You would think it is impossible for an investment linked to the stock market to plummet at the same time as the market rallies. But this is exactly what has happened to the value of with-profits policies held by millions of homeowners and pension savers.

Since 2003, when the stock market began to recover from the bursting of the bubble in technology shares, with-profits policies have slumped. Despite this week’s stock market jitters, the FTSE all-share index has enjoyed gains of about 100 per cent since March 2003. The maturity values of with-profits policies has fallen by an average of 45 per cent over the same period. This fall in values has left thousands of homeowners who bought endowments without the means to pay off their mortgages.

In 2003 the average maturity value of a 20-year with-profits policy, started with a one-off investment of £10,000, was £111,901, according to a survey by Money Management magazine. Now the same amount invested over 20 years is worth only £61,903.

When you invest in a with-profits fund, the cash is pooled with other investors’ money. The pooled cash is invested on the stock market in a mixture of shares, bonds and cash. Each year the insurance company running the fund declares bonuses, or the amount of money to be added to the policy. Annual bonuses add guaranteed amounts each year to the value of a policy, while the terminal bonuses that make maturity values look high are paid only at the discretion of the insurer.

The idea is that a with-profits fund smoothes stock market fluctuations by withholding some profit in good years and paying out extra in the bad times.

The problem with the products now lies in the way in which the with-profits funds are invested. Traditionally, between 70 per cent and 80 per cent of a fund was invested in equities and property and the remainder in less-risky bonds. But between 2002 and 2003, before the market began to improve, many insurers reduced their exposure to equities and property to about 20 per cent to 30 per cent. At the same time, they increased the amount of the funds invested in bonds. When the upturn came, the with-profits funds missed out.

Justin Modray, of Bestinvest, the independent financial adviser, says: “They cut back on equities and property right on the cusp of a boom. In terms of timing, this is exactly what you don’t want to do.”

Bonus announcements this year have also shown that some strong funds, such as Legal & General, Liverpool Victoria and Prudential, are showing good underlying growth. But that strong performance is still not feeding though to maturity values.

Large numbers of funds are closed to new business. The performance of these “zombie” funds has been poor. This is partly because they were closed in the first place for being financially weak. A weak fund cannot afford to take the risks of a high equity holding.

The rush to close with-profits funds to new business, and today’s continued poor performance, has its roots in the past of the with-profits funds. When times were good, they paid out too much. When times were bad, there was too little left in the pot to avoid the poorly timed switch away from equities.

Kim North, managing director of Techonology and Technical, a financial services con-sultancy, says: “Actuaries have different methods for calculating how much extra to pay out in lean times and how much to withhold during periods of good performance. They are looking to produce an overall consistent return over the term and their strategies vary from company to company, which is why there are such massive discrepancies and payouts look poor relative to stock market performance now.”

With uninspiring annual bonuses, investors’ policies that are still some way off maturity are relying on better terminal bonuses. Mr Modray says: “While payouts on maturity have been falling, prospects are improving thanks to stock market performance. But this is in the lap of the gods and impossible to predict.”

CASE STUDY: Higher repayments the safest policy

Keith and Carole Lynn, of Ashford, Kent, face the prospect of a £25,000 shortfall on their Standard Life endowment, which was projected to pay out £50,000 at the end of the term on their £90,000 mortgage.

The Lynns, pictured with their children, Christian and Naomi, are proceeding with a compensation claim, but with ten years left on the loan, Mr Lynn, a 40-year-old business development consultant, is not taking any chances. Each time the couple remortgage, they increase the amount of the loan they are repaying by £5,000 so the endowment, which costs £64.50 a month, now has to achieve only £40,000 to clear the loan. The mortgage repayments are currently £611 a month on a two-year Alliance & Leicester tracker.

Keith says: “We are slowly chipping away at the loan but will continue to pay into the endowment plan. We now look at it as a standalone investment rather than a way of paying off the mortgage.”

Endowment shortfall action plan The sooner you address any shortfall the better, even if you are expecting to receive compensation for mis-selling. James Cotton, of London & Country Mortgages, the broker, says: “If you have a shortfall, do not assume that a nice compensation cheque will sort it out. There is a danger of focusing too much on the mis-selling and the potential for compensation rather than taking remedial action.”

Borrowers should steer clear of making additional payments into a poorly performing endowment. Mr Cotton says: “This is like throwing good money after bad”.

You can make your payments into an alternative investment product, such as an Isa. However, there is no guarantee that the returns on an invesmtent Isa will grow sufficiently to repay the loan.

You can cash in the endowment policy or sell it on the secondhand endowment market and use the proceeds towards paying off the mortgage.

Careful consideration is required before deciding whether to encash or sell an endowment. The best options depend on the performance of the policy, how long is left until maturity, any penalties for surrendering and any additional benefits for keeping it, such as life insurance. Mr Cotton says: “There is no simple answer. For instance, if you get rid of a policy that includes life cover, this may mean having to find replacement cover, which could be costly.”

The safest way to repair a shortfall is to switch the outstanding mortgage from interest-only to repayment. For example, imagine you have a £10,000 shortfall on a £50,000 loan with an interest rate of 5.25 per cent. You have five years to go until the endowment matures. The switch from interest-only payments of £218.75 to capital repayments of £364.86 would cost an extra £146.11 a month but would repair the shortfall by the end of the term.

If you have a poor mortgage deal, switching to capital repayments on a more competitive deal will pay for itself. For instance, someone with a shortfall of £10,000 on a £50,000 loan at 7.25 per cent with ten years to go is paying £302 a month. Byremortgaging to Leek United Building Society’s lifetime tracker at a rate of 5.33 per cent and switching £10,000 to a repayment deal, the monthly payments would drop to £285.

Another option is to make make regular overpayments on your mortgage. Most lenders allow overpayments of up to 10 per cent of the loan size each year without penalty. Some fully flexible deals allow unlimited overpayments for those that can afford to make even bigger contributions, although this usually come with a higher rate. On a £50,000 interest-only loan at a rate of 5.25 per cent with five years until the endowment matures, overpayments of £200 a month would reduce the balance by about £13,700, leaving you with £36,300 left to pay. If you can afford to overpay by £400 a month, the balance would fall by £27,400, leaving £22,600 to pay.

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