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Were the red letters junk mail?

Millions of endowment mortgage borrowers have been panicked by letters over the past year or so from their insurance companies. These letters have suggested that growth of their endowments has been slower than forecast at the beginning and the policy was not on target to pay off the mortgage as planned.

Some policies have already failed to do their job. So it was perfectly reasonable for the FSA to feel it should do something. In early 2000, the ABI instructed life offices to carry out a spot check on their endowment-paying client bank and report to each customer. There were to be three versions of these letters. One, where policy growth was “on target” to redeem the mortgage on time; two, where there seemed to be the possibility of a shortfall and it was advisable to keep an eye on things and three, where a shortfall was likely and some corrective action was urged.

By the end of March this year, 10.2 million letters had been sent out, representing 94.2 per cent of all the endowment policies in force.

Of these, 13 per cent were considered to be in the third category – “red for danger”. That means that some 1.25 million cases are giving real cause for alarm, according to the FSA guidelines.

But was all this necessary? The FSA lays down the limits of growth at which policies may be projected. These are altered from time to time to cater for trends in interest and investment returns.

Since 1991, when financial services regulation came into being, the middle rate of projection for endowment policies has been as follows: January 1991 to November 1993 – 8.75 per cent; November 1993 to July 1999 -7.5 per cent; and July 1999 to date – 6 per cent.

It is clear that rates can change frequently and each time they change they throw off target any projection figures already in use.

It may well be reasonable to forecast a shortfall where a policy has only a few more years to run but some people are getting letters about policies which will not mature until 2019 or later.

Over such a long term, growth will only be perfectly smooth if the same rate is maintained throughout. It never happens that way. Rates change constantly and the speed of a policy&#39s growth will change from time to time. If a mid-term snapshot is taken at a time of relatively slow growth, a falsely pessimistic picture must result.

How can anybody, even skilled mathematicians such as the actuaries of the FSA, possibly suggest that an 18-year look in the crystal ball might be anywhere near accurate?

This must surely be the acid test – if the exercise is to have any point to it.

Valuable lessons on the perilous pastime of making long-term financial projections can often be learned by taking a look at historical fact.

In 1964, interest rates were broadly similar to today. In February that year, Halifax Building Society was offering mortgages at 5.75 per cent. Rates had been hovering just above that figure for some little while, just as they have at present.

We may reasonably assume that if there had been an FSA in those days it would have set projections at, or very close to, today&#39s middle rate of 6 per cent.

But Standard Life&#39s endowment policy&#39s actual average growth over the 18 years 1964-1982 was 9 per cent. For policies just two years longer, 1964 to 1984, it was 10 per cent. An average difference of 4 per cent over 20 years is substantial.

At 6 per cent growth, an annual investment premium of £600 over 20 years produces £23,396 while at 10 per cent, it would make £37,801.

That means that somebody with a £30,000 mortgage might have received a “red for danger” letter, suggesting a poss-ble £6,604 shortfall, leading to worries about how to find more money to pump into paying off their mortgage.

But if history repeats itself, which it has a habit of doing, they will find that the fretting and sleepless nights were needless and that they are £7,801 in profit.

Welder Ian Kevan, 31, of Scarborough, has a £34,800 mortgage with 18 years to run, backed by a Winterthur Life endowment policy. He has received a letter from Winterthur advising him there is likely to be a shortfall on maturity of the policy and if the present investment climate continues for the remainder of the term, his present premium of £54.87 a month should be increased by a colossal £40 simply to pay off his mortgage.

According to this, the surplus windfall to celebrate redemption of Ian&#39s mortgage, which was planned at the outset, would seem to be out of the question.

But if the current prognosis is as far off beam as it would have been back in the mid-1960s, Ian will be in for a nice surprise.

Admittedly, history proved the converse to be equally true when interest rates fell dramatically throughout the 1990s. The consequences of high FSA projection rates in the 1980s, often in excess of 10 per cent, are the direct cause of the worries we see today.

When asked to justify the projection of growth rates as far ahead as 20 years, FSA spokesman Rob McIvor says: “We would always take the view it is prudent to err on the side of caution. Actuaries advise us it is their considered opinion that there is likely to be a period of sustained low growth, hence the rates that are in use currently.”


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