Question:
Please can you tell me what an endowment policy is?

Answer:
An endowment policy is a savings vehicle through which an investor is able to invest and have access to various funds covering a multitude of asset classes and fund managers. It is a contractual agreement between an investor and an insurance company whereby the investor agrees to pay a lump sum or a regular premium to the insurer and the insurance company agrees to pay the investor the savings as a lump sum, after the period agreed to by the parties (minimum of five years), 'tax free'.

The policy is issued in terms of the Long Term Insurance Act (LTIA) by a registered life insurer. In terms of this Act, the policy has a restriction period of five years during which the investor has two access points to their funds via one loan and one surrender.

A further 'constraint' is something known as the 20 percent rule. What this stipulates is that should premiums increase by more than 20 percent of the higher of the previous two year?s contributions, the five year restriction period will reset and impose the five year period from that date.

Because the funds essentially sit on the books of the life company, the investor will not be responsible for the tax administration on the growth of the investment over the period. This is because the insurance company will pay tax in terms of the 'four funds approach'. The 'four funds approach' distinguishes between four 'pools' of investors, namely: companies, corporates, untaxed (e.g. PBOs and churches) and individuals. In the case of an individual investor, the tax levied is 30 percent of all net rental income and interest accrued as well as 7.5 percent of Capital Gains.

There are generally two types of policies that have been marketed as endowment policies, namely endowment policies (a type of life policy) and sinking funds. Although the tax and liquidity constraints are identical, there are a few subtle differences that deserve highlighting.

Let?s first look at 'endowment' policies:

Sec. 1 of the Long-term Insurance Act defines a 'Life policy' as a contract in terms of which a person, in return for a premium, undertakes to ?

1. provide policy benefits upon, and exclusively as a result of, a life event, or
2. pay an annuity for a period,

and includes a reinsurance policy in respect of such a contract.

'Life event' means the event of the life of a person or an unborn:

1. having begun
2. continuing
3. having continued for a period, or
4. having ended

The term 'endowment policy' is an industry term only and not defined as such in the LTIA ? the above definition of 'life policy' covers what is known as an 'endowment policy'.

In terms of the act, there has to be at least one life assured nominated in order for the contract to exist. Upon death of the life assured, the nominated beneficiary becomes the beneficiary for proceeds and the fund value will be paid out. In the instance of multiple lives on a contract, it will be upon last one dying.

A sinking fund has also been labelled as an endowment fund in the industry but it is, strictly speaking, a different type of policy. Sec. 1 of the Long-term Insurance Act defines a 'sinking fund policy' as a policy (excluding a life policy) which provides one or more sums of money at a fixed or determinable future date. There is no requirement for a life assured.

In this instance, (which highlights the key difference between a true 'endowment' and a 'sinking fund') there is no need for a life assured and the beneficiary will be for ownership as opposed to proceeds. In effect, on death of the owner of the policy, the ownership will be transferred to the nominated beneficiary. The most notable benefit of this is that it prevents beneficiaries from having to incur re-investment costs upon receiving the benefit as well as potentially having to enter into a new endowment contract and having the five year restriction period being imposed.

Therefore some of the benefits of investing through an endowment or sinking fund include:

1. No tax administration

2. Favourable tax rates for individuals that are on a high marginal tax rate and who have utilised the interest exemptions granted to them

3. By nominating a beneficiary (proceeds or ownership), one can avoid paying executors fees upon death thereby saving up to 3.99 percent on the investment amount.

Of course, there are some disadvantages with the major ones being:

1. Liquidity constraints (five years)

2. Loss of interest exemptions which may mute returns especially if heavily weighted in cash.

Choosing to use an endowment policy as an investment vehicle must be done within the context of the investor?s circumstances in relation to existing investments, future liquidity needs and tax situation. This should ideally be done by a financial planner who will be able to assess your needs and recommend an investment vehicle to suit your portfolio in terms of your long-term needs and not merely in terms of the short-term gains available.

acsis Limited is an authorised financial services provider. The response to the question covers some of the issues in a general and factual manner and does not constitute advice. It is important to consult with a financial planner who, after an analysis of the individuals? personal needs, goals and circumstances, will be able to provide comprehensive and appropriate advice.