Investment bonds are sold by life insurance
companies and allow you to invest in a variety of investment funds
managed by the fund management arm of a large insurance
company. They are normally designed to produce long term
capital growth, but can also be used to generate an income.
The minimum investment is typically £5,000 or
£10,000. When you buy a bond you will be allocated a certain number
of units in the funds of your choice. Each fund will hold a
portfolio of investments, such as shares or bonds, and the price of
your units – in other words the value of your capital – will
normally rise and fall in line with the value of these
investments.
Technically investment bonds are single premium life
insurance policies. This means an element of life insurance is
provided. But it is tiny, typically adding an extra 1 per cent or
less to the value of your investment, if it is paid out after your
death.
In the past, investment bonds provided a
choice of around half a dozen ‘unit linked’ funds covering
different types of investments - UK equities (shares), overseas
equities, commercial property, fixed interest securities and
cash.
Investors could choose a combination of funds
and switch between them a couple of times a year free of charge, or
they could opt for a managed fund which included a combination of
different investments such as equities, bonds, cash and
property.
During the 1990s, with profits investment
bonds started to become popular. Like managed funds, with profits
funds invest in a spread of investments, but the way the gains and
losses on these investments are passed on to investors differs.
Returns on with profit funds are distributed
through bonuses decided by the insurance company. The aim of with
profits bond was to smooth out the returns so that investors did
not suffer the fluctuations that occur when investing in the stock
market.
However, after the stock market downturn
between 2000 and 2003, many insurance companies had to cut their
bonuses dramatically, investors lost money and with profits bonds
fell from favour.
Investment bonds linked to distribution funds
which are geared to producing a regular income by investing in
equities and bonds and sometimes property have become more popular
in recent years.
These bonds can fluctuate in value, but many
have a good record for producing a steady income. However, due to
the relatively poor past performance of unit linked funds generally
and with profits funds in particular, many investment bonds
nowadays tend to offer investors access to funds which invest in a
wide range of top performing unit trusts.
A portfolio of these funds can be held in a bond and switches
made between them when required.
As bonds are life insurance policies, it is
the insurance company that must pay tax on the income and capital
growth generated by the investments held in the bonds. Investors do
not pay capital gains tax on any gains, nor do they pay
basic rate income tax on any income.
Higher rate taxpayers may become liable to tax
at a rate equal to the difference between the basic rate and the
higher rate of income tax, but not until they cash in their bonds
or make partial withdrawals of over 5 per cent per annum of their
original investment.
This is because there is a special rule which
allows annual withdrawals from bonds of up to 5 per cent for 20
years without any immediate tax liability.
It is possible to carry these 5 per cent
allowances forward, so if you make no withdrawals one year, say,
you can take out 10 per cent of your investment the next, without
triggering a tax charge.
When you finally withdraw your money, your
gain could potentially push you into the higher rate tax bracket
even if you are normally a basic rate taxpayer. ‘Top-slicing
relief’ can compensate for this.
The way this works is that your total gain
(the difference between the amount you invested and the final value
of the bond, including any withdrawals) is divided by the number of
years you have held the bond to, in order to find the average
annual gain.
If the average gain, when added to
your other income, falls within the basic rate tax band, you will
have no further tax to pay. If it falls into the basic and higher
rate tax band, you will be charged higher rate tax on the part that
falls within that tax band, multiplied by the number of years you
have held the bond.
If it all falls into the higher rate tax band, you will have
to pay extra tax on the whole gain. However, you may be able to
avoid paying higher rate tax by delaying the encashment of your
bond until you are a basic rate taxpayer, say after retirement, or
by gifting it to a spouse or partner who pays less tax.
Investment bonds may be recommended in a
number of situations:
- If you are a higher rate taxpayer seeking an extra income, an
investment bond may be suggested, so you can take advantage of the
rule that allows 5 per cent annual withdrawals, for twenty years,
without any immediate tax liability;
- If you are retired and want a supplementary income, but
you are in danger of falling into the age allowance ‘trap.’ This is
the situation where the extra personal tax allowance you receive
when you are 65 (£9,180 for 2008-09) is reduced if your income
exceeds a certain level (£21,800 for 2008-09).
Annual 5 per cent withdrawals from investment
bonds will not count towards your income, so it will not affect
your age allowance. However, before you cash in your bond, you will
need to consider how your age allowance might be affected in that
year.
- If you are an active investor with a large investment portfolio
and you have already mopped up your annual capital gains tax
allowance. Using an investment bond to manage your money will mean
you will not liable for capital gains tax when you make switches
between funds.
- If you are trying to shelter capital from inheritance tax
through a discounted gift trust or loan trust. Life insurance
companies often sell packaged products where these trusts are
linked to investment bonds. The advantage of using an investment
bond is that the investment income in trusts will generally be
taxed at 40 per cent, but when it is accumulated within a bond it
is only taxed at 20 per cent.
- If you are an investor who is likely to need long term care.
Life insurance policies will not normally be counted as part of
your means when your eligibility for local authority funding is
assessed.
One of the drawbacks of investment bonds is
that their charges are not always easy to understand. Sometimes
there is an initial charge of 5 per cent, plus an annual management
charge (AMC) of 1 -1.5 per cent. However, some bonds have no
initial charge, but a higher annual charge in the first three to
five years.
There is also the ‘allocation rate’ on your
bond to taken into account. This may be more than 100 per cent for
larger investments. But don't be fooled into thinking the company
is being incredibly generous.
A higher allocation will often simply reduce
the initial charge. For example, if you invest £10,000, a 5 per
cent initial charge will reduce your capital investment to £9,500,
so if you receive an allocation of 102 per cent, the amount
actually invested will be increased to £9,690.
Over the longer term, say 10 years, charges on
investment bonds can actually work out lower than on unit trusts.
But there is not the same flexibility. Almost all investment bonds
incur hefty early withdrawal penalties, if you cash in your bond
during the first five years.
Some insurance companies also apply Market Value
Adjustments (MVAs) on investment bonds invested in with profit
funds at times of market volatility, which will reduce the value of
your investment.
That said, some insurers allow you to encash bonds
on each 10 year anniversary, without applying the MVA.
Advisers who sell investment bonds can receive
up to 6-7 per cent or even 8 per cent initial commission. These
high initial commissions are seen as the primary reason why
unscrupulous advisers might recommend investment bonds when an
alternative investment product may be just as good or better.
However, nowadays advisers can opt for a lower commission of
say 4 per cent to start with, plus an annual commission of 0.5 per
cent which is similar to commission paid on unit trusts. A good
adviser will rebate some of their initial commission (particularly
on large lump sums) to boost your investment.
Nowadays almost all of the investment funds
offered within investment bonds can be bought directly as unit
trusts or Oeics (open ended investment companies).
But increased annual charges on unit trusts
and Oeics mean they are not necessarily cheaper than investment
bonds over the long term.
However, unit trusts and Oeics are much more
flexible. You can take your money out of a unit trust or Oeic at
any time without penalty. The other advantage is that no capital
gains tax is paid by the fund manager.
In addition, with unit trusts and Oeics, gains
are liable to capital gains tax. You have a CGT allowance of £9,600
for 2008-09) which means you can take these gains free of tax up to
that threshold. If you have gains in excess of £9,600, you have to
pay CGT at a flat rate of 18 per cent.
Since 6 April 2008, CGT has been charged at a
flat rate of 18 per cent, making the tax position of unit trusts
and Oeics more attractive (in most cases) than that for investment
bonds.
The latter are potentially liable to
income tax at 20 per cent on encashment of the bond, if you
are a higher rate taxpayer (ie the difference between the basic
rate of 20 per cent and higher rate of 40 per cent) in the tax
year 2008-09.
Unit trusts and Oiecs can also be held in Individual Savings
Accounts (ISAs) where they are sheltered from most income tax and
all capital gains tax. Interest paid out on bond funds within an
ISA is tax free and there is no further tax to pay on any dividend
income on equity funds. All capital gains within ISAs are tax
free.
Before you buy an investment bond for
investment purposes, you should make full use of your annual ISA
allowance (£7,200 in 2008-09) and also consider whether you
couldn't achieve your objectives better by using unit trusts or
Oiecs.