Investment bonds explained

What are investment bonds?

The name 'bond' is given to all sorts of saving and investment products, but 'investment bond' typically means a type of investment issued by life insurers.

They are also sometimes called single premium bonds, insurance bonds or life insurance bonds. There are several variations, such as distribution bonds, high-income bonds and with-profits bonds.

To invest, you pay a lump sum into a life insurance policy which is then invested in one or more investment funds. You may be able to add further lump sums (top-up payments) to your bond.

The bond could have a fixed term, say, five years. Alternatively, you might invest for an indefinite period and be able to cash in the bond at any time. But there may be surrender charges, especially in the early years.

Investment bonds can be designed to provide you with income (see below), growth or a mix of the two.

Investment bonds may be issued by life insurers based in the UK (onshore bonds) or abroad (offshore bonds). Which you choose affects the tax position (see below).

Who are investment bonds suitable for?

Provided you are comfortable with the risk of stockmarket investments, such as equities and fixed-interest, investment bonds could be suitable.

Whether you choose investment bonds or direct investment in investment funds (such as unit trusts), neither option is likely to suit you if you do not want to take any risk with your money. They are higher risk than, say, keeping your money in a bank or building society savings account.

In particular, some investment bonds aim to provide a regular income which can look attractive when the interest on savings accounts is low. But it is essential to understand that, like any investment fund, investment bonds are more risky than savings accounts. These bonds are designed for medium- to long-term investment: the value of your investment can fall as well as rise; and, if you draw a high income, this may increase the risk of losing some or all of your original investment.

Investment bond or unit trust?

There are different ways you can invest in investment funds. For example, you might invest direct, through an individual savings account (ISA) or through a pension scheme.

ISAs and pension schemes are sometimes thought of as 'wrappers' that hold the investment funds you choose and alter the way your investment is treated for tax. Investment bonds can be thought of in a similar way: the life policy is like a wrapper that affects the way the funds inside are taxed.

Important reasons for choosing an investment bond rather than direct investment are differences in tax treatment and differences in charges.

In 2010, the UK financial regulator, the Financial Services Authority, carried out research which suggested that charges for investment bonds are often cheaper than for direct investment in unit trusts and similar funds. The research also suggested that:

• Non-taxpayers are likely to pay less tax if they invest direct rather than through a bond.
• The position for basic-rate taxpayers is not clear-cut.
• Higher-rate and additional-rate taxpayers, who are still paying tax at these rates when their bonds come to an end, are at high risk of paying more tax if they choose an investment bond than they would investing direct.

You might want to consider investing through an ISA, if you have not used your ISA allowance for the year. An ISA can be used to invest in insurance-based funds or unit trusts and similar funds.

Investment bond advantages

Investment bonds have some particular features that make them different from direct investment.

For example, bonds can be an efficient way to invest in a mix of different investment funds if you expect to switch funds fairly frequently. This is because you invest in the life policy not directly in the underlying funds. Switching does not involve actually selling one fund and buying another (as it would, for example, if you invested using unit trusts). The life insurer simply records the change. It might levy a charge, but often switches are free.

As life policies, investment bonds are taxed in a special way. One potentially useful feature is that you can draw out part of your money each year without an immediate income tax charge. The withdrawals are taken into account later, when the bond comes to an end, to see if there is any income tax for you to pay then. This can be especially useful if you are a higher-rate or additional-rate taxpayer now, but expect to be paying tax at a lower rate when the bond ends (for example, because you will have retired).

Because your investment comes wrapped in a life insurance policy, these bonds make a pay-out on death. This can make the bonds useful for inheritance tax planning - this is a complex area, so seek professional advice.

Investment bond disadvantages

If you invest in an onshore bond, the insurer will have paid (or allowed for) tax on the income and gains made by the underlying investment funds. You can't reclaim any of this tax even if you personally would have paid less had you been investing direct through, say, a unit trust. This means that people who pay income tax at the basic rate or less or have unused capital gains tax allowance may get a better return by investing direct in, for example, unit trusts rather than through investment bonds.

Because the insurer has paid this tax, you are not charged any basic-rate income tax on the proceeds you get from the bond. So, if you are a basic-rate taxpayer, there is no further tax for you personally to pay.

If you are a higher-rate (40% in 2012-13) taxpayer you may have to pay extra tax at 20%. If you are an additional-rate (50% in 2012-13 / 45% in 2013-14) taxpayer, you may have to pay extra tax at 30%, or 25% from April 2013.

However, where adding the proceeds of the bond to your other income for the tax year tips you into a higher tax bracket, a special rule called top-slicing relief may reduce or eliminate the tax due.

If you invest in an offshore bond, these are typically set up in areas of the world where the insurer pays little or no tax on the return from the investment funds. The tax then depends mainly or only on your personal tax position.

When an investment bond is finally cashed in, the total of any return at that time plus the sum of any untaxed withdrawals made earlier (see above), counts as income for the year of encashment. If you will be aged 65 or over, be aware that this could reduce the amount of age allowance you qualify for and produce an unexpected jump in your tax bill. This effect will continue until 5 April 2013 by which time the age-related personal allowance will be phased out.

The same applies, whatever your age, if your income is in the region (£100,000 to £114,950 in 2012-13) where you are losing personal allowance.

What are distribution bonds?

Some investment bonds, such as distribution bonds, are designed specifically to make use of the withdrawals you can make each year without any immediate tax bill (see above).

The maximum you can draw out each year without an immediate tax charge is 5% of the sum you invested. For example, if you put £10,000 into one of these bonds, you would be able to draw off £500 a year as income. This can carry on, at this level, for a maximum of 20 years.

If you draw off less in a year, you can carry the unused amount forward to draw out more in a future year (in which case, the withdrawals could last for longer).

What makes distribution bonds special is that the funds they are invested in have been chosen to generate income which is paid out to you rather than being reinvested.

Typically 40% to 60% of your money is invested in fixed interest, with the rest in equities to hopefully produce some growth as well as income. But neither income nor the return of your capital are guaranteed.

How do high-income bonds work?

Some investment bonds offer an unusually high level of income, but you need to be aware of the risks involved.

Generally, a high-income bond is a type of 'structured product'. It relies on complex arrangements to offer guarantees that you will not lose any of your original investment, provided the underlying investments fall by no more than a specified amount. But, if the underlying investments fall by more, the amount you lose could be substantial. The guarantee is typically backed by another company (usually an investment bank) but you need to be aware that, if that company fails, the guarantee may evaporate.

In the past, some high-income bonds have been mis-sold to cautious investors who did not understand that their money would be subjected to these risks.

What about with-profits bonds?

A with-profits bond is a type of investment bond - often used to provide income - that is invested in a particular way.

Instead of your bond being linked purely to the performance of a particular fund or funds, it is linked to the performance of part of the insurer's business. The main influence on the return you get will be the performance of an underlying pool of assets, such as equities, fixed interest and property. But other factors affecting the insurer's business will also have an impact.

With-profits investors get their return in the form of bonuses added each year and when the policy ends. The insurer tries to maintain a steady stream of bonuses by a process of 'smoothing'. This means holding back some of the return in good years to top up the bonuses in years when returns are poor.

You can ask the insurer concerned for a guide explaining in detail how its with-profits returns are determined.

In theory, then, a with-profits bond is backed largely by a well-diversified pool of assets and should produce steady returns from year to year. In practice, some of these bonds have not coped well with the global financial crisis and associated volatile stock markets. Returns from some companies' policies have been poor and the smoothing policies, which are often opaque and hard to understand, have failed to produce steady returns.

Many investors, misled into thinking they were investing in a relatively low-risk investment, have found with-profits bonds to be anything but low risk.

Tips on investing

Before you choose investment bonds, make sure that this is the right investment for you. Ask yourself these questions:

• Do I understand the risks of stock-market investments? Investment funds and bonds that invest in them are not like savings accounts. Any income I draw may eat into the capital I invested.
• Do I understand the limits of any guarantees and risks that are specific to the bond I am looking at?
• Could I get a better return investing direct in an investment fund, given my tax position?
• Do I understand the charges: how much I'll pay and in what circumstances I may pay extra?

If you are uncertain on any of these points, get help from an independent financial adviser.