Home > News > 1999 > December 1999 > Endowment Mortgages - The next Mis-Selling scandel
Endowment Mortgages - The next Mis-Selling scandel
As the insurance industry grinds its way towards completion of the personal pensions mis-selling review, a potential new mis-selling scandal has emerged recently. This concerns the sale of endowment policies associated with mortgages. Simon Spencer from our Life insurance consultancy team reviews the issues following the publication of a report by the Faculty and Institute of Actuaries.
Introduction
In November 1999 the Faculty and Institute of Actuaries published a report on the subject of UK endowment mortgages. The report considered whether, and in what circumstances, a new endowment mortgage could be considered "best advice" when compared with other forms of mortgage repayment. It went on to say that in 1999 there are many situations in which a recommendation to take out such a mortgage cannot be considered as "best advice". The implications for the UK mortgage market are profound.
In the past many mortgage providers (life companies, banks and building societies) have advised clients to purchase these products and have received considerable commission income in the process. Remembering the pension mis-selling debacle, it seems that these organisations are now at risk of being called to account for their actions. If so, they could suffer considerable financial penalties and a loss of future new business.
Repaying a mortgage - the alternatives
In the UK there are two main methods of repaying a loan used to purchase property.
Repayment mortgage
Regular (usually monthly) payments are made to the lender, which cover the interest on the loan and also gradually repay the capital. In this way the entire loan is repaid at the end of the term. A separate life policy is used to repay the loan in the event of death. As interest rates vary, the repayment amount is varied in order to meet the revised interest cost and capital repayment objective.
Endowment mortgage
Regular payments cover the interest on the loan. The intention is that, at the end of the term, the capital is repaid from the maturity proceeds of an endowment policy to which additional regular payments have been made. This policy also repays the outstanding loan in the event of death. As interest rates vary, the regular loan interest payments also vary. However, the premium to the endowment policy usually remains fixed, although it may be reviewed every five years or so to check that the capital repayment target is being met. Endowment premiums are invested in life company funds, which usually have a high equity (stock market shares) content.
The fundamental difference between these alternatives is that a repayment mortgage effectively guarantees to repay the loan, while the endowment mortgage relies on investment performance (and regular premium reviews) to accumulate sufficient funds to repay the loan.
So what's the problem?
During the 1970s, 1980s and early 1990s endowment mortgages were very popular, although, with the removal of tax relief on life policy premiums in 1984, the reasons for this have not always been clear. Part of it must be that the commission paid to mortgage providers generated more cash (and profit?) from selling an endowment mortgage than from selling a repayment mortgage. The situation was also obscured by the excellent returns produced from life company investments. This meant that some policyholders did very well and that benefit illustrations for new mortgages could be produced showing handsome possible future returns. Indeed, it seems that the regulator prescribed illustration basis contributed to this situation.
Investment conditions have now changed. Interest rates have fallen and seem likely to remain low. The lower returns now projected means that many current endowment policies may not repay the mortgage they back unless premiums rise substantially. It is estimated that half a million homebuyers will be sent letters warning them that they are in this position. This will shock many, who may feel that they were promised the mortgage would be repaid. Indeed, many expected to have money left over once the mortgage was ended.
Tony Holland, the Personal Investment Authority Ombudsman, has said that people who were not warned of the possibility that endowment payouts may be insufficient to repay the mortgage might be entitled to compensation of a return of premiums plus interest.
Not all doom and gloom
Low interest rates, low inflation rates and low investment returns have all contributed to the current problem. However, this situation has had benefits. Interest payments required to service the loans have come down, which may more than offset any required increase in endowment premiums. In addition, falling interest rates have meant that the performance of life company funds have been good and policies maturing in the recent past have benefited from this.
What should policyholders do?
Current holders of endowment mortgages should not make hasty decisions. The option most likely to be suggested by the lender is to 'top-up' the endowment policy. However, this is not the only possibility, and may indeed be poor value. Borrowers should also consider other savings options such as ISAs or unit trusts. It may be tempting to cash the endowment policy in and invest the proceeds in an alternative investment vehicle. In this case, surrendering the policy should be viewed as a last resort. Surrender values are often penal and a higher amount may be obtained by selling the policy on the second hand endowment market. In any event, the borrower should seek independent advice before making any decisions.
For people about to take out a new mortgage, the Faculty and Institute report concludes that short term endowment mortgages (10, possibly 15 years) are unlikely to be justifiable, while longer term endowment mortgages may be justifiable, but must be demonstrably better than a repayment mortgage before being recommended. Again, independent advice is vital.
How much will this cost?
The full extent of the problem is not yet known. Current estimates of the total cost of personal pensions mis-selling are in the region of £11 billion, and many commentators believe the cost to the mortgage industry of endowment mis-selling could be of a similar order or even higher. However, in this case banks, building societies and life companies would all share the cost. Some may think that the regulator should be included in this list.
The Trade and Industry Secretary, Stephen Byers, has promised a tough package of mortgage reforms by Christmas, so the situation may become a little clearer over the next few months.
For further information, readers are referred to the report of the Endowment Mortgages Working Party, which can be downloaded from the Faculty and Institute of Actuaries web site (www.actuaries.org.uk).
Simon Spencer, November 1999.