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Endowment Calculator - work out how much to save / invest in order to fund for a shortfall.

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The purpose of this calculator is work out the amount that you would need to invest now, at a given rate of return, in order to make up the shortfall on an endowment policy - i.e. to ideally put you back in the position you would have been if the endowment policy was meetings its expected projected returns.

You will need to input the amount of the shortfall, the amount of your mortgage, the current interest rate applicable to the mortgage, and the expected rate of returns from the additional savings / investments that you would make to try and make up the shortfall.

The information below gives a brief outline of the history and current problems associated with endowment policies. It does not go into areas such as ‘mis-sold’ endowments or endowment claims and compensation, as you can find plenty of resources on this subject elsewhere. All this calculator does is give you a rough estimate of how much you would need to save / invest in order to clear a shortfall.

What is an endowment policy?

Although endowment policies have historically been linked to mortgages, and the term ‘endowment mortgage’ has often been quoted, they are completely separate products. An endowment is an investment policy, and the mortgage is long-term loan.

However, to complicate matters, endowments combine life insurance and an investment element in one package. They were most commonly used as a way of repaying a mortgage and vast numbers were bought/sold to homebuyers in the 1980s/1990s. However, it is currently estimated that c. 80% of the endowments sold during this period are not on target to produce a sufficient return in order to repay the mortgage when it due to be redeemed.

Endowment policies were sold in conjunction with interest-only mortgages, where by you pay off the interest on the mortgage, and repay the capital amount of the loan at the redemption date - most commonly after 25 years. However, as you need some method to pay off this large capital liability in the future, some form of investment strategy needs to put in place in order to provide a sum at least equal to the amount owed - and for a long time an endowment policy was viewed as THE method to do this.

By combining an element of life insurance into the endowment, policyholders were assured that were they to die before the mortgage was repaid, the endowment would provide an amount equal to the capital amount of the mortgage.

So, what went wrong? After all, these types of arrangements did work for huge numbers of people for a long time. We all probably recall members of the previous generation whose matured endowment policies not only allowed them to repay the mortgage, but also paid a significant bonus on top.

There are a couple of important factors that largely explain this:

  • Inflation / Interest Rates
  • With-Profits investments

When they first became popular, inflation was high, interest rates were high and tax relief was given on premiums paid to life assurance policies - and an endowment is classed as a life assurance policy. In such an environment, high inflation and interest rates usually feed through into high investment returns, and the effect of inflation rapidly reduces the capital value of the loan in real terms. Therefore, endowments looked like great ways to repay home loans.

However, tax relief on life assurance premiums ended years ago and inflation and interest rates have fallen to their lowest points in recent history. This means that investments are not growing as fast as they did, but the effect of inflation is not reducing the value of the loan as quickly as it did, say, 15 years ago. This means that your money has to work much harder in order to meets its original investment target.

Another major - some would say ‘structural’, problem is that the vast majority of existing endowments are ‘with-profits’ endowments, which are invested in the with-profits fund of the respective life assurance company. Often the ‘with-profits’ option was the only choice available, or if there was a choice, they were overlooked in favour the ‘with-profits’ option that would pay ‘significant’ terminal bonuses in the future. Therefore, we need to ask the basic question of:

What is a with-profits fund?

There has been a lot of bad news about with-profits investments, amid announcements from life assurance companies that they are cutting bonuses. There have also been stories about companies imposing exit penalties on investors who want to withdraw their money at times when the stock market has fallen.

The term ‘with-profits’ usually applies to investments within a pension, endowment, savings scheme or investment bond. The concept is to smooth out the rises and falls in the stock market for the benefit of the investor. Actuaries working for the insurance company or fund manager hold back some profits in good years in order to make up the difference in bad years when shares have performed poorly.

The insurance company usually adds an annual bonus at the start of each year and a final bonus at the end of the policy's term. When you pay your premium each month, the insurance company will invest it for you. It will buy a mixture of shares, cash, and fixed interest products (known as gilts and bonds) in order to make your money grow. Every year, it gives you a bonus based on its success in investing your money. In good years, you don't get the full amount because a portion is held back in case of bad years. This is how the smoothing works and this is why the products are known as "with profits".

Instead of a with-profits fund you can buy a "unit-linked" fund. This doesn't have a mechanism to smooth out volatility, so that the value of your fund rises and falls with the stock market. In bad times you are exposed to greater fluctuations in the value of your fund, but in good times you benefit from the whole amount of growth in your fund.

Why are companies cutting bonuses and charging exit penalties?

Although these funds are quite complicated, they were popular because they offered the benefits of stock market investment without exposing you to the risk of buying shares. Plus, you made regular investments over the long term, so you had the opportunity to build up your wealth steadily.

When you invest in a with-profits fund you effectively buy a right to share in the fortunes of the insurance company. This applies particularly if you have invested with a mutual insurer. As a policyholder in the with profits fund, you share in the successes of the mutual's investment strategy and its other lines of business. So if the insurer has a good year on the stock market and sells a lot of extra business, you will benefit. When things go wrong, however, with-profits policyholders are affected because they are the owners of the business. So if you have three years of losses on the stock market, as we experienced during 2000-2003, the with-profits fund will take the hit.

How come insurers have the right to impose exit charges if you want to leave the fund?

With-profits funds have a clause called the market value adjuster (MVA) that allows managers to smooth the returns on your funds. But you only get the real benefit of this if you hold your policy until the end of its term (usually 25 years or so). In hard times, when share prices are falling, the MVA allows managers to charge a penalty if lots of investors want to get out at the same time. The more people who withdraw their money, the more shares the company has to sell at a loss to give them their cash back. So managers use the MVA to spread the loss between those who stay put and those who want to go.

However, the term ‘With-Profits’ itself can be misleading, as the underlying assets of a specific fund can vary widely between different insurance companies - some companies who have closed to new business may have no exposure to equities (shares) within their funds, whilst other With-Profits funds may have a relatively high exposure to equities. Therefore, when comparing two with-profits funds, you are not always comparing like with like.

For instance, the several with-profits fund run by insurance companies who are ‘closed’ to new business are invested largely in Fixed Interest securities. Whilst this is a safe option, there is little potential for growth, as when recently, the equity markets have recovered and rallied. To all intents and purposes, these have become Fixed Interest funds, but with much less transparency than a unit-linked fixed interest fund.

By comparison, the With-Profits funds of the larger and more financially secure insurance companies have significantly less fixed interest holdings and significantly greater equity holdings - in theory this should smooth out the current problems over the longer term.

Therefore, if you need to return of say 9% per annum in order for your investment to repay the outstanding loan, and you are invested in a with-profits fund that holds mainly fixed-interest securities, the underlying growth rates is likely to be in the range of c. 4-5% for the foreseeable future. This leaves little scope for applying higher annual and terminal bonus rates.

Charges implicit in many endowment contracts

There is also another factor to be taken into consideration. The reason why so many endowments were sold during the 1980s/1990s was because the companies / individuals who sold them earned large commissions on each sale. The charges tend to be 'front-end' - i.e. for the first few years, your premiums were used to pay the agent commission and the charges implicit in these contracts - therefore, until the later years, you will get little back if you have to stop paying the premiums.

What can I do about the shortfall on my endowment policy?

Never ignore the shortfall - there are several ways you can deal with it.

Consider making up the shortfall through another type of investment or savings account such as an ISA: consider seeking independent financial advice to help you.

Think about converting the part of your mortgage not covered by your endowment to a repayment mortgage.

Consider converting the whole of your mortgage to a repayment mortgage. You can either keep paying your endowment premiums and use it as a savings plan or you can freeze payments. If you freeze them, your plan will continue to be invested until maturity date, but you will receive back much less than predicted as no further premiums are paid in. Before you do this you should check whether charges will be applied to your policy and what will happen to the life cover under your policy.

When considering the above and any other options you should also consider seeking independent financial advice to help you decide what to do about your shortfall.

If you are intending to move or change your mortgage again before you reach the repayment date, you may not need to take any action about your shortfall now. However, when you get your new mortgage you should consider whether to go for the guarantee of a repayment mortgage or, if you go for interest-only again, how the balance of the capital will be paid off.

You should probably not cash in your endowment unless there is absolutely no alternative. You will definitely lose out if you cash in the policy in the early years (as a rule of thumb, within the first 10 years on a 25-year policy). Decide either to keep it as a long-term savings plan for your own use, or if you really don't want to pay any further money into it, freeze the plan but keep it at least until the value has overtaken the premiums paid in, and hopefully given you a bonus.

You should take professional financial advice if you are worried about your endowment. The decision on whether to stop paying depends on the type of policy, the stage it is at and the potential penalties of cancellation.

On average around half of the total payout on an endowment comes on the very last day. This is the so-called terminal bonus, which is not guaranteed. Stop paying in before then and you are likely to lose this. All you will get are the annual - also known as 'reversionary' - bonuses added to your policy. However, once you have identified the fact that you have a shortfall; you can work out the likely amount that you need to invest now to make up the shortfall.

The figures projected by the calculator are only for guidance purposes, and are by no means guaranteed.