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ARE YOU AN IFA? IFA's PLEASE READ THIS... DO YOU OWN MORE THAN 10 POLICIES? IF SO, PLEASE ENQUIRE ABOUT OUR SPECIAL BULK DISCOUNT RATES...
The Personal Investment Authority (PIA) announced the issuing of mortgage endowment re-projection letters in January 1999 within Regulatory Update 62 (RU62). Originally an Association of British Insurers (ABI) initiative the re-projection letters have since been adapted and modified by the Financial Services Authority (FSA). The ABI also issued an amended Code of Practice in June 2004. Current PositionThe typical re-projection letter appears to show the with profit low cost endowment as off track and unlikely to hit the relevant target. Why is this? Why is it that in just six years these plans appear to be so poisonous?The consumer section of the FSA website www.fsa.gov.uk/consumer currently explains that falling projection rates are “because funds supporting your endowment policy are mainly invested in shares”. This viewpoint is at best outdated and at worst disingenuous. As the April 2005 edition of Money Management points out the average equity content of with profit life funds is 41%. Scottish Equitable held only 17% equities and Royal London none. Until the mid 1980s the traditional with profits low cost endowment comprised a guarantee augmented by annual bonuses and a terminal bonus. This type of plan was considered quite safe because the guarantee was typically based around an assumption that 80% of the then current annual bonuses would be paid. This style of traditional with profits plan was considered low risk, a view recently endorsed by the Financial Ombudsman Service. Between 1995 and July 1999 the standard annual growth assumptions were 5%, 7.50% and 10%. The default rate for most providers was the middle growth figure of 7.50% and the majority of plans were written on this basis. In 1999 the growth assumptions were reduced to 4%, 6% and 8%. Therefore, even if an existing plan was achieving the targeted 7.50% annual growth, and consequently was on course to repay the loan, the assumed 6% figure would trigger an ‘amber’ warning implying a significant risk of failure. Some providers did not allow a choice of growth assumption, basing their plans on the established practice of projecting 80% of the then current reversionary bonus and making no allowance for a terminal bonus. With profit funds enjoy operating profits but also suffer the consequences of new business costs, system upgrades, regulatory expenses - including fines – and also the cost of compensation payments. The reduction in the equity content of these funds is not entirely due to the 2000-2002 market crash but to the ‘realistic’ accountancy principles mandated by the FSA, a requirement which cost Standard Life, and by default their with profit policyholders, incalculable billions when they were constrained to sell shares early in 2004 when the FTSE100 stood at 4,500. Consistently low interest rates over the past ten years have also had an effect. More importantly, the adverse impact of insurers using the erroneous LAUTRO (Life Assurance and Unit Trust Regulatory Authority) expense assumptions has diverted many plans off course from day one. A travesty that is sure to have legal ramifications. The many reasons for the current situation are shown in Box 1. The Traffic Light SystemRe-projection letters are traffic light coded. Projected failure using the higher growth rate prompts a ‘red letter’ with notice of a high risk of non-repayment. Failure at the middle growth rate signifies a significant risk and an ‘amber’ warning. Apparent failure at the lower growth rate throws up a ‘green letter’.Now this may seem unambiguous and in some eyes a perfectly sound basis for relating a complex issue in a way that the layman can understand. Of course, in financial services nothing is ever so straightforward. For instance, what growth assumption generates a ‘red letter’? Alba Life, AXA, Clerical Medical and Prudential, amongst others, all confer red status on plans that appear off target assuming future annual growth of 8%. Norwich Union and Scottish Widows, companies generally viewed as financially sounder than Alba Life, have chosen to issue ‘red letters’ when the plan is off target at 6% future growth. Norwich Union explained that they use a lower growth assumption to cover the cost of the guarantees as an alternative to reducing the equity content of the with profits fund. This re-projection exercise reaches its nadir with Eagle Star which issues ‘red letters’ if off course using 5% future growth. Similar variations abound in the issuing of ‘amber’ and ‘green’ letters. The FSA allows such discrepancies because each insurer is able to choose a lower growth assumption if it considers such a rate more realistic. Box 2 highlights the variations currently being used. This must be confusing to the average policyholder. Imagine a client holding low cost endowments with both Prudential and Eagle Star where the anticipated future growth is 5.50% p.a. Prudential will issue a ‘green’ letter whereas Eagle Star generates a ‘red’ letter. Was it truly the regulators intention that such a veil of confusion be draped across the question of mortgage repayment? Further ConcernsThere is an additional disturbing aspect to many of the re-projection letters and it centres on the mechanism that insurers use to project future growth. RU62 stated that the basis of calculation should be “the full value of the policy, taking into account the underlying assets and an allowance for any accrued miscellaneous surplus”. It also noted that, “the use of a surrender value, if lower than the current value, would produce a conservative rather than a realistic result”.The RU62 guidance appeared to balance achieved returns against the need for prudence and was issued a full year before the bear market of 2000. In reality it allowed a great deal of latitude and the insurers have devised various calculation methods, all of which impact on the projected values. In many instances these serve to mislead the policyholder. Purposely misinforming the policyholder, whether through corporate arrogance, for altruistic reasons or simply system convenience, fails to satisfy the recent FSA initiative toward treating the customer fairly. Conversely, many argue that the whole re-projection exercise is the regulators less than subtle method of appeasing the consumer lobby by effectively instigating an industry-wide review without fielding the same level of flak as with the unreasonable pension reviews. A view reinforced by evidence from the recent FSA v Legal & General miss-selling case. MethodologyIt is in the interests of policyholders, advisers and the insurers themselves for re-projections to be fair and honest without provoking undue alarm or overestimating future growth prospects, which is precisely what happened in the late 1988-1995 period with the LAUTRO prescribed projection rates and synthetic expense assumptions. After all, an apparently poor performing plan is more likely to cause alarm and is also more likely to be surrendered.From an advisers perspective there is the alarming consequence that whilst the investment returns within these plans is not in itself cause for a complaint, it is this implied lack of growth that serves as the catalyst for such complaints and fuels the tanks of the burgeoning bands of ambulance chasers. Variations of these re-projection calculations can be seen in Box 3. AXA, Guardian, Legal & General, Scottish Equitable and Scottish Widows have all chosen to re-project from what, effectively, is the surrender value. It defies logic as to why a value based on penalised early encashment should be used to establish a possible maturity figure. Perversely, the FSA is fully aware of this because the consumer section of its website advises that the starting point for re-projections is usually the surrender value. This folly, and the use of other dubious re-projection methods, has the ability to mislead in a major way. Insurers are desperately trying to rebuild their reserves. This exercise involves limiting current bonus payments which is then reflected in the projections. This further develops the reliance on terminal bonus and of course further diminishes the current plan values for re-projection purposes. AXA asserts that it “only makes sense…to use the surrender value as a proxy for the value of the underlying assets”. Friends Provident accepts that the application of a Market Value Adjustor (MVA) penalty will show the re-projection in an unfavourable light but explains that it produces the same result as a true value projected at a lower growth rate. The logic seems nebulous and such an explanation will prove beyond the understanding of most policyholders. Legal & General asserts “there is nothing to be gained from having a full and detailed breakdown of the projection calculation”. Advisers and policyholders will surely disagree. They are one of the providers using surrender values, which may explain their reticence. Scottish Provident uses a concept called ‘supportable bonus’ where different levels of terminal bonus are assumed for the three growth assumptions. Eagle Star failed to respond to enquiries however their calculations raise numerous questions, as shown in Box 4. Laudably, Prudential uses conventional mathematics to project future growth and whilst their growth rates of 4%, 6% and 8% may or may not prove reasonable they are dealing from the top of the pack and in the process not adding to policyholders woes. Tellingly, Standard Life asserts that a projection is only an estimate as was the original illustration because charges can change during the life of the policy. They further assert that regardless of whether the charges were true calculations or LAUTRO inventions the onus for the advice remains with the adviser! Growth Rates and Traditional With Profit PlansThe concept of projecting these plans using annualised growth rates is doomed from the outset. The very nature of these plans and the concept of smoothing fails to lend itself to assumed level growth.A typical 25 year low cost endowment maturing this year with a £50,000 target may show a guarantee of £13,500 together with annual bonuses of £25,000 and a terminal bonus of £19,000. It is manifest that a plan offering a guarantee, augmented by further bonuses with the additional potential for a terminal bonus on maturity, cannot be conceived in terms of consistent growth. It is only at maturity, when the terminal bonus may have been paid, that a yield can be measured. The smoothing process cannot, in every instance, allow for large market fluctuations as evidenced by events in recent years. This lack of transparency has been the undoing of the with profit concept and has never been more obvious than in the re-projection exercise. Growth Rates and Unitised With Profit PlansThese plans offered no guarantees at the outset and relied on the compounding of annual bonuses and the expectation of a terminal bonus. As such they are similar to unit-linked plans apart from the gradual build up of bonuses guaranteed at maturity. Although boosted by providers as no different to the traditional variety (Standard Life again) it is fact that by removing the guarantee and assumption of bonuses and moving to a growth assumption the onus was switched from the provider across to the adviser.Some plans have bonus additions lower than the underlying asset value and on surrender a market value adjuster (MVA) penalty is applied. Given that the penalty can only apply if the plan is surrendered logic suggests that such a penalty should not be applied when re-projecting maturity values. However Clerical Medical, Friends Provident, Guardian and Scottish Mutual all use such a device to diminish the current plan value and consequently the projected values. Many of these plans were based on low allocation rates in the early years. Typical was Standard Life where only 50% of the premium was invested during the initial 24 month period with 103.50% invested thereafter. Unsurprisingly these plans will show a low value in the early years as they play catch-up until maturity. A low value that is then used to produce flawed re-projections. Terminal BonusMost insurers include an element of terminal bonus within their base value, however the method of allocating any such bonus again mitigates against fairness. Standard Life is not untypical in this regard. In arriving at a base value for a policy currently in the fifteenth of a twenty-five year term it uses the amount of terminal bonus accumulated thus far. At first glance this may appear reasonable but it is a fact that terminal bonuses on maturing 25-year plans are higher than those on maturing 15-year plans. As a result, using the notional 15-year terminal bonus effectively understates the potential return. The FSA, in its summary of responses to CP158 rejected claims that terminal bonuses were not being taken into account within re-projections stating that “explicit guidance” was provided within RU62. The guidance confirmed the incremental nature of terminal bonuses but the reality has always been that terminal bonuses on 25 year endowments have been higher than those on maturing 10, 15 and 20 year plans due to the build up of surplus assets. Box 5 shows the percentage addition to the guarantee and accumulated bonuses as shown in the April 2005 With Profits survey.Flawed Re-projectionsAs stated, the effect of the various calculations is often one of misinformation. Box 3 shows examples of this. Such misinformation can have the consequence of turning what would have been a green letter into amber and an amber letter into red. RU62 advised, “an appropriate assessment of the current policy value in respect of premiums paid to date is critical in ensuring that the projection is realistic”. The examples in Box 3 are anything but realistic.Example 1 highlights the bizarre scenario of 4% growth over a six and a half year period achieving no additional growth. Such a projection confirms the folly of using a surrender value, or equivalent, as the base figure. Some might suggest that the current guarantee is higher than the asset share and therefore has yet to be earned, however a bonus of £72.69 has recently been added to this particular policy and one assumes that a terminal bonus of some kind will be added on maturity. Currently, a maturing 25 year Standard Life plan receives a terminal bonus equating to 47% of the guarantee and attaching reversionary bonuses. This may be significantly different in the future, but… Friends Provident projects 95% of the calculated asset share on traditional plans, which is effectively a 5% penalty and therefore a projected £19,000 maturity would really be £20,000. One client has a Friends Provident plan which has a guarantee and accumulated bonuses of £5,711. The client pays £19.18 per month and has just over 8 years to maturity. His re-projection letter advises that over this period 4% annual growth will add £79 to his pot! How can this be? How can 8 years of growth at 4% equate to £79? Why are companies using Monty Python mathematics and misleading their clients? The FutureThe with profits concept seems to be mortally wounded. Are insurers losing interest in these funds now that they are no longer being sold in volume? In the 1980/90s they were only too eager to project forward using the maximum allowed growth assumptions to many policyholders disadvantage. Today they appear diffident and apologetic choosing to use lower rates than required – again to their policyholder’s disadvantage. Formerly providers overstated the potential of their endowments, now their re-projection mechanisms are such that the future growth is being understated.Box 1 - REASONS BEHIND RE-PROJECTION DEFICITS
Box 2 - CURRENT RE-PROJECTION RATES
Box 3 - VARIOUS CALCULATION METHODSTraditional With Profits Unitised With Profits
Box 4 - ILLUSTRATIONS OF FLAWED RE-PROJECTIONS
Box 5 - TERMINAL BONUS ADDITIONS AS A PERCENTAGEAdditional Terminal Bonus on a 10 year plan 15 year plan 20 year plan 25 year plan
Endowment Check is using exactly the same calculation for the future maturity value of your policy as your Life Company calculates the maturity at the end of its term. If bonus rates stay the same during the remaining term then the future maturity value will match the actual maturity value you are going to get from your Life Company. As bonus rates change so does the future maturity value of your policy. We at Endowment Check are constantly updating our system with the latest bonus rates of all major Life Companies, allowing us to accurately calculate the future maturity value of your policy based on current bonus rates. With our online facility you can now check the effect of these bonus rate changes on your policy’s maturity value and monitor them over time. To take advantage of this facility simply click here to begin the Endowment Check process The FSA provides very useful information in their consumer information telling you how to deal with an estimated shortfall and what action you can take.
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