What these policies really cost you

Many people put blood, sweat and tears into buying a home, and far less effort into investing in a pension or other long-term policy from an insurance company. Yet some of the insurance products on offer, especially the pension plans, are likely to be worth as much or more than a family home when they mature. A nice house at retirement is not much good without a decent pension.

In the last few years, there has been a growing realisation that decisions on investment need to be given just as much weight as those about buying bricks and mortar. But much of the information published about insurance products is impenetrable.

To help clear away this fog, the Independent asked John Chapman, a former senior official of the Office of Fair Trading, to analyse the investment products offered by insurance companies.

Mr Chapman was the author of a number of hard hitting OFT reports on the life insurance industry. Before be retired this year he suggested a pioneering new method of rating the performance of insurance companies and their products, on which this analysis is based.

It shows which companies are selling the best products. Just as significant, it shows which of them can back their claims about future performance by pointing to good results in the past. The analysis will help buyers of new policies to make a choice, and those with existing investments to check how well they are performing.

The problem with many policies is that if they were not on the market already, nobody would ever think of inventing them. They occupy a niche rather like aspirin and paracetamol in the health industry - they are so dangerous and have so many unexpected side-effects that they would probably be banned from over-the-counter sale if they were launched in the 1990s.

Indeed, with-profits endowment policies, the traditional basis of pensions and other insurance investments, are probably the most one-sided contracts ever sold. Some policies have proved with hindsight to be very good value. But it was certainly not possible to work this out at the time they were bought.

Buyers of with-profits endowments invest their money with no idea of what they are going to get back. There is a guaranteed annual bonus, but the level each year is at the company's discretion, based on its own judgement of performance. Around half the final proceeds are likely to be in the form of a discretionary terminal bonus that the company is not obliged to pay.

It is hard to believe that until 1995, sellers of with-profits endowment policies also managed to avoid declaring their charges. Policyholders did not know the cost of having their money managed by an insurance company until they cashed in their investments.

In recent years, the insurance industry has come up with an alternative to with-profits endowments, in the shape of unit-linked policies for pensions, mortgages and other products. Unit-linked policies are claimed to be much easier to understand and have become very popular.

But they are not nearly as transparent as they are claimed to be. Companies normally declare initial charges of around 5 per cent of premiums and annual charges of 0.625 per cent to 1.5 per cent, but an array of seemingly unimportant charges announced in the smaller print can swell the initial charge on a unit-linked policy to the equivalent of 12 per cent of premiums.

There is a simple reason why charges are the most important consideration in buying a policy from a life insurance company, whether it be for mortgage repayment, a pension or some other form of savings. This is that the primary determinant of policyholder returns is not investment performance but the total amount of charges levied by the insurers on their customers over the years the policy is in force.

Investment performance is important, of course. But the arithmetic of charges puts it in perspective. The charges reduce the overall yield of a policy by the equivalent of between 1 and 5 percentage points a year. For those cashed in early, the reduction in yield can be 10 per cent a year or more.

Not only are some of these numbers startlingly high, the range between best and worst is also extremely wide, suggesting some companies are charging far too much. The fact is that a company with charges at the higher end of the scale would need a truly miraculous investment performance over the years to overcome the cost handicap, and beat a rival with low charges. This is why charges are so important in making a decision about what to buy.

Life assurance is heavily marketed. In theory, charges should therefore drop as companies fight for business. But in reality there is very little evidence of this happening, and some charges are actually rising. The reason is not hard to find. The insurance industry has been selling to a public that has not had the information on which to make informed decisions.

The only way to introduce real competition into the industry is therefore to put the spotlight on charges in an easily accessible way, and keep it there.

If customers begin to seek out the lowest cost companies, rather than the ones with the biggest brand names or marketing teams, then charges should fall.