Investment Bonds
What are they?
Investment bonds are sold by life insurance companies and allow you to invest in a variety of funds managed by professional investment managers. 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.
Investment options
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 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 out the returns so that investors did not suffer the fluctuations that occur when investing in the stock market. However, following the stockmarket 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 which invest in a wide range of top performing unit trusts.to improve performance. A portfolio of these funds can be held witin 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 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 per cent), 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, you can withdraw 10 per cent of your investment the next, without triggering a tax charge.
How ‘top slicing’ works
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:
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 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 a unit ‘allocation rate’ which 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 £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 Adjuster” (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..
Alternatives
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 always cheaper than investment bonds over the long term. But they 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 managers.
For financial advice in Norfolk, Norfolk Financial Services are Independent Financial Advisers.
In addition, with unit trusts and Oeics, gains are liable to capital gains tax at only 18 per cent (whereas as a higher rate taxpayer you might be liable to a further 20 per cent income tax). . Your personal CGT allowance is £9,600 for 2008-09 which means you can take these gains free of tax up to this threshold. If you have gains in excess of £9,600, you have to pay CGT at your marginal rate.
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 than that for investment bonds which 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 for 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.
Who should I buy investment bonds?
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.
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