Saturday, 24 May 2008

Lessons of a Failed Endowment

An acquaintance here in the UK recently received the annual statement for a Life with Profits Endowment policy. An endowment is a kind of investment whose purpose is to provide a target lump sum a specified number of years in future, when it matures. Most often, as in this case, it is meant to pay off an interest-only mortgage when the mortgage ends. The word "Life" means that there is also a life insurance policy that pays off the lump sum if the person dies before the policy matures. The "with Profits" bit refers to the method of crediting the profits generated by the underlying investments in stocks and bonds (the details of which are hidden and unknown to the investor). The profits are dribbled out in the form of so-called bonuses to smooth out returns from year to year. The proceeds are normally free of further tax in the hands of the investor since the life insurance company has already paid taxes. Endowments were often touted as "tax-free" investments when all that really meant is that they were tax-prepaid. For a longer explanation, read this page at

In this case, the endowment was to generate £24,000 over the twenty years, starting in 1992 and maturing in 2012. My acquaintance would pay £49 a month during the twenty years. That's about a 6.5% rate of return. It would actually be a little more since the insurance component costs something and not all goes into the investment component, but the insurance cost is minor - less than 10% of the premium.

"RED ALERT: HIGH RISK OF SHORTFALL" read the top of the statement in big bold (though not red) letters. You're not kidding! The plan as of May 2008 was worth £13,162. That's about 4% return per year. The statement also provides low/medium/high projections of possible value at maturity in 2012 were £16,400, £17,500 and £18,600 using 4%, 6%, 8% growth rates. Hmm, wonder which one to count on? High risk of shortfall? Is this the British fondness of under-statement?

To put this abysmal rate of return since 1992 in perspective, consider that the FTSE 100 index has risen about 5.3% a year since 1992 (see EconStats for the numbers). That's not even counting the 3% or so per year in dividends distributed by those companies, which would give an annual return of 8.3%. In that context, the 6.5% per year that would have been required to produce £24,000 seems quite achievable, even if lower yielding bonds were added to the mix.

I suspect that fees and expenses ate away the returns as much or more as Standard Life's investment incompetence. Whatever the cause, the result is awful, especially since the person is still locked in and cannot cash out, or even suspend payments, without paying severe penalties that would be worse than simply sticking with it for another four years. Caveat emptor indeed!

The lessons I draw from this:
  • don't invest in something merely for tax savings or a tax-free payoff
  • fees and expenses are a critical investment evaluation factor, the lower the better
  • passive index-type investments will more often do better for the average person than any type of active fund management, even when the approach of the fund company is conservative - the fund performance is just under a lower bar
  • a complicated product like an endowment should be subject to much skeptical scrutiny - e.g. why is an endowment better than simply buying term life insurance separately and getting a repayment mortgage? If you cannot understand what you are buying, there is a significant chance you will be taken advantage of - see ThisIsMoney article amongst many, on how mis-selling of endowments caused enormous criticism and compensation for some has come about.

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