# 3% Risk Premium?



## Sir Ivor (5 Sep 2001)

<!--EZCODE BOLD START-->*   <!--EZCODE ITALIC START-->   Mithrandir<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END--> says (in another Forum):
<!--EZCODE QUOTE START--><blockquote>*Quote:*<hr>   <!--EZCODE ITALIC START-->_ 
The Endowment method only makes sense if there is risk premium, some 3%pa above the net cost of borrowing. Merely paying off the loan is an abject failure, and a huge waste of money.

Over 70% of sales were unit linked, why? Because of 90% first year commission, typically half again more than the with profit stuff you chose . Windfalls are paid out of lower future bonus'es, you know the old TINSTAAFL Theory. 

_<!--EZCODE ITALIC END--><hr></blockquote><!--EZCODE QUOTE END-->

I want to nail this one.

a) Originally much touted in the <!--EZCODE BOLD START-->*   <!--EZCODE ITALIC START-->   Endowment Mortgage War<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END--> of the early 1990s, this is really quite an arbitrary criterion and should have been challenged during that War.  However, for the purpose of this thread let us take that premise as reasonable in the context of <!--EZCODE UNDERLINE START-->advising to take out an Endowment Mortgage.<!--EZCODE UNDERLINE END-->

b) Its use with hindsight, as in the context of the above quote, must be wrong.  If with hindsight an <!--EZCODE BOLD START-->*   EM*<!--EZCODE BOLD END--> has worked out only a Euro Cent better than an <!--EZCODE BOLD START-->*   AM*<!--EZCODE BOLD END-->, surely that is still better!

c)  I have also noticed this 3% thing popping up in the SSIA debate.  Surely a totally different and <!--EZCODE UNDERLINE START-->much lesser<!--EZCODE UNDERLINE END--> hurdle should be applied to investing Charlie's <!--EZCODE ITALIC START-->_   gimme_<!--EZCODE ITALIC END--> than to paying off a Mortgage!
:smokin


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## Brendan Burgess (5 Sep 2001)

*Were endowment mortgages a good decision at the time?*

Sir Ivor

I am trying to get to grips with your post and its implications.

Are you saying that people who took out a with profits endowment mortgage back in the early 1990's are better off than people who took out an annuity mortgage ?

As most with profits endowment mortgages were for 20 year periods, is it safe to say that 10 years later when we are only half way through the period ?

Are you implying that this means that it was a good decision <!--EZCODE ITALIC START-->_ at the time_<!--EZCODE ITALIC END--> back in the early 1990's to take out a with profits endowment mortgage ?

A friend of mine put all his money in Bula and the share price tripled. I bought a mixed portfolio of shares and I have had a 10% annual return.  My friend's decision has turned out to be correct in retrospect, but surely it was not the right decision at the time ?

Brendan


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## Sir Ivor (5 Sep 2001)

*Re: Were endowment mortgages a good decision at the time?*

<!--EZCODE BOLD START-->*   <!--EZCODE ITALIC START-->   Brendan<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END-->, you will probably have noticed, as <!--EZCODE BOLD START-->*   <!--EZCODE ITALIC START-->   Mithrandir<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END--> has, that some of my contributions are a wee bit tongue in cheek.

Getting real serious for a moment. 

I think the theological debate about <!--EZCODE ITALIC START-->_   "hindsight versus foresight"_<!--EZCODE ITALIC END--> is a bit of a cul de sac, and I withdraw it. If someone shuts their eyes and darts across the dual carriageway and makes it to the other side before somebody who waited for the <!--EZCODE ITALIC START-->_   green man_<!--EZCODE ITALIC END-->, you wouldn't say the act was justified with hindsight.

On the more substantial point, I don't have actual figures to hand, but consider a friend of mine.  She <!--EZCODE ITALIC START-->_   (really is a she)_<!--EZCODE ITALIC END-->  took out a Scottish Provident <!--EZCODE BOLD START-->*   EM*<!--EZCODE BOLD END--> about 10 years ago.  She got very concerned during the War.  I told her to hang on in.  She is now very pleased with her <!--EZCODE ITALIC START-->_   carpetbag_<!--EZCODE ITALIC END-->, thank you.  However, my sense is that it would have stacked up anyway.  Mortgage rates have halved.  An <!--EZCODE BOLD START-->*   EM*<!--EZCODE BOLD END-->, being a geared investment in the markets, does especially well in such a scenario.  Maybe someone who is closer to this than me can run up a few examples.  Was the War really worth fighting after all?  <!--EZCODE ITALIC START-->_  (Don't get me wrong - I do not believe the average punter should be having geared investment in the markets, especially on the collateral security of the Home.)_<!--EZCODE ITALIC END-->

My other (serious) point is that I definitely do not believe that the <!--EZCODE UNDERLINE START-->same<!--EZCODE UNDERLINE END--> arbitrary 3% premium should apply to SSIAs as apply to funding to repay the mortgage on the family home.

BTW, what is TINSTAAFL?,  I'm afraid to ask Mithrandir as he <!--EZCODE ITALIC START-->_   (recently clarified correction to my misunderstanding)_<!--EZCODE ITALIC END--> would only laugh at me.


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## Brendan Burgess (5 Sep 2001)

*Tinstaafl*

I assumed that the "f"  "l"at the end meant future liabilities - something to do with paying people now.

Then I thought it might be a character from the same stable as Mithandir !

But I Googled the word and it came up with the very boring:
There is no such thing as  a free lunch !

If there is one thing worse than an AA or a RAIPI - it's a TLA !

Brendan


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## Mithrandir (6 Sep 2001)

*Risk Premium*

Hi Guys,

The risk premium of 3%pa above the net cost of borrowing was accepted eventually by the life industry in 1993. It finally was copperfastened, 8 years later in a Society of Actuaries statement specifically related to the endowment mortgage market, despite having been pooh poohed by some of it's old dinosaurs in the Jurrassic era of the early nineties.

So, take the ncb averaging, say, 6% to 7% on the target market, ie larger mortgages, add on your 3%, and you'll get 9% to 10% pa net, ie after RIY. Now add back RIY, and you'll reach fairly heavey territory, like about 3% to 4%, above the illustration rate used by the industry to sell the stuff!

Neat trick that. So how did the industry eventually begin to convince nearly one in every two punters to chose this route? Simple first don't breathe a word about the risk premium principle, that'll really screw things up, even today. 

And secondly produce a financially incorrect standard illustration that compares two unequal outflows of money, coming to the conclusion that the bigger outflow, by producing the bigger outcome is better. Heaven help the poor punter, when the nonesense of this presentation, wasn't,and still isn't, accepted or perhaps understood by the salesfolk.

If the same, higher inflow is committed in the form of accelerated capital repayments to the annuity loan the capital clears earlier - and without investment risk. But anyway all this was fully explained in the critique ' Endowment Mortgages The Hometruth', except a tiny handfull of professional advisors actually bothered to obtain a copy, and read it. Eight years later no wonder the myth remains?

Sure there will be some that may overcome the odds and outperform by the risk premium. But here's the $64m question, if the poor sods that were sold this guff were told the truth, and given the probability of not reaching this benchmark, how many would have been convinced? My guess, where the market eventually settled, about 5% of new homeloans. And not 50%.


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## Sir Ivor (6 Sep 2001)

*Re: Risk Premium*

Ok, Ok, <!--EZCODE ITALIC START-->_ Mith_<!--EZCODE ITALIC END-->, Let's not fight <!--EZCODE BOLD START-->* WWII*<!--EZCODE BOLD END--> all over again.

I'm still sure glad I recommended my friend to hang on in with the <!--EZCODE BOLD START-->* SP*<!--EZCODE BOLD END--> policy (to be fair, <!--EZCODE ITALIC START-->_  EMTHt_<!--EZCODE ITALIC END--> would probably have recommended the same)

But what about my point that a much lower risk/reward trade off is warranted for most people in the context of their SSIA?

It is slightly confused, I suppose, by the short term nature of SSIAs as 3% doesn't amount to a whole hill of beans over 5 years.:smokin


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## Mithrandir (6 Sep 2001)

Hiya Sir Ivor, no invitation to repeat that debacle all over again. 

You and your female client may have beaten the odds, I dunno, but the potential misinterpretation that this was the case that proved the method, was my concern. But you've differentiated. I'm not surprised. Sir Ivor, I haven't the first clue who you are, but you've clearly got an uncommon mix of intellect, humour and tact. It's a potent formula.

Great to have you on board. You really do add a lot to AAM, in my view.


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## Sir Ivor (6 Sep 2001)

*Who Am I?*

<!--EZCODE BOLD START-->*  <!--EZCODE ITALIC START-->  Mith<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END-->, thanks for the kind words and you can find out all you wish about me [broken link removed].

<!--EZCODE BOLD START-->*  <!--EZCODE ITALIC START-->  Clubman<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END--> thinks I am the British Ambassador.  Despite the striking resemblance, I assure you he is mistaken.:hat


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## Freddie Kruger (10 Sep 2001)

*The Above*

Mith & Sir Ivor,

Taking the following case, is there any way of calculating how bad the client has done.

Company A

Mortgage Amount                                 : £23,150
Term                                                   : 15 years
Endowment Premium                             : £86.94 per month
Maturity Value On Endowment Policy       : £41,311


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## Sir Ivor (10 Sep 2001)

*Re: High Hurdle*

[broken link removed]

My humble figures give that as a return on the Endowment Policy, <!--EZCODE UNDERLINE START-->after all expenses and taxes<!--EZCODE UNDERLINE END-->, of <!--EZCODE BOLD START-->* 12%*<!--EZCODE BOLD END--> per annum.  Allow for a Mortgage Protection element and it is around <!--EZCODE BOLD START-->* 13%*<!--EZCODE BOLD END--> per annum.  More than enuff to meet <!--EZCODE BOLD START-->* <!--EZCODE ITALIC START--> Mith's<!--EZCODE ITALIC END-->*<!--EZCODE BOLD END--> hurdle, with metres to spare!  But are you sure of the figures?  Name the company.:smokin


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## Mithrandir (11 Sep 2001)

*Example Given*

Hi Freddie. Excellant return. Hope it's not a staff or broker case where there was no initial expenses. Perhaps not.Pity it doesn't reflect most consumer experiences of single digit IRR % over the same period.

Anyway it's 11.4% IRR. Deduct the risk premium (RP), and you're at an NCB hurdle of 8.4% pa. If the net cost of borrowing was lower, the borrowers have had an efficient endowment mortgage.Interesting to know though how much was based on a last year Terminal Bonus, and what the running surrender value was year 14.

By the by, if we assume a mortgage protection cost of say £10pm, and average interest rates of say 9%, the equivalent inflow would have cleared an annuity mortgage after 12.72 years, saving 27 month's costs.

The yield on long term with profits, assuming this is one is not just a function of asset performance, but also the lottery effect of how much of the yield has propped up the transfer effect of those who surrendered prematurely, ie the folk who suffered from the method.

The value of the endowment method was not measured by individual results, but rather the macro effect on society as a whole. And as a whole most sales, have since required rescues with increases in premiums, just to hit the target, whatever about surpluses.

Nevertheless the example you quote is a good result. The interesting question is how many of the population of 15 year endowment mortgages sold, presumeably in 1986, crossed the hurdle, and how many didn't.


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## Freddie Kruger (17 Sep 2001)

*Re: Example Given*

Some more examples

Company B.

Mortage Amount     £35000
Term  20 years
Endowment Premiun £65.74
Maturity Value  £43,150

Company C

M A   £35,000
T     14 years
E P     £150.60
M V      £47,473.8

M A   £14,834
T     10 years
E P   £100
M V    £23,628

All policies matured in last couple of months.


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## Mithrandir (18 Sep 2001)

*Last Examples*

Hi Fred,

Refer to my earlier entry.

First two above on dodgey ground, depending on the loan contract actual ncb over the term. These are at IRR% of 8.84, and 8.05 respectively, less the risk premium. The last ones better at 12.02. A couple of swallows don't make a Summer, Fred, particularly if they're WP swallows with specially extended TB wings that sprout in the final year to get them over.


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## Freddie Kruger (18 Sep 2001)

*Re: Last Examples*

Hi Mithrandir,

For my own curiosity I asked four WP offices to give me actual maturities on policies, linked to mortgages, that
were coming to fruition. I was curious as to how they had stood the test of time.

I think the poor soul in the fourth office did not understand the request.

Anyway, thanks for the number crunching. I understand the points made and agree that for these four maturities there are probably double(if not more) with broken wings. I don't think the individuals that have the policies maturing are too concerned now what level of TB was added. 

You're not suggesting that those benevolent assurers are paying out over the top to save face now, are you?


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## Mithrandir (18 Sep 2001)

*examples*

Certainly not. In fact I guess that the underlying asset performance is the same as UL managed funds. Be interesting to ask a few of those what results they got.

The difference is argueably the effect of internal transfers from those that deserted to those that lasted the course. And for the latter it looks like success for some, from the above. 

But from a society standpoint, the key question is the rate. The rate of success and it's converse, the rate of failure. That's why retention rates are key to measuring the system of endowment repayments. Eg how many 20 year endowments sold in 88 to 93 have lasted to 2001? And what is the expected retention rate to 20 year maturity that can be correlated from this answer.

I suspect that thew reason the industry is quiet on yields is because it doesn't want to have to answer this central question. Throughout the long dead debate one question kept resurfacing - 'Fine that's the current maturity yield, but what percentage of policyholders who started out on the course, finished it?'.

Regards.


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## Sir Ivor (18 Sep 2001)

*Re: Has there been a paradigm shift?*

Mith,

When <!--EZCODE ITALIC START-->_  EMTHt_<!--EZCODE ITALIC END--> was written, mortgage rates were 11% and Mortgage Endowments had outrageous upfront charging structures.

Today, mortgage rates are half of what they were then, and going lower.  Moreover, companies like QLD are providing equity type savings products with no upfront charges and with low recurring charges.

Is it time for the Endowment Mortgage to make the greatest comeback since Lazarus?:smokin


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## Mithrandir (18 Sep 2001)

*Lazarus*

Far as I know Lazie baby was a once off. 

But Sir Ivor, I guess you're spot on. The removal of the underlying problem does shift things. Hard to see how many post death experiences could be manufactured if the miracle worker ain't paid the old rates, of up to 90% year one premiums though.

My guess is that the penetration level would be a lot lower, and far better targeted. Like at the commercial market, where the combination of much lower ncb, entrepreneurial customers, and argueably, better informed advisors, makes the endowment or pension backed mortgage a real possibility. And no ones home is being linked to equity markets through the conduit of a life policy.

On the homeloan market, sticking to the business audience who are financially strong elsewhere the new style product has to be a valid one to explore. But retargeting the low middle income sector, whose chief asset is their home, needs to be very carefully considered. 

In either event I suspect that, even with positive coverage today, the penetration level would be a fraction of the truly awful one in two that emerged in 92?93. 

So to answer your question, yep things have changed for the better. A lot. As the industry went about cleaning up its act, improving consumer trust, look what's gone. The life industry is no longer a regular target for public anger on radio shows like LiveLine, and in newspapers, like it was in the past. That's the dividend I guess, and in this transparent market, even the endowment method of loan repayment can hold its head up. On conditions.


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## Mithrandir (18 Sep 2001)

*Lazarus*

Far as I know Lazie baby was a once off. 

But Sir Ivor, I guess you're spot on. The removal of the underlying problem does shift things. Hard to see how many post death experiences could be manufactured if the miracle worker ain't paid the old rates, of up to 90% year one premiums though.

My guess is that the penetration level would be a lot lower, and far better targeted. Like at the commercial market, where the combination of much lower ncb, entrepreneurial customers, and argueably, better informed advisors, makes the endowment or pension backed mortgage a real possibility. And no ones home is being linked to equity markets through the conduit of a life policy.

On the homeloan market, sticking to the business audience who are financially strong elsewhere the new style product has to be a valid one to explore. But retargeting the low middle income sector, whose chief asset is their home, needs to be very carefully considered. 

In either event I suspect that, even with positive coverage today, the penetration level would be a fraction of the truly awful one in two that emerged in 92?93. 

So to answer your question, yep things have changed for the better. A lot. As the industry went about cleaning up its act, improving consumer trust, look what's gone. The life industry is no longer a regular target for public anger on radio shows like LiveLine, and in newspapers, like it was in the past. That's the dividend I guess, and in this transparent market, even the endowment method of loan repayment can hold its head up. On conditions.


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## Sir Ivor (18 Sep 2001)

*Re: Am I seeing double?*

Mith, you seem to be dogged by unregistered impersonators though this latest manifestation appears to be in agreement with you.:hat


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