House of Commons - Treasury

Select Committee on Treasury Fifth Report

2 Endowment mortgages

6. The finance needed to purchase a home has traditionally been provided via one of two main long-term financial products. The simplest is a repayment mortgage, where the home buyer receives a loan secured against the property from a bank or a building society and repays the loan via monthly instalments that pay off a combination of both the capital sum borrowed and the interest costs of the loan. The second product is an endowment mortgage, in which the home buyer receives a loan as with a repayment mortgage, but only repays interest on the loan. Rather than repay any of the capital sum borrowed, the home buyer instead makes monthly payments into an endowment policy, typically a with-profits policy investing in a mixture of bonds, equities and property, purchased from an insurance company. The consumer hopes that when the endowment policy matures the investment return will be sufficient to repay the whole of the bank or building society loan and possibly leave something left over as a capital windfall.

7. Endowment mortgages grew rapidly in popularity through the 1970s and 1980s, particularly 'low-cost' endowment mortgages which carried a guaranteed maturity value for the endowment policy below the outstanding mortgage debt, but anticipated the addition of 'with-profits' bonuses sufficient to repay the debt. Such policies enabled premiums to be set at levels which made them appear competitive with repayment mortgage, but carried the risk for the policyholder that the maturity value of the endowment policy would be insufficient to pay off the mortgage. Figures provided to us by the Association of British Insurers (ABI)[4], shown in the Table overleaf, suggest that the share (in terms of the number of mortgages issued) of the mortgage market accounted for by endowment mortgages rose from 7% in 1970 to a peak of 83% in 1988. Data presented to us by Cazalet Consulting suggests that over 1.7 million endowment mortgages were sold in 1988[5] and that sales of endowment policies consistently topped one million a year between 1986 and 1991. Since the early 1990s, however, endowment mortgages have taken a steadily falling share of the overall market, with a particularly abrupt decline over the past four or five years. The latest figures we have available suggest that endowments accounted for just 5% of the new mortgages taken out in 2002.

Table: % Share of UK Mortgage Market

	% Share of UK Mortgage Market
Year	Repayment	Endowment	Other
1969	88	9	3
1970	88	7	5
1971	86	8	6
1972	80	12	8
1973	72	17	11
1974	73	16	11
1975	74	16	10
1976	72	18	10
1977	71	21	8
1978	67	25	8
1979	64	27	10
1980	69	23	9
1981	74	20	6
1982	73	20	7
1983	41	54	5
1984	38	61	1
1985	42	57	1
1986	28	70	2
1987	18	80	2
1988	14	83	3
1989	18	79	3
1990	20	76	4
1991	18	77	5
1992	21	68	12
1993	26	59	15
1994	30	56	14
1995	35	46	16
1996	38	32	24
1997	41	34	26
1998	43	34	25
1999	47	28	25
2000	60	17	23
2001	72	9	19
2002	82	5	13

Source: Association of British Insurers

8. As the Personal Investment Authority (PIA), a predecessor organisation of the FSA, warned some years ago, "compared with an ordinary repayment mortgage, endowment-related mortgages are complex products. They have features with which many borrowers will be unfamiliar—especially the nature and extent of their exposure to market risks."[6] This view was reinforced by evidence the Committee heard from independent experts, such as Professor Davis of Brunel University, who argued that in reality there was a "fundamental problem"[7] with endowment mortgages. The consumer is assuming a liability which is both fixed in nominal terms and often very large relative to his available assets. To pay off this liability the consumer is investing in an endowment policy which is often largely invested in equities, an asset class that is both volatile and exposed to lower nominal returns as inflation falls. As Mr O'Brien of Nottingham University Business School told us, "the problem with endowment mortgages is you have this nominal liability and it isn't going to be covered when you get disinflation."[8] Set against these drawbacks were certain tax advantages in the 1970s and 1980s (discussed in paragraphs 13 and 14 below). While the balance of risks and possible rewards offered by endowment mortgages may have appealed to some individuals, the lack of certainty that an endowment policy would be worth enough at maturity to pay off the mortgage means that such mortgages were probably unsuitable for many homebuyers.

9. Buying a home is the largest single financial transaction most people undertake in their lives and the financial services industry owes a particular duty of care to its customers in the marketing and subsequent management of relatively complex financial products such as endowment mortgages. Unfortunately, the reality is that in selling low-cost endowment mortgages the industry often failed to provide homeowners with a suitable product for their individual circumstances or a product that was fit for the purpose it was being used for. The performance of the financial services industry in providing reliable and effective products to those looking to fund a house purchase is likely to be crucial in shaping consumers' views of the industry. The failures in respect of endowment mortgage policies are a contributory factor towards the low consumer confidence in the industry.

With-profits policies

10. The endowment policy written as part of the endowment mortgage product was typically a 'with-profits' policy. With-profits policies are legally a form of life insurance, although most people buy them as a savings product rather than as an insurance product. The key characteristic of with-profits policies is that investment returns are smoothed. The smoothing process is often very complicated and is at the product provider's discretion. Such policies have therefore attracted widespread criticism for their inherent lack of transparency. Mr Sandler, author of a major review of the long-term savings market for HM Treasury[9], told us that "there are very few insurance companies or with-profits providers who actually provide the policyholder with any indication of what the investment performance has been. The policyholder receives, at the end of a period of time, a bonus, which is delivered on the basis of all sorts of factors: amounts coming from inherited estates; amounts due to other profits which arise within the activity set of the provider."[10]

11. Some companies told us that with-profits policies had a valuable role to play. Standard Life said that "we remain committed to the with-profits concept because of its potential to provide better performance than deposits without full exposure to the volatility associated with longer term, equity-type investments."[11] Independent experts and consumer groups have nevertheless typically told us that there is a strong case for reform. The National Consumer Council, for example, said that "Despite the well-documented weaknesses of the with-profits model, we do consider that some consumers might welcome a good value smoothed investment product offering some long-term stock market exposure alongside limits on volatility. But this requires greater transparency regarding the basic product proposition, and a fairer deal in terms of charges."[12] Mr Sandler told us that "I think a large part of the answer for the insurance industry lies in the reform of with-profits, which are in a sense the flagship product of the insurance industry—less so today than was the case even as recently as a few years ago but, nonetheless, historically, the core savings product of the insurance industry. That is a product which represents the extremes of opacity, which has the extremes of complexity built into it, and a very substantive process of reform in my judgment has to be mandated on with-profits if we are going to get the sort of functioning of the industry that we all, I believe, would wish to see."[13]

12. The FSA has proposed reforms for with-profits products in its consultation paper CP 207, commonly referred to as "Principles and Practices of Financial Management". The view of several experts we asked was nevertheless that the FSA's proposals were unlikely to significantly improve the position of the consumer. Mr O'Brien of Nottingham University Business School told us that "the principles of financial management that companies will be issuing earlier next year will help, but even so my view is that with-profits will still be an act of faith and that you are not going to be able to understand exactly what has gone on."[14] Several witnesses suggested that more fundamental reform might well be appropriate. Mr O'Brien told us "the benefits of with-profits can now be met by different means to avoid the situation where we have lots of discretion and lack of transparency, so I think there are now products in the financial markets that firms can invest in that can actually deliver smoothing on a more mechanical basis than we currently have with with-profits."[15] This view was endorsed by Mr Sandler, who told us that "I think, generally speaking, there are few investment needs which are addressed by a with-profits policy which cannot better, more cheaply and with greater flexibility be addressed by a combination of other investment products."[16] Many of the basic problems identified in endowment mortgages are shared by other with-profits products sold by the life insurance industry. The Committee is concerned by evidence that even after the FSA's proposed reforms, buying any with-profits policy will still be little more than an "act of faith" for the consumer. Developing cheaper, more transparent products offering the same smoothing benefits to the saver as the traditional with-profits product is now a key challenge for the long-term savings industry.

The role of the tax system

13. Two issues, tax and changes in the estimates of likely investment returns, played a key role in the rise and subsequent fall of the share of the mortgage market taken by endowment mortgages. Looking at tax issues first, in the very early 1980s anyone taking out an endowment mortgage enjoyed two major tax advantages relative to someone in a similar position taking out a repayment mortgage. The most important benefit related to the tax relief available on life assurance premiums, which most endowment policies qualified for. Life assurance premium relief was abolished in 1984. Endowment mortgages also enjoyed some benefit relative to repayment mortgages from mortgage interest relief because the interest-only mortgage underlying the endowment product implied a higher outstanding capital sum and hence higher interest payments over the lifetime of the mortgage. This advantage was progressively scaled back through the 1990s, as the level of mortgage interest relief was limited, initially to the basic rate of tax, and then to progressively lower tax rates before the relief was finally abolished in April 2000.

14. Legal & General have described the endowment mortgage product as "the child of generous tax breaks"[17] and, as Mr O'Brien, one of our expert witnesses, noted, the on-going growth of endowment mortgages after the product's tax advantages began to be withdrawn in 1984 appears to have been simply a "bandwagon that continued [rolling]."[18] It seems likely that the tax system played a key role in encouraging the growth of endowment mortgages relative to repayment mortgages. The Sandler Review noted that tax complexity can "weaken competitive forces by distracting attention away from the real economic costs and benefits of different products—charges and performance—and by making comparison between different products more difficult."[19] This view is shared by some of the major players in the financial services industry. Mr Bloomer, Chief Executive of Prudential plc, told us "I would much prefer a simpler [tax] system which makes it much more transparent and easier for customers to see where they are saving."[20] It seems clear that it was undesirable for the tax system to be so slanted as to entice consumers into one relatively complicated financial product rather than a broadly comparable, but much simpler, product such as a repayment mortgage. The Committee believes that this is an important lesson for the future and strongly endorses Mr Sandler's call that "the overriding policy goal in this area… should be one of reducing complexity and distortions in the taxation of savings products".[21]

Projected investment returns and the role of actuaries

15. While the share of the mortgage market taken by endowments declined through much of the 1990s as tax relief was progressively withdrawn, the Table above indicates a particularly abrupt fall in just five years from 34% in 1998 to just 5% in 2002. Many major companies ceased selling endowment policies over this period. A variety of factors seem to have conspired to undermine endowment mortgage sales, but one major problem was that a slide in likely investment returns exposed the risks for all to see that were always inherent in endowment mortgages. Major insurance companies told us that they, alongside the Institute of Actuaries, began to review the likely returns on endowment policies in the late 1990s in the face of the changing economic environment, with the Institute of Actuaries panel reporting on the issue in 1999.[22] Thus when asked what was the first point at which the appointed actuary raised the issue, Prudential plc told us "that it was late 1999, [as] part of the discussion we were having about asset allocation, which was also linked with future expected yields on investments, which is really the key part of it, together with changes on the interest side that led to consideration of the balance between an endowment mortgage and a repayment mortgage and the economic effects of them."[23] In the wake of those discussions the company stopped selling endowment mortgages from 2000.[24]

16. The period in which endowment mortgage sales collapsed also coincided with intense regulatory activity on a variety of fronts. Looking at potential investment returns, the investment landscape had changed fundamentally through the 1990s. Base rates fell from 14% in late 1990 to levels that were less than half that through most of the mid-1990s. The risk free rate of return expressed by long-bond yields, widely used as a benchmark in gauging likely returns across a range of financial assets, had also fallen from 11.8% at the end of 1990 to just over 7% at the end of 1997, before falling below 6% in 1998. It was against this background that the PIA embarked in October 1998 on a formal consultation exercise on the need to reduce the illustrative investment returns used in marketing material. They were subsequently reduced from 5%, 7.5% and 10% to 4%, 6% and 8% in July 1999.[25]

17. The industry's slow switch to a more realistic internal assessment of the likely investment returns underpinning endowment products as the investment environment changed through the 1990s may have reflected a desire to maintain the apparent competitiveness of endowment mortgages relative to repayment mortgages. The industry's failure to respond quickly to the sharp fall in bond yields and inflation rates nevertheless raises significant questions about the effectiveness with which the appointed actuaries within insurance companies fulfilled their roles. Legal & General, for example, told us that throughout this period the appointed actuary had not issued a warning about likely investment returns—"not formally, informally or in any other way"[26] and the evidence the Committee heard from other major insurance companies[27] confirmed that the appointed actuaries had generally failed to provide the warnings that might have been expected about the changing investment climate. As well as providing an earlier alert to everyone of the potential problems building on endowment mortgages, if the actuaries had raised such warnings on investment returns in a more timely fashion the industry may have entered the bear market in equities from 2000 onwards with rather more robust investment portfolios.

18. The FSA has launched a major reform of the actuarial function within life insurance companies, prompted partly by the events surrounding Equitable Life. The evidence the Committee has heard about the role the actuarial profession played, or failed to play, in advising companies and their customers on the unfolding problems in endowment mortgages confirms the urgent need for change. The FSA's proposals, contained in consultation paper CP167 "include discontinuing the role currently fulfilled by the appointed actuary. Responsibility for actuarial aspects of the insurance business would then clearly rest with the board and senior management, rather than the appointed actuary."[28] A new actuarial role is also being introduced for with-profits business, in the shape of a with-profits actuary who will be barred from sitting on the board and "will play an important continuous role in protecting consumers."[29] In addition the FSA is also requiring auditors to seek independent actuarial advice, but the issue of the appropriate role for actuarial advice is an important one which the Committee intends to return to later in the course of our broad inquiry into restoring confidence in long-term savings. The events surrounding Equitable Life raised questions about the effectiveness of the pre-existing actuarial regime, but the insurance industry's approach to endowment mortgages through the late 1990s also demonstrates an inadequate approach to investment issues by appointed actuaries. The Committee considers it important that the FSA's proposed reforms of the actuarial process within insurance companies are effective in providing warnings and a more proactive and independently minded actuarial advice.

Conclusions

19. The evidence the Committee has received has shown that there are a range of issues surrounding the basic nature of the endowment mortgage as a product. First and foremost, despite their great popularity in the 1980s and 1990s (in part because they sometimes enabled the borrower to take out a larger mortgage), there must be a question as to whether it was ever appropriate for consumers to be sold a complex savings product with potentially volatile returns as a means of paying off a fixed debt without a clear explanation of the risks they were taking. There are, however, wider issues which raise concerns about long-term savings generally. These include the 'with-profits' model, the role of actuaries and the part played by the tax system. These are issues which will form an important part of our wider long-term savings inquiry, but it seems clear to the Committee from its review of endowment mortgages that generally more needs to be done to ensure that financial products and the tax system surrounding them are simplified as much as possible, that officials whose role is in part to protect and re-assure the consumer actually discharge that function effectively and, above all, that when complex financial products are sold to consumers they accurately fit the purpose for which they are bought.

4 Ev 3, Table 1 (HC 275) Back

5 How Many Endowments Fall Short? Cazalet Consulting 27 January 2004 Back

6 PIA Regulatory Update Number 72, December 1999 Back

7 Q 109 Back

8 ibid Back

9 Medium and Long-Terms Retail Savings in the UK, A Review, HM Treasury, July 2002 Back

10 Q 319 Back

11 Ev 186 paragraph 29 (HC 275) Back

12 Ev 162 paragraph 42 (HC 275) Back

13 Q 299 Back