How to end the mortgage endowment misery

Got a poor-performing endowment? Here's my view on what to do with it.

Millions of people saddled with endowment-linked mortgages must be wondering what on earth is happening to their policies.

At least two thirds of the nine million endowment policies originally taken out to pay off borrowers' home loans are unlikely to hit their target, with some shortfalls running into tens of thousands of pounds.

Conventional wisdom has told us to stick with these policies. It is now time for a re-think.

What you can do if you've got an endowment shortfall

There are three main options:

1. Top up the existing endowment. Most insurers have created endowment top-up policies that can run alongside the main one.

Generally, advisers do not recommend taking them out. Not only might you face continuing poor performance, there is also the issue of tax: if you have a policy for less than 10 years your policy may not qualify for tax relief.

2. Take out an alternative tax-free investment, such as an ISA. This would only suit someone prepared to accept even greater stock market volatility than a generally less risky endowment.

3. Switch to a repayment mortgage. This means converting part, or all, of the loan into a repayment, usually by the amount of any predicted shortfall plus a bit more just to be on the safe side. This way, repaying the mortgage at the due date is virtually guaranteed.

The Financial Services Authority has produced a guide to what you can do if you have an endowment.

What about the endowment itself?

That then leaves the question of what to do about the endowment itself. Up to now, conventional wisdom has generally been to maintain payments wherever possible and affordable.

This is because, even though no longer linked to the mortgage itself, an endowment remains a reasonable long-term savings vehicle.

Surrender penalties

Meanwhile, cashing in the endowment (known as 'surrender'), not only means the saver misses out on a terminal bonus at maturity, in the case of with-profits policies.

It also risks a substantial penalty for those who have only kept the policy going for a few years. Most policies levy high initial charges and their 'break-even' point – where the value of the endowment is equal to the contributions made – only happens after eight to 10 years.

Make the policy paid-up

If the policyholder simply cannot afford to keep contributions into the endowment while also opting for a repayment mortgage, the advice is to make the policy 'paid up'.

This means halting future contributions into a policy but still letting it run until maturity. While payouts may be lower, this avoids having to pay hefty surrender penalties.

Conventional wisdom is challenged

The problem with generic advice is that when confronted with reality it can turn into a load of old cobblers.

Weak stock markets and the poor performance of endowments means maturity returns are being reduced year after year. This trend is likely to continue for at least another year, perhaps several more, even if markets recover.

Meanwhile, if a policy is left paid up, what happens is that heavy initial charges continue to be deducted from the policy.

At the same time, the policyholder will be paying for the life insurance element of the endowment, which is taken from underlying returns. Given that most endowment-linked life cover is quite expensive, this means further inroads into the sum saved to date.

Stay or go?

So how do you go about calculating whether it makes sense to surrender?

Here is an example, based on a real-life scenario I was involved in recently.

A friend of mine with a mortgage started in 1986 borrowed a further £8,000 in 1994 for some home improvements. As with so many other people, he took out another endowment, designed to mature at the same time as the main policy in 2011.

Despite making monthly payments of £26.68 over nine years, he was recently told that he would face a significant shortfall at maturity.

Indeed, even if the policy grew by 5.6 per cent a year for the next eight years, he would only receive about £4,550.

What should he do? This is how did the sums:

Check the surrender value. Here, he found that despite having paid in about £2,900 in the past nine years or so, his surrender value would only be £1,500.

Had the policy been taken out with a highly-regarded insurance company and there were a few years left to run, he might have been able to sell it on the second hand market, through a so-called “traded endowment” firm. These can sometimes deliver a further 10 or 20 per cent on top of the surrender value. But in his case, the endowment was with a firm whose policies no-one wants to touch.

To find out more about selling endowment policies, click here for Moneyextra's web site

Calculate the effect of investing the £1,500. Assuming a typical variable rate of about 5.6 per cent, using it to repay a chunk of the mortgage would deliver 'returns' of around £2,300 over eight years in terms of reduced interest.

Calculate the effect of increased contributions into the mortgage. If he diverted that monthly £26.68 into the mortgage instead, his extra payments would be worth about £3,200 over the next eight years, assuming the same rate of interest.

Deduct the cost of life cover. My friend's policy offered both life and 'critical illness' insurance, which pays out on diagnosis of 'dread diseases' like heart attacks, strokes or cancer.

The cheapest £8,000 of life and critical illness cover for himself and his wife, over eight years is £6.50 a month. For bog-standard life cover the cost is £5 a month.

Paying for the life cover separately reduces the amount he could put towards his mortgage to about £20 a month. At a rate of 5.6 per cent, his 'return' would be roughly £2,400 over eight years.

Add the sums up. In his case, the total 'return' from diverting both future monthly payments and the lump sum from the surrender of his policy towards the mortgage would be about £5,500, or £4,700 with the life cover. This compares with a total return of £4,550 from the policy, assuming annual growth at 5.6 per cent until maturity.

Given that his policy would have to grow by about 5.9 per cent to match the £4,700 from just putting the money towards his mortgage – something which he believes is unlikely to happen – my friend's decision was to take the money and run.

One more thing...

My friend's insurance company is one of those recently fined by the Financial Services Authority (FSA), the financial watchdog, for endowment mis-selling. It has set aside large amounts to compensate those wrongly advised to take one out.

If he were to make a claim, might a decision to surrender early imperil his chance of winning compensation for having been mis-sold a policy?

Not according to the FSA. Regardless of whether a firm has been fined or not, as long as a request for a review of the policy sale has been made to one's insurer, it is quite acceptable to surrender or sell the policy on in the second-hand market.

If mis-selling is proved, the basis on which redress is paid generally involves assuming that the individual concerned took out a repayment mortgage at the time and then calculating how much would have been paid off in the intervening years, minus the cost of life insurance, set at a 'fair' rate over that period.

Of course, this ignores the issue how to make an effective complaint. I will come back to that at a later date. Meanwhile, to see how the Financial Services Ombudsman determines whether mis-selling took place and how redress is calculated, click the link below:

So, for anyone who feels they have been mis-sold a policy, the sensible course of action is to complain to your insurer. Then do the sums above and stay or leave - based on what you find. Good luck...

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