More hit by mortgage shortfall

Thousands more homebuyers who are relying on endowment policies to repay their mortgages are to be warned that the policies are unlikely to produce the cash they need.

In addition, nearly 3 million homebuyers who have already been advised that their policies are likely to fall short of expectations may now be told that the gap between the cash they need and what they are likely to receive is larger than was previously estimated.

As a result, in order to repay their home loans they may have to increase their monthly premium payments - or find cash sums which can run into tens of thousands of pounds from other savings.

The fresh warning about the performance of endowments and other long-term savings plans comes from the financial services authority (FSA) as it launches a major review of the growth projection rates used by financial firms.

The City regulator has written to the chief executives of large insurance companies because it is concerned that insurers that have transferred their investments out of shares and into bonds to seek protection from the recent stockmarket falls may be overstating the possible returns to investors in the future.

Bonds are far less volatile than equities, but historically the returns have been much lower. The traditional split of investments in a with-profits fund is 70% in shares and 30% in bonds, but as stockmarkets have tumbled worldwide in the past three years, many insurers have made big changes to their portfolios in an attempt to limit their losses. Some major insurers are thought to have 60% of their funds in bonds and 40% in equities.

The warning affects not just a potential 9 million mortgage endowment policyholders but anyone with a pension, or long-term insurance-backed saving scheme.

Before the stockmarket bubble burst, most homebuyers with endowments were encouraged to believe that their policies would not only pay off their mortgage but also provide a sizable additional cash payout. But plummeting share prices prompted many insurance companies to cut their payouts. The Prudential, with 2.1 million with-profits policyholders, has cut its payouts by 21%, while Legal & General, with 1.7 million endowment policies, has cut them by 20%.

As the payouts were scaled back, the FSA ordered insurers to reassess whether their policies were on track to provide the cash that homebuyers were expecting. Some 4.3 million policyholders received letters. More than two-thirds of them were told that there was either a "significant risk" that their policy would not live up to expectations, or that they would need investment returns of 8% a year to hit their targets. In the current low-inflation climate, such high returns are seen as unfeasible.

The new FSA warning means that many more thousands of homebuyers are expected to receive warning letters for the first time. Those that have already been alerted to problems are likely to be told that the situation has worsened. For some it will be the third time they have been warned that their situation has deteriorated.

The FSA currently requires projections on mortgage endowments to be made at stan dard rates of return of 4%, 6% and 8%, and for products that are tax-free, such as pensions, at 5%, 7% and 9%.

However, it is now making it clear that companies that have shifted their investments from the traditional 70/30 equities/bonds mix will need to reduce these standard rates.

Using research it commissioned from accountants PricewaterhouseCoopers, the FSA has concluded that equities will outperform gilts (British government bonds) in the long-term. According to Jeremy Clivaz of the FSA, the PWC research shows that while equities are volatile in the short-term, over a 25-year period they still outperform gilts by 3% to 4% each year.

To head off criticism that the PwC research is too optimistic, it has been reviewed by Martin Weale, director of the national institute of economic and social research, David Miles of Imperial College and the actuary, Andrew Claringbold.

As a result of the PwC research, the FSA is allowing companies still with a traditional bias towards equity investment to maintain the current calculations they use to project the value of a policy in the future. This will surprise some investors, who believed they were more at risk in the rollercoaster equity markets.

Michael Folger, director of conduct of business at the FSA, said: "For their financial planning, consumers can find it useful to have some idea of potential returns, but it is important that they appreciate the uncertainties. No one can predict the future. Projected returns are not promises."