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Tap into a Tep

The misselling of with-profits endowments has again brought the product under the spotlight and resulted in criticism. I believe, however, that the with-profits principle is good and has proven to serve investors well over the years. Traded endowment policies continue to provide investors with the security of capital and good returns of investment, which investors currently seek. The volatility of the stockmarkets, low interest rates and inflation heightens investors&#39 interest in Teps.

Over the past 10 years, there has been little change in annual returns achieved from 25-year with-profits endowments. This will surprise many. Despite the changes in bonus rates which have already taken place over the last few years, the average return from 25-year with-profits endowments maturing at the beginning of this year is 12.2 per cent a year. That is only 0.5 per cent a year less than last year and only 0.1 per cent less than 10 years ago. This clearly indicates the resilience of with-profits.

With reductions in equities, which represent the greater proportion of the underlying assets of with-profits funds, is it so unexpected that bonuses do not now follow suit? With-profits has the ability to smooth these changes but cannot avoid them altogether.

It is unreasonable to expect a with-profits investment not to be affected by the economic conditions which have affected returns from other investment products.

We must not, therefore, view these changes in isolation but relative to the returns being achieved from other investment products, over the same investment time period and having been exposed to the same economic conditions such as lower interest rates and inflation.

With-profits bonds have produced an average return over five years of 4.9 per cent. However, the surprise here is that the average Tep has outperformed the average with-profits bond. This is partly due to policy charges applied to with-profits bonds, which are not applicable to a Tep. The average return from a Tep investment of five years is 5.18 per cent.

The key difference is that, although invested in the same with-profits “pool”, at the point of purchase, a Tep comes with the benefit of a guaranteed locked-in value that has accumulated from higher performance in past years.

This gives the Tep a lower-risk profile than a with-profits bond. The guaranteed minimum maturity value of a Tep represents a floor below which the value of the investment cannot fall, which increases over time as new bon- uses are added to the policy, usually annually.

Teps enable investors to tap into the excellent returns achieved from with-profits endowments in the late 1970s and 1980s, which, as previously mentioned, have produced, on average a very respectable 12.2 per cent a year.

Teps held for longer investment terms such as seven to eight years have produced average returns of 9 per cent a year. Teps are held by an investor for only a proportion of the policy&#39s full term, providing the long-term policy benefits over a short investment period.

Investment in equities is higher risk but, over the longer term would be expected to produce the best performance.

In the short to medium term, the performance of equities has been poor.

Our comparisons of the returns from the average balanced managed unit trust show that Teps have outperformed over one, three, five and 10 years. The average returns for the former over these periods have been -20.3, -7.1, -0.6 and 7.4 per cent respectively.

A Tep is invested primarily in equities and property and it is these real assets which have provided the engine for excellent long-term growth within this product. Property values and gilts have increased but equities, fixed interest and cash have seen a decline over the past five years. The performance of this overall mix affects the bonuses paid.

Much coverage has been and will continue to be given to bonus rate changes in the coming weeks, but how does this all relate in terms of what the investor receives?

For Tep investors, help is at hand. It is possible for many Tep market-makers to pro-vide tables to indicate the effect of changes in future bonus rates on a particular policy. This information is freely available, which will help the adviser in considering the use of this type of investment vehicle.

The majority of life offices have already cut their bonus rates. To demonstrate the resilience of Teps, the table here shows the level of further bonus rate cuts that could be withstood before the Tep showed no future investment growth at all.

The table above illustrates an example of policies currently being traded.

Even taking account of any future reductions, it is still possible for an investor to achieve good comparative returns of investment without the need for increased exposure to risk. All of the policies in the example guarantee the investor&#39s capital investment by the accrued value to date.

In addition, investors should not lose sight of the effect of this lower inflation on the real rates of return achieved.

Each year for the last 10 years the real rate of return has increased. The current real rate of return from a 25-year with-profits endowment is 6.6 per cent – an increase from 2.9 per cent 10 years ago.

Investors are benefiting from the current economic climate where the inflation rate has fallen from 15 per cent in 1975 to only 1.38 per cent in August 2002.

The annual returns quoted from the various types of investments are before deduction of tax. Some investment vehicles are more tax-efficient than others and should be taken into account for net comparison purposes.

An average Tep return of 9 per cent a year for a sevento eight-year investment which could be received tax-free is equivalent to a gross return for a basic-rate taxpayer of 11.5 per cent and for an investor on a higher rate of tax this would amount to 15 per cent gross.

The FSA ruling that life companies must now notify policyholders of the option to sell their policy rather than surrender it and the review letters will increase the number of policies entering our market, this in turn will create more opportunities for investors in Teps.


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