Investment bonds

The minimum investment is typically £5,000 or £10,000 and 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% or less to the value of your investment, if it is paid out after your death.

Investment options

In the past, investment bonds provided a choice of around half a dozen ‘unit linked’ funds covering different types of investments including 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 profit’ investment bonds started to become popular. Like managed funds, with profit 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 the bonuses so that investors did not suffer the fluctuations that often occur when investing in the stock market. However, following the stock market downturn at the turn of this century, 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, however, 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.

Nowadays, many investment bonds tend to offer investors access to funds that invest in a wide range of top performing unit trusts to improve performance. A portfolio of these funds can be held within a bond and switches made between them when required.

Taxation

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 a bond. Investors do not pay capital gains tax (CGT) on any gains, nor do they pay basic rate income tax on any income.

Higher rate taxpayers may become liable to income tax at a rate equal to the difference between the basic rate and the higher rates (20%), but not until they cash in their bonds or make partial withdrawals of over 5% per annum of their original investment.

This is because there is a special rule which allows annual withdrawals from bonds of up to 5% for 20 years without any immediate tax liability. It is possible to carry these 5% allowances forward; so if you do not make a withdrawal one year, you can withdraw 10% of your investment the next, without triggering a tax charge.

Withdrawing your money

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, 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 only 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.

Why are these bonds sold?

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 recommended because you may make 5% 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 whereby the extra personal tax allowance you receive when you are 65-74 (£9,490 for 2010-2011) is reduced if your annual income exceeds a certain level (£22,900 for 2010-2011).
• Annual 5% withdrawals from investment bonds do 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 used your annual capital gains tax allowance (£10,100 in 2010-11), using an investment bond to manage your investments means you will not be liable for CGT when you switch funds.
• If you are trying to shelter capital from inheritance tax through a discounted gift trust or loan trust, some life insurance companies sell packaged products whereby these trusts are linked to investment bonds and many will provide the necessary documentation. The advantage of using an investment bond is that the investment income in trusts will generally be taxed at 40%, but when it is accumulated within a bond it is only taxed at 20%.
• If you are an investor who is likely to need long term care, life insurance policies are not normally be counted as part of your means when your eligibility for local authority funding is assessed.

Charges

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%, plus an annual management charge (AMC) of

1 to 1.5%. However, some bonds have no initial charge, but a higher annual charge in the first three to five years. There is also a unit ‘allocation rate’ which may be more than 100% for larger investments.

However, do not 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% initial charge will reduce your capital investment to £9,500, so if you receive an allocation of 102%, the amount actually invested will be £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.

In the case of investments in with profits funds some insurance companies also apply a ‘Market value adjusters’ (MVAs) 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.

Commission

Advisers who sell investment bonds can receive up to 6-7% or even 8% 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 even better.

Advisers can opt for a lower commission of say 3-4% to start with, plus an annual commission of 0.5%, 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. Make sure you ask for this and get the rebated commission applied to your fund value!

However, times are changing and advisers must now agree their remuneration with their clients before investment. Many products do not now pay commission so any adviser remuneration is taken straight from the amount you invest or a specific fee is agreed and paid separately.

Alternatives

Increased annual charges on unit trusts or OEICs mean they are not always cheaper than investment bonds over the long term although they are much more flexible. You can take your money out of either at any time without penalty and CGT is paid by the fund managers.

In addition, with unit trusts and OEICs, gains are liable to CGT at only 18% (whereas as a higher rate taxpayer you might be liable to a further 20% income tax with a bond). Your personal CGT allowance is £10,100 for 2010-2011, which means you can take these gains free of tax up to this threshold. If you have gains from a bond in excess of £10,100, you have to pay CGT at your marginal rate.

CGT is charged at a flat rate of 18%, making the tax position of unit trusts and OEICs more attractive than that for investment bonds, which are potentially liable to income tax at 20%. Unit trusts and OEICs can also be ISAs where they are sheltered from most income tax and all CGT. 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 (£10,200) and also consider whether you couldn't achieve your objectives better by using unit trusts or OEICs.