Your money: When it comes to savings, drive a hard bargain

At first glance the type of car an investor drives bears little resemblance to the choice of investment vehicle used to repay a mortgage. Yet millions of investors rely on the investment equivalent of a Ford Mondeo to produce the goods and pay off their mortgages.

But the Ford Mondeo, or with-profits endowment contract, with its steady if less-than-exhilarating performance, looks set to be challenged by the sexier Aston Martins of the investment world.

Annual additions to with-profit policies, which once declared are guaranteed and cannot be taken away, have fallen by nearly 3 per cent over the past seven years, from just under 9 per cent to marginally more than 6 per cent now. With record returns from the equity markets last year, the FTSE 100 index grew by 40 per cent. Investors are asking why the returns are not feeding through to policies as higher bonus rates.

Most large life assurance companies recently reduced their annual bonus rates by 0.25 per cent, to 0.5 per cent. Mike Urmston, chief actuary at General Accident, says that this is due to a number of factors, including the effect on the economy of meeting the convergence criteria for Economic and Monetary Union. He predicts that rates will continue to fall, to mirror Europe's lower inflationary and interest rate environment.

This means that the pay-outs on with-profit policies will become increasingly dependent on the bonus paid at the end of the policy - the terminal bonus - which is not guaranteed.

All this goes against the grain of what with-profits is intended to do: provide guaranteed returns that smooth the ups and downs of the stock market.

The situation is compounded if with-profits (or Mondeo) payouts over the past 10 years are compared with the equivalent unit-linked (or Aston Martin) returns. A Scottish Mutual policyholder paying pounds 50 a month received a return of pounds 8,021 from its with-profit policy in February this year. But a saver with the same policy invested in its unit-linked growth fund would have received pounds 709 more, pounds 8,730.

Bob Marriott, research manager at Sedgwick Noble Lowndes, the independent financial adviser (IFA), explains that returns are all about risk and reward. "With-profits has guarantees; unit-linked doesn't. So you just won't know what you are going to get until the day the cheque arrives."

Mike Baugh, manager at the IFA network DBS, adds that unit-linked policies offered potentially higher returns, but warns that the risks are much higher. Both advisers argue that with-profits policies remain good value and will provide good returns for cautious investors.

Simon Bond, client services manager at the IFA Towry Law, admits that the performance of 10-year with-profit policies has become poorer, but suggests that the balance may swing back in favour of endowment policies.

"They have had some bad press because the not-so-good companies are in danger of not covering mortgages they are often linked to," he explains. "When you compare the returns on maturing endowments with inflation, you are still getting a very good return. I think the see-saw has gone too far against them, and people will again appreciate the security in the right circumstances."

The average returns from 10-year policies are currently around 9.9 per cent a year, some 2.7 times the rate of inflation, while the annual return from a 25-year policy is around 13.4 per cent, more than twice the inflation rate during the life of the policy.

Even so, it is generally possible for investors who have with-profits endowments to switch into unit-linked funds if they are prepared to take the risk. Most insurers will allow savers to either switch out of with- profits entirely into unit-linked funds, or, say, leave what is already invested in with-profits and pay future contributions into a unit-linked fund.

However, it can be dangerous to chase the past few years' performance. The value of a unit-linked policy is directly related to the value of the stocks in the fund. In the event of an '87-style crash the day before a mortgage is due to be repaid, a shortfall is more likely to occur in a unit-linked fund than with-profits.

Mr Baugh says: "If the insurers' assertion that the UK is entering a low-inflation, low-interest environment is correct, the relative performance of unit-linked funds will also suffer." The choice facing the investor is between the smooth ride offered by the Mondeo or the altogether more bumpy but more exiting ride offered by the Aston Martin.

Jo Gill is a writer at `Financial Adviser'.