Look at the with-profit possibilities

Looking for security in a downturn? You could do worse than buy a second-hand endowment policy

IT IS easy, when markets appear to be heading South, to feel that there are few, if any, funds which can offer that elusive combination of exposure to equity markets, relatively low risk and a guaranteed - if not particularly exciting - return on a sum invested.

Secondhand endowment policies, the offspring of the much-reviled with- profits policies sold throughout the Seventies and Eighties, can offer all the above. When compared to a sickly Footsie, the annualised returns many such policies are delivering at present - between 10 and 13 per cent a year - makes their performance seem positively stratospheric.

Indeed, Lee Portnoi, chairman of the Association of Policy Market Makers (APMM), whose members trade in secondhand endowments argues: "Traded endowments represent the most successful defensive strategy this decade."

With-profits policies are essentially inflexible beasts. They are designed to run for up to 25 years, with policyholders paying in regular monthly premiums over that period. They have heavy up-front charges and must be held for their full term for the cost to come down.

A typical with-profits fund consists of a mixture of equities, gilts and other securities, and property - they are low-risk, at the cost of lower returns than a full-blooded participation in the stockmarket.

But what makes them particularly attractive in a market downturn is that each year a small bonus is attached to a policy which cannot be taken away. The bonus is small, barely 4 or 5 per cent a year, but it protects investors if markets should fall. The remainder of any increase in the value of a with-profits policy comes from the terminal bonus paid when it matures, which can be up to 60 or 70 per cent of the fund's value.

Over 20 companies now specialise in traded endowments in a market worth pounds 223m a year. For those who want to cash-in an old endowment policy, selling it on, like you would a second hand car, offers an alternative to accepting the surrender value.

Typically, that penalises early encashment by only paying out a proportion of the bonuses that the policy has built up. Insurers argue that this is necessary to avoid having to sell investments bought for the long term and to offer maximum value to those who stay the course.

There are three ways to buy:

Market makers. They buy suitable endowment policies then sell them on to investors, and can give advice on what to buy and how to construct a suitable portfolio. The APMM provides a free guide and list of its members.

At auction. Foster & Cranfield is the best established auction house, and policies are bought and sold just as at any other auction. Buyers will be guided by them, but investors need to ensure that they are buying the right policies from the right companies - generally, stick to the bigger insurers.

Investment trusts. Barclays Global Investors, Kleinwort Benson and Dresdner RCM offer investment trusts which themselves invest in traded endowments. The advantage of this route is greater spread, and it is also easy to buy and sell shares in the trusts.

Rather than buy a single policy, most investors choose a portfolio of policies, according to Lee Portnoi. A market maker will provide a list of policies for sale, showing the asking price and the pricing discount rate (PDR). The PDR shows the annual return if all current bonus rates continued, and currently varies from 10 per cent for a policy with five years to run, to 13 per cent for 15 years. The higher return for longer plans indicates the greater risk that bonus rates will be cut, or that terminal bonuses may not be as high as at present.

Having bought a policy, an investor has three ways of getting a return on his or her money:

Paying the premiums on the policy until maturity. While most policies are paid monthly, they can be converted to annual payment, usually with a 3 to 5 per cent discount from the insurer. If the original life assured dies before then, the sum assured plus bonuses is also payable, giving a windfall profit.

Surrendering the policy. Most insurers do not offer guaranteed surrender values, so values can go up or down. Generally, the closer to maturity, the greater the return.

Selling the policy back to a market maker. Even allowing for the mark up, this can be attractive, and is likely to give a return around 10 per cent higher than the surrender value.

Lee Portnoi claims the only risk is future annual bonus rates and the amount, if any, of the terminal bonus. At maturity, only the terminal bonus will be in any doubt, and that will be the same for all similar policies maturing that year.

If the downside is limited, the upside is that a return to high interest rates or good investment conditions could see bonus rates climbing again after falling recently, although most commentators discount this, for the time being.

Today's bonus rates may not last if interest rates fall further, or investment conditions are poor, but a traded endowment may still represent good value for money compared to the alternatives.

The Association of Policy Market Makers: 0171 739 3949; H E Foster & Cranfield: 0171-608 1941; Barclays Global Investors Funds: 0800-783 4567; Dresdner RCM Funds (UK) Ltd: 0171-475 6151