgage loan. Where comparisons were made between endowment mortgages and repayment mortgages, the endowment seemingly always appeared a few pounds a month cheaper than the alternative repayment mortgage. In contrast, other policyholders have alleged that comparisons were not made between endowment and repayment mortgages and that consumers were not made aware of the different types of mortgage available. Q. So when did it all start to go so wrong? In 1984 the Government removed LAPR i.e. the tax relief available on endowment premiums, making them proportionately more expensive. Insurers responded by introducing low-cost endowments that kept the premiums at an affordable level. However, these required greater and some would say, unrealistic investment performance to reach their target. As the monthly premiums were set so low, insufficient money was going into the investment portion of the policy, which perhaps explains why they appeared cheaper at the outset. Also, to keep costs in check, the guarantee that was part and parcel of previous endowment regimes was removed leaving policyholders financially exposed. Since the new millennium, the stock market has fallen by a third and has shown little or no sign of recovery or sustained growth in the period to date due to the slump in global equities. As a consequence of the lowest interest rates for 40 years, endowment payouts have fallen significantly. Some pundits have predicted stock market returns will be much smaller in the future and as a result, most endowments may not achieve their target figure, which was based upon projections of often-unrealistic returns over long periods of up to 25 years. However, what happens to the stock markets and endowment policy payouts in the future is pure speculation, as no one knows for sure; you need to know is what to do, right now. Q. Shouldn't someone have seen this coming? Pundits, who had experience in these matters, issued warnings back in the ‘80s that some low-cost endowments were unlikely to repay the mortgage debt. In addition, they claimed the projection figures were unrealistic and the loss of the guarantee, which the “full” endowment enjoyed, meant that the risk was too high. However, the life office providers and financial salesmen who stood to gain from their continued sale did not agree. Although investment returns were falling from the early Nineties, endowment payouts were often sustained at unrealisticly high levels, as insurers competed to be top of performance tables. It would be ironic if today's endowment policyholders were suffering because of the generosity of those bigger payouts in previous years. Q. Why were advisers so keen to sell endowment mortgages? In a word, commission. A salesman selling a 25-year endowment policy would, typically, have received the total of the first year's premiums as a commission payment, as well as getting a further payout of renewal commission for each year the customer hung onto his policy. The commission on a £100-a-month policy in 1990, over a 25-year term, was extremely generous. After a payment of a lump sum, once the policy was "in force", the salesman might receive £2.50-a-month renewal commission. A salesman, selling only two such policies a week, could make £100,000 a year on initial commission and be guaranteed £250.00 a month for the next 24 years. If he arranged a repayment mortgage he would have received nothing, except perhaps a rebuke by his manager for not selling an endowment! If you think about it, you are the one who has paid for this unsustainable situation and one way or another it is you who owe more than you should on your mortgage as a direct result. Q. Was it entirely the fault of the sales people? Yes & No. These sales people were often inexperienced and were selling endowments using figures, which were inherently meaningless and based upon unrealistic growth rates. Before 1988, insurance companies used figures set by their own industry body, the Association of British Insurers. The Financial Services Act, when introduced in 1988, allowed these people to tell customers what they might get if their policies grew at 7%, 8.75% or 10.5% a year. From November 1993 it was 5%, 7.5% and 10%. From July 1999 projection rates of 4%, 6% and 8% were allowed. Arguably, with the benefit of hindsight, it would have been wiser to lower these projected figures somewhat earlier. Just how viable these rates are is now most certainly questionable. Bank and insurance company staff were often put under tremendous pressure by their employers to meet their sales targets. This could have meant that customers may not have been given the full facts about the inherent risks associated with what they were being advised to undertake. This could well have led to them not being given a product or a choice of products, which suited their individual needs at the time. In fact, the needs of the providers more often than not came first. To most of you this is likely to be shocking news. Nevertheless these are the facts and you the customer, is unfortunately caught up in what has now been dubbed the ‘Endowment Mis-selling Scandal'. Now that the (FSA inspired) Redress Package is in place it is now the right time to resolve the problem. Q. When did the Financial Services Authority announce there was a problem and instruct the industry to act? In early 2000 the insurance companies that managed endowments were advised by the FSA to write to tell policyholders how their policies were performing in relation to their targets. These so called 'traffic light' letters, told policyholders how, based on the aforementioned projections of 4%, 6% or 8%, their policies were likely to perform. A ‘Red' letter meant that even if the policy grew at 8% per year, it was unlikely to repay the mortgage loan at maturity. ‘Amber' meant that there was a possibility that the plan would not cover the entire loan if it grew by 6%. ‘Green' meant that even if the policy grew at only 4% a year, it was still on course to repay the mortgage. Millions of these reprojection letters have now been sent out since to policyholders, some of whom face potentially huge shortfalls on their mortgage loan target. As a result there has been a barrage of media criticism of endowments and their poor performance. However, those within the financial services industry and at the FSA are keen to make the point that complaints which focus primarily on poor performance are not always justified, and will therefore be rejected. Q. What is the situation now? Before the first batch of reprojection letters went out in 2000, it was estimated that half a million policyholders faced a potential shortfall. It later emerged that three million policyholders were at risk of not being able to repay their mortgages in a timely manner. However, as the stock market continues to flounder, it is now estimated that up to six million households will be told that they have a problem. This is nearly two-thirds of all endowment mortgages. Even if a proportion of these people were not mis-sold their endowments and therefore choose not to complain, they still face some difficult decisions as to the best way forward with their mortgage predicament. Logically, each day the downturn continues more people will be drawn into the shortfall situation. It must be remembered also, as investment returns continue their downward spiral, the gap between the current value of many endowments and the repayment mortgage equivalent will continue to widen, making it virtually impossible to find an affordable solution to get the mortgage back "on track". So be prepared to act now. "Delay could be catastrophic", advises the FSA. Q. Is it likely that this situation is going to get better? In order for this situation to improve, the stock market will need to stage a dramatic and consistent recovery after six years of stagnation. A bout of high inflation and high interest rates would help, but both appear to be extremely unlikely in the current economic and political climate . The real catalyst for positive stock market returns in the past has been growth in the US economy. However, the business cycle has turned negative and the Americans themselves seem, for the time being at least, to have their minds on something else.
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