Endowments that pay off

They are probably the most hated financial products of the past decade. Millions of people are in shortfall on their mortgage endowments. But there may be an opportunity to make some short-term cash out of these flawed products.

Negative publicity in the national media - and Jobs & Money last week warned of a coming second wave of 10 million reprojection letters - has resulted in a rapid widening of discounts in traded endowment investment trusts. After the fall in their share prices, a major investment bank this week issued a report saying the trusts may now represent good value for investors.

The trusts represent the other side of the coin in the endowment market. People who want to cash in their endowments have two choices: they can either "surrender" it to the company they bought it from, or sell it to a market maker in endowments. The market makers are choosy; they don't want any old endowment, preferring those offered by big names and with a good pay-out record - but if it falls into a sought-after category, then the seller can probably pick up 15%-20% more than they would by cashing it in at the life office.

To be put in contact with three market makers who will give you a quote on the value of your policy, contact the Association of Policy Market Makers at http://www.apmm.org or call 020-7739-3949.

The market makers sell the policies on to investors who will carry on paying the premiums and, when the policy eventually matures, will pick up the valuable terminal bonus.

Some of the biggest buyers of second-hand endowments are a number of investment trusts set up in the 90s. The trusts are operated by Barclays Global Investors, Dresdner RCM Investors and Scottish Value Management. One of the main attractions of the funds was that they offer investors a fairly steady outlook, as well as offering a tax-efficient vehicle. All the gains are treated as capital gains rather than income, and can therefore be set against investors' capital gains tax annual allowance, currently £7,500.

But in recent months the trusts have moved to a wide "discount" as endowments have been hit by poor publicity. What this means is that the trust's share price is below the value of the underlying investments. Discounts of 10%-20% are quite common in the investment trust sector, but are relatively new for the endowment investment trusts.

Yet many of the endowment trusts are scheduled to be "wound up", in one case in just 18 months' time. As the discount automatically goes to zero when the trust is wound up and its assets are paid out to shareholders, buying now while the discounts are high is likely to be very attractive.

The enthusiasts for these investment trusts accept that underlying returns on endowments have fallen - maturity values are down by 15% in 2002 alone - but argue that the prices of the trusts' shares have been marked down too far.

"Traded endowment policy trusts appear to be undervalued, as widening discounts have overcompensated for the expectation of future cuts in reversionary and terminal bonus rates," said David McFadyen, investment funds analyst at ABN Amro.

He picks BGI Endowment III, Dresdner Second Endowment 2009 and Dresdner Endowment 2010 as the best buys in the sector, although it's worth noting that Hoare Govett, a member of the ABN Amro group, is broker to the Dresdner trusts, so the recommendations need to be taken with the usual pinch of salt.

Investors might also gain from demutualisations and distributions from the "orphan assets" of life companies over the coming years, says ABN Amro.

The trusts have been careful to only buy the endowments of financially strong life offices where the prospect of bonus cuts is limited.

Simon White, head of investment trusts at Dresdner RCM, says its 2006 endowment trust is more than 25% invested in Standard Life endowments.

The choice has been judicious because Standard Life has cut bonuses less than any other leading endowment provider. Maturity pay-outs on the typical £50 per month 25-year Standard Life endowments are still around £100,000, compared with the £70,000-£80,000 bracket at other big life offices and the dreadful £40,000-£50,000 figures coming from the shut-down life offices such as Life Association of Scotland and Crusader.

White says: "The trust is made up of a pool of mid-term endowment policies bought from the original policyholder at a discount to the underlying asset share. The aim is to provide low-risk capital growth."

The Dresdner 2006 trust is on a 22% discount, yet it has only four years before it must be wound up. Dresdner's 2003 trust, to be wound up next year, has a 7% discount. Taking into account trading and stamp duty charges of 2%, that suggests a near-guaranteed 5% gain just from the inevitable closing of the discount alone.

These discounts are unlikely to remain for long. Small amounts of buying could very quickly close the gap, so if you want to make some rare cash out of an endowment, act fast.