The Past is not necessarily a guide to the future

An endowment policy used to be an excellent way of repaying a mortgage, and life insurance was built in, unlike a repayment mortgage when it was an extra cost.  What changed?  There were three main sorts of policy: -

  1. Full with-profit endowment.  This is where the insurance company guarantees to pay out the initial sum assured at maturity regardless of intervening performance.  Bonuses (an amount added to the final maturity value of the policy to reflect the performance of the insurance company and its underlying investments) were added annually which, once added, could not be removed, so the final value of the investment only got better, never worse.  The monthly premium on such a policy was quite expensive: with the mortgage interest as well, the overall monthly mortgage costs was prohibitive for most first time purchasers.  Not many people took them out.
  2. Low-cost endowment.  To reduce the monthly premium, insurance companies roughly halved the size of endowment policy.  A £50,000 mortgage needed only a £25,000 full endowment policy (approximately, depending on the mortgage term) assuming that future bonuses should be sufficient to cover the initial shortfall by the end of the term, judging by the past.

    Importantly, this required a projection of future bonuses yet to be paid and so which were not guaranteed at outset.  An extra element of pure life insurance was added in to ensure the full loan was paid if you died at any time during the mortgage.  With its lower premium, the overall monthly cost of the mortgage, including the interest, was now similar to that of a repayment mortgage, after MIRAS. 
  3. Unit-linked endowment.  The premium is invested directly into one or more of many different specific funds, equities (UK and overseas), property, gilts or even cash.  The policyholder may switch from one fund to another at any time.  This concept, in theory, enables the investor to choose between strategies of being adventurous or cautious by simply selecting the appropriate funds.  In practise, you need to know what you are doing to make it effective and clearly no performance guarantees are available.  Life insurance is also included.  The monthly premium is higher than a low-cost endowment but not as high as a full endowment.

The low-cost endowment became a best seller.  The projected returns provided by the insurance company even predicted a surplus at the end of the mortgage.  It was seen to be a no-brainer, since if the monthly costs were the same or lower and you got a bonus too, why have a repayment mortgage?  And because it was based on the with-profits principle, it seemed to be very “safe”.  The full life cover and the words “with-profits” encouraged people to think it was a full endowment, forgetting it was actually only half the size.

What went wrong?  The answer lies in the bonus rates used to project the estimated maturity figures and the consequent premium calculation.  After a decade of high inflation, the bonuses rose to record levels:  equity based funds (stocks & shares and property) were always expected to out-perform inflation given enough time, and indeed they did.  Even with profits funds invest in some equities.  But the higher the bonus projection, the lower the premium required on the policy to repay the mortgage.  In the event, many over confident companies quoted too low a premium.

Falling Bonus Rates
When inflation started to fall in the 1990’s, so did the expected returns on equities, and so bonus rates dropped too.  Insurance companies found it difficult to advertise a lower bonus and many retained their projections at unrealistically high levels.  The consequence, as time moved on, was that it became increasingly clear that the low monthly premiums, set when bonuses where projected at higher rates, were just not sufficient to even repay the mortgage, let alone provide a surplus.

The brokers and salesmen were not entirely to blame.  Whilst some salesmen failed to highlight the lack of a guarantee, the life insurance companies themselves provided the future projections, and they also calculated the premiums.  Life insurance companies were always thought to be “conservative institutions”, so it was not unreasonable to assume that there were sufficient “hidden reserves” to match their heady projections.  Sadly, for many companies, this was untrue. 

Sales-led insurance companies, in a highly competitive market, just could not bring themselves to bring the bonus rate projections down and the premiums up.  Worse still, the regulatory authorities at the time accepted that the projections that were being made were “reasonable”.  Even the press failed to identify the seeds of scandal until it was too late. The companies eventually had to write to their policyholders and admit that their premiums were insufficient to repay the mortgage. The saga was and still is a travesty, it need not have happened had product providers projected with more care, and that is why the word “scandal” applies.

Moreover, even if the premium was increased to a level sufficient to repay the loan, the overall net return for the more conservative endowments is now unlikely to be sufficient to make a with-profits endowment mortgage worthwhile, because mortgage tax relief had gradually disappeared.

Ironically, with-profits endowment policies on their own can, and do produce reasonably good returns.  But if they are used specifically to repay an interest-only loan, the return still may not beat the net (now the same as gross) mortgage rate because their fundamental design is too conservative.

Tax relief in the past
The most important current scenario change has been loss of tax relief on mortgage interest.  In the early 1970's, when I was starting out as a mortgage broker, you could get up to 83% tax relief on mortgage interest.  If the mortgage interest rate was 10% pa gross, it only cost an effective 1.7% pa because 83% of it was subsidised by the taxpayer. 

In the 1970's, an endowment policy also enjoyed tax relief on the premiums, tax privileged status on its internal funds and tax-free maturity benefits.  For an investment to improve on a net mortgage interest rate of only 1.7% pa was just no contest.  It was crazy not to have an endowment mortgage in those days, particularly for the higher rate taxpayer.  Ironically, life insurance premium relief (LAPR as it was called and was once some 17.5 % of the premiums) was introduced to encourage the less well-off to take out life insurance.  In practise, it enabled the richer cognoscenti to exploit the rules to their significant benefit.

To further compound the advantages of home ownership in those days, mortgages are particularly beneficial during inflationary times, such as the double-digit inflation experienced during the 1970's and some of the 1980's as well.  You could actually borrow money at a net rate of interest substantially lower than even the inflation rate.

Even if you simply bought goods with the borrowed money you made a profit. Since you were enjoying such high tax relief, the net borrowing rate was then effectively only about 6% pa.  Inflation was running at around 20% pa, so you were making 14% pa just by borrowing the money and spending it!  In other words you could buy something for £100 on borrowed money and you could repay £106 in a year's time @ 6% net interest.  The same goods would have cost £120 the following year because of inflation, but had you tried to save £100 @ 6%, the resultant £106 would never be enough!  There was never any point in saving if the net return is less than the inflation rate.

Better still, if you bought a house with borrowed money, you have purchased a “real” asset, that is to say, one intrinsically linked to the inflationary process, like equities.  The house would appreciate eventually by more than the already high inflation rate. Furthermore, when you sell your own home there is no capital gains tax to pay.  You also live rent-free in the meantime - you can't live in a share certificate.  The adage in those days was to borrow today's expensive pounds and pay back with tomorrow's cheap ones;  get the largest, longest, cheapest mortgage you can afford.

In summary, for the mortgaged homeowner in the 70' and 80's, it was win, win all the way to the bank: win on the low net mortgage rates, win on the endowment mortgage gearing, win on house prices and more win on inflation which shrunk the mortgage debt.   It was no surprise that MIRAS was eventually phased out and life insurance premium relief was removed.  The tax payer was subsidising an activity which was profitable enough without any subsidy being necessary.  The changes were not sudden but gradual.  Moreover, endowment mortgage sales had already gained such a high momentum that it was difficult to reverse a conceptual idea that had been perfectly valid for decades earlier.

But what a shame that the previously so conservative life insurance industry let down their customers, and their salespeople, so badly in the last decade by simply not quoting realistically conservative premiums, and by not recognising the obvious signs for the demise of the with-profits endowment method as mortgage tax relief slowly sank into oblivion.  They should have known better.

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