Traded Endowment Policies (TEPs)

Why buy a TEP - somebody else's endowment policy? How a traded endowment policy may make investment sense. The tax situation for buyers and sellers of traded endowement policies (TEPs).

• What is a traded endowment policy (TEP)?
• Why would I sell my policy rather than surrender it?
• Why would my endowment policy be worth more in a sale?
• Will somebody want to buy my endowment policy?
• Do I face a tax bill if I sell my endowment policy?
• Does a traded endowment policy make sense as an investment?
• What's the tax situation for TEP investors?

What is a traded endowment policy (TEP)?

A traded endowment policy (TEP) is an endowment policy that the original policyholder has sold by absolute assignment of all future benefits. "Traded endowment policy" is merely a fancy way of saying second-hand endowment policy.

Endowment policies are long-term and relatively inflexible by their nature. Many people have found that these policies do not suit changing financial needs or circumstances.

If you took out a 25-year policy but after, say 15 years, decide you no longer need/want the long-term savings plan or it has not performed as you expected, you have a number of options:

• Selling to a third party in the second-hand market - the TEP market
• Making the policy paid-up
• Borrowing against the policy
• Surrendering the policy to the life assurance company you purchased it from

For a variety of reasons, many policyholders cash in their policies early. According to the Association of Policy Market Makers only around 30% of all endowment policies actually reach maturity. A further 30% are cancelled in the first few years of their intended lifespan. The 40% that neither last the full term nor get cancelled are either sold or surrendered somewhere along the way.

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Why would I sell my policy rather than surrender it?

For the obvious reason! You may have decided, for whatever reason, that your endowment policy is no longer relevant to your financial circumstances. It follows logically that you will, therefore, want to get as big a return from your investment into the endowment policy as you possibly can.

First you should approach your life assurance company to find out how much the policy will be worth if you surrender it. This "surrender value" may or may not be more than you have actually paid in to the policy. Indeed, you may be unpleasantly surprised by how low this is.

Endowment policies generally take approximately 5-7 years before their cash-in values match, and then exceed, the amounts of money invested, although this performance cannot be guaranteed. You may well be familiar with the press coverage about why this is so - commissions to the sales people, administration charges, fund management costs etc. The key point is that long-term contracts rarely offer especially attractive short-term encashment values.

This is where the traded endowment policy (TEP) market may help. There may be a substantial difference between a quoted surrender value and a policy's underlying worth if held to maturity. Through the TEP market, policyholders may be able to sell 'unwanted' policies and buyers with the initial capital to invest and the income to meet future regular premium commitments may buy them mid-term with entitlement to all the potential future benefits.

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Why would my endowment policy be worth more in a sale?

Surrendering a policy is unlikely to produce a return reflecting the policy's full potential value, if only because the terminal bonus paid on maturity, while not guaranteed, usually represents a large chunk of the policy's return. In fact, policies surrendered early may not even reflect the full value of funds invested owing to high initial charges. The reason the traded endowment policy market exists is because surrender values do not always reflect the full potential inherent worth of policies as long-term continuing contracts.

Analysis for the Association of British Insurers by Tillinghast-Towers Perrin in 2002 showed that the charges (the reduction in yield) on a mortgage endowment policy held for 25 years were equivalent to an average of 1.5% of the value of the policy. However, if the policy is cashed in after three years, the charges on it represent almost a third of the policy's value on average.

The alternative option, if the policy is suitable, is sale through a market-maker or the auctioning of the policy through an auctioneer. In either case, the policyholder is likely to realize a higher cash sum than through surrender. The Association of Policy Market Makers admits that surrender values may not always be beaten but where they are, policyholders realise an average of 10-15% in excess of surrender value.

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Will somebody want to buy my endowment policy?

Most saleable policies must be traditional with-profits type endowments or whole of life contracts issued by major UK life assurance companies:

• which have already run for at least five years
• and have a surrender value of at least £1,500

Anyone wanting to sell a policy - or at least get a quote for what might be on offer - needs to provide the following information or give written authority for the market maker to obtain these details from the life company:

• the name of the life company and the policy number
• the name of the life assured (you)
• commencement and intended maturity dates
• the "basic sum assured"
• gross regular premiums
• quoted surrender value at a recent date
• amounts of attaching annual bonuses at the same date

On receipt of all the relevant details, an offer to purchase (or a reason why the policy is not suitable) will usually be made within a couple of days. Payment will normally take a few weeks to account for all the paperwork and exchange-of-ownership declarations that have to be completed between the market maker and the original insurer.

Policies sold or auctioned are assigned to the investors who purchase them and who then take on the responsibility for the payment of future premiums. When the policy reaches maturity or the life assured dies, all the benefits are paid to the investor owning the policy.

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Do I face a tax bill if I sell my endowment policy?

If you are the original beneficial owner of the policy, that is to say if you were the person who took it out, unless you are a higher rate taxpayer there is generally no tax liability on the proceeds of the sale or auction of the policy. As you may be aware, income tax will already have been paid on any dividend income generated by the policy's equity investments. When you sell a policy that you originally took out and have paid premiums for at least ten years, or at least three quarters of the policy if sooner, you should have no income tax liability irrespective of your tax rate and nor will you be liable to Capital Gains Tax.

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Does a traded endowment policy make sense as an investment?

Why would anyone want to buy anyone else's unwanted endowment policy? Surely they are selling the policy because it has underperformed or is in some other way unsuitable. Either or both may be true. That does not mean that a traded endowment policy (TEP) does not make sense as an investment to others.

TEPs may not sound exciting but for thinking investors, they may be ideal vehicles for building capital to meet future financial needs or obligations at a fixed time in the future. They may be used to provide future lump sums tailored to specific needs. Popular uses - albeit not exclusive - include 18th or 21st birthdays, school or university fees and general savings as part of a wider portfolio of investments.

TEPs' appeal is based on the fact that they are backed by the strength and proven performance of leading UK life assurance companies, with exposure to a broad range of asset classes, and, in theory, offer steady and stable growth prospects.

TEPs ideally suit investors who are looking for a combination of relative safety and security together with growth potential although, due to their exposure to the performance of the equity market, they may not get back the full value of their investment. Such investors are often wary of investing directly in stocks and shares or other equity-linked vehicles, such as unit trusts, investment trusts and OIECs. In most circumstances, TEP investors can rest safe in the knowledge that they cannot lose any of their initial investment provided they continue to pay the remaining due premiums and keep the policy in force until its stated maturity date.

This is because the basic "sum assured" and annual bonuses allocated by the time of purchase are guaranteed - i.e. "locked in" and together are likely to be worth more than the initial purchase price. In addition, the expenses incurred in the early years (commission and other costs) have been absorbed already by the original policyholder.

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What's the tax situation for TEP investors?

A traded endowment policy (TEP) can be regarded as an asset just like any other investment and may therefore be potentially subject to Capital Gains Tax (CGT) on profits made over the period it is held. However, the tax situation with TEPs can be more complex than this. There are two different classes of TEP for tax purposes: qualifying and non-qualifying. Non-qualifying means the policy has not been certified by the Inland Revenue to benefit from specific income tax exemption.

Qualifying TEP proceeds, whether at maturity, death of the life assured or resale of the policy, are normally liable to CGT. However, depending on your individual tax circumstances, if a 'non-qualifying' TEP is chosen to meet your requirements, you may be liable to income tax on the proceeds instead of CGT. Furthermore, if you hold a qualifying policy and sell it within 10 years or three quarters of its term, it will no longer be classed as a qualifying policy and may, therefore, give rise to tax liability.

If you hold a qualifying TEP, CGT is payable on any capital gain - the maturity value less purchase cost and premiums paid since purchase. Your CGT liability may be mitigated by taper relief on TEPs purchased after 5 April 1998 and by your annual CGT allowance.

Non-qualifying TEPs are taxed under income tax rules and are subject to 'top-slicing' relief. The 'chargeable gain' is calculated by deducting total premiums paid, including those of the original policyholder, from the maturity value. Higher rate taxpayers will then face tax on the amount of chargeable gain at the difference between higher and basic rates of taax (18% in 2007 / 08).

For basic rate taxpayers the chargeable gain is divided by the number of whole years the policy has run. This figure is the 'top-slice'. The top-slice is then added to all other taxable income received in the same tax year. If total income including the top-slice is below the higher rate tax threshold no tax is payable. However, if the addition of the top-slice takes the taxpayer above the higher rate threshold then the proportion of the slice falling over the threshold is applied to the total chargeable gain and this amount is subject to income tax at the difference between basic and higher rates.

Top-slicing is a complex tax process and you should discuss it with a tax adviser.

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31 August 2007 © Moneyextra.com

Our senior editor Robin Amlôt recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.