Once upon a time – when it came to regular savings with stock market exposure – the endowment policy was king. Although a product of Victorian times, the endowment policy came into its own in the post-war years, when growing prosperity meant that people who were inclined to save for a ‘rainy day’ looked not to the stock market or the banks, but to their insurance company.

At their peak in 1988, endowment mortgages accounted for over 80 per cent of all new home loans. The theory was that homebuyers commit to making monthly payments into an endowment, typically a with-profits policy from an insurance company, and these aim to deliver sufficient investment growth over the term to clear the mortgage when it’s due. (See box on page 24 for a fuller explanation of how they work).

Fall from grace
And then it all went a bit pear-shaped. Returns on an endowment were calculated on the market conditions prevalent in the mid-1980s (in 1985 the Bank of England base rate briefly hit 14 per cent and annual bonuses were also into double figures). As the 1990s progressed – with inflation and interest rates falling, and stock markets cruising upwards – endowment returns were reassessed downwards, as most with-profits funds had large exposure to cash and fixed-interest securities.

As a result, annual bonus rates fell and panic spread that the policies wouldn’t mature with enough cash to pay off mortgages, let alone the ‘tax-free lump sum’ many IFAs and insurance brokers had assured would be a nice surplus.

‘Many IFAs sold with-profits endowments claiming, for example, that the client would get £100,000 upon maturity, when their mortgage was only £80,000, therefore leaving them with a £20,000 profit,’ says Dan Farrow, CEO of the TIS Group, whose subsidiary, AAP, is the UK’s largest endowment buyer. He adds, ‘The IFAs implied that it was some sort of “guarantee”. In hindsight, what happened was that, in the case of the previous example, the policy matured at £60,000, leaving the client with a £20,000 shortfall and unable to pay their mortgage off. This is damaging to any industry and so people are reluctant to use the endowment route today.’

It’s glib to suggest that there are many alternatives to endowments on the market – indeed, if you are looking simply for capital growth, that is a hard point to argue. However, with-profits endowments have a number of features that many investors see as sound and are keen to benefit from.

One is the ‘floor’ that the basic sum assured and the accrued annual bonuses put under the investment. Another is the smoothing effect of the bonuses – with money held back in good years to compensate for bad years – which reduces volatility. So are there any other products in the financial services marketplace that offer such features?

Protected funds
Protected or guaranteed funds are designed for cautious investors – sacrificing some of the potential gains of investing in the stock market, in return for capital protection. One provider in this area is Close Fund Management. With its Close UK Escalator 100 fund, the unit price is fixed each quarter – rising if the FTSE 100 goes up in the three months, but not losing value if it falls, so the capital is 100 per cent protected. Similarly, with the Close UK Escalator 95 fund, prices can fall by a maximum of five per cent each quarter.

Regular price fixes can work in the investors favour, but it all depends on how the market performs, since a maximum five per cent loss per quarter still equates to a potential loss of 20 per cent over the year. These funds also have higher than average initial charges. And more significantly, there is the cost of the protection, the general rule being ‘the more protection the fund promises, the lower the overall return’.

The impact of the protection on returns can be a disincentive. ‘The price of protection on these funds is too big a drag on performance, which is why I never recommend them to my clients,’ says Philip Johnson, director of IFA Kenwood Associates. ‘In rising markets, they lag too far behind active managed funds. In falling markets, they do put a floor under any losses – but good fund managers still make money in falling markets, as they can buy cheaply and then wait for the market to pick up to crystallise gains. I think if you are considering the stock market, you have to accept volatility.’

Guaranteed equity bonds
The term ‘guaranteed equity bond’ (GEB) covers a multitude of products that – although the specific details change for different providers and issues – all share elements in common.

Basically, you make a lump-sum investment into a GEB and the provider guarantees that at the end of the term – often five years – you’ll get back your original investment in full, even if the stock market falls. These bonds are linked to one or more stock market indices, but are generally capped at a certain percentage of the return on those indices – often 50 per cent or less.

The schemes work by putting around 75 per cent of the money that’s invested on deposit, so that it’s safe and earns interest. As the interest is added annually over the five years, it compounds up and should bring the capital up to the 100 per cent originally invested, which you get back. The remaining 25 per cent is used to buy derivatives linked to the stock market indices being tracked, making bets as to whether they’ll rise or fall.

However, these bonds were sold in great numbers in the late 1990s – with some providers offering yields of ten per cent per annum, as the concept of seemingly risk-free returns was a tempting prospect – and many investors piled in. As these bonds matured in 2002-03, when markets were falling, many investors got their fingers burned.

Hidden caveats
Moreover, some GEBs hide sneaky surprises in the small print. Some five-year bonds don’t calculate the return on the index over the entire investment period, but instead take the average of the first and last six months’ index performance, which they say helps reduce volatility. But if the markets go nowhere in these two periods, and in the intervening four years the markets soar, your return will be based on the not-so-spectacular periods.

One of the most successful and high-profile companies offering GEBs is Keydata Investment Services, which launched the 20th issue of its Dynamic Growth Plan on 1 October 2007 (offer closed on 14 November, 2007). The product offered investors 12 times any growth of the FTSE 100, up to a maximum total return of 84 per cent over six years, with a 50 per cent tracking capital protection to mitigate any potential losses.
However, an investor’s capital is not protected if the index falls by more than 50 per cent at any time during the product’s term. In this case, the amount of capital returned to the investor is reduced by one per cent for each percentage fall in the index.

‘Structured products are a low cost way of balancing risk within a portfolio,’ comments Mark Owen, sales director at Keydata. ‘Most investors in the UK don’t have sufficient capital to take on too much risk, yet by seeking greater returns they take on unnecessary risk. Conversely, high-net-worth investors tend to be more risk averse and have financial strategies based on preserving capital by investing heavily in structured products.’

Limited appeal
These products are often only open to investment for short periods of time – so if they appeal to you it’s important to be on the lookout for new offers, and to read the small print.

But again, IFA Philip Johnson is less than impressed. ‘They pay very generous commission to advisers, but I never recommend them,’ he says. ‘I don’t think they’re particularly transparent and I’m always wary of a product that says, “If it does this, you get that, but if it doesn’t you don’t.” Some offer various degrees of capital protection, but you never know how much until you read the very fine print. And they can go wrong.’

Spectacularly wrong, as anyone who bought the Scottish Widows Extra-Income Growth Plan – sold in branches of Lloyds TSB and through advisers, between October 2000 and May 2001 – will testify. Many thought they were getting a guaranteed ten per cent income per year – but thanks to falling stock markets in the wake of the dot.com crash of 2000, investors’ capital was halved. In September 2003, Lloyds TSB was fined £1.9 million by the FSA for the mis-selling of bonds and ordered to pay £98 million in compensation to investors.

Government security
In the wake of Northern Rock, even those who like the idea of capital-protected products but are suspicious of high street banks can go to, arguably, the most secure lender in the UK – the Government.

National Savings & Investments – whose products are available through a number of outlets, not least the local Post Office – offers a guaranteed-capital bond. The current tranche is Series 30, and because the rates increase every year (3.6 per cent in year one, 3.9 per cent in year two, 4.2 per cent in year three, 4.5 per cent in year four and 4.81 per cent in year five), it’s best to keep your money invested for the full five years to benefit from the compounding. This is because – like bonuses in with-profits – the interest paid is added to the value of the bond, and subsequent years’ interest is paid out on the lump sum you originally invested and on accumulated interest payments.

The minimum for each purchase is £100 and the maximum holding is £1 million in total. And even though the interest earned from capital bonds is taxable each year, it is automatically credited to your bond gross (i.e. with no tax deducted).

So if you are a non-taxpayer, you don’t have to fill in a tax form to have your interest credited gross (of course, if you are a taxpayer, you’ll need to declare your interest to HM Revenue & Customs).

With-profits endowment funds
For those who like the concept of guarantees and bonuses in endowments, but prefer the flexibility offered by conventional investment funds, there are funds that invest in endowment policies. These are generally closed-ended funds, and because the share prices run at a hefty premium to net asset value, it’s hard to put a value on a policy until it matures. So these funds can look risky, especially as they have finite lives and definite wind-up dates.

However, there is a floor of sorts, as the net assets of the fund (the policies themselves) will never be worth less than their estimated surrender value to the life assurance companies. And there’s a guarantee of sorts, in that there’s a definite date when the policies in the portfolio mature.

But supply of policies for the funds to buy is diminishing. ‘The peak of with-profits sales, in terms of number of policies, was between 1986 and 1988, and it has slowly tapered off since,’ says Dan Farrow. ‘Hence, the majority of policies will mature between 2011 and 2013, at which point the market will become considerably smaller.’

Proper diversification
So the endowment policy, for all its faults – inflexible, hard to value, front-end loaded so your initial years’ premiums pay for the salesman’s commission – have some attributes that investors find attractive. But IFA Philip Johnson still maintains that a carefully chosen portfolio of investment funds is the way to go. ‘The big selling point of a with-profits fund is diversification – property, shares, bonds and cash,’ he says.

‘But if you’re an owner-occupier, you’ve already got enough exposure to property; if you have cash in the bank, that is more diversification. So investment funds, in my opinion, are the way to go. If you think that the average endowment premium was, say, £100 a month, then with a multi-manager approach that’s £25 each into four different funds, which reduces volatility.