Give me dull any day

They're not the most exciting investment, but with-profit bonds have their place.

If savers were ever allowed to design their ideal investment product, it would almost certainly aim to deliver a combination of decent returns with relatively low risk. Financial reality dictates that life is never that simple. In practice, the higher the gain, the greater the risk you must accept. The only thing you can hope to do is find an investment where you don't risk your shirt for the sake of a satisfactory investment performance.

At present, this doesn't appear to be an easy task. UK share prices in the past few months have risen and fallen by up to 5 per cent in the space of a few days. This week, they closed at record highs. But many experts still fear things could rapidly turn sour.

Charles Timm, managing director at The With-Profits Bond Shop, says: "Many members of the public who are ringing us up at the moment are saying that they are getting very nervous about the way share prices appear to be moving recently. They are also worried about the volatility we have been seeing recently in the markets. There is [still] a view that there could be a major correction."

For hundreds of thousands of investors, with-profits bonds offer that seemingly elusive blend. Their investment mix - a combination of equities, fixed interest securities and property - are designed so that while bondholders can expect better returns than from a typical building society account, the risk required to obtain it is not that great.

Unlike traditional equity-based investments - which can rise like a rocket and drop like a stone within the space of a day - bonds behave differently. They are designed so that each year, an annual bonus is added to the original sum invested. This "reversionary bonus" is allocated in one of two forms. For traditional with-profits policies, it is based on an actual amount added to the value of the policy. So-called "unitised" policies, where the policy is divided into units, will add a few percentage points to the value of each one.

But the important effect of this bonus is that once added, it cannot be taken away. As a result, with-profits bonds will generally grow by a small but regular amount each year, no matter what stockmarkets are doing.

This growth is linked to yields from fixed-interest securities, including government gilts. It is also related to an assessment by the life insurance company selling the bond of future investment returns. The reason for this is that the insurer aims to "smooth" investment returns each year, using surpluses built up in good times to pad out poor years. The result is steady, if unexciting, growth year after year.

Although annual bonuses cannot be taken away, they are not hugely generous, barely a few percentage points a year. However, investors in with-profits bonds will generally also receive a further sum, the "terminal bonus", when they decide to cash the bond in.

This terminal bonus, as with a normal with-profits endowment, is virtually impossible to know in advance. Generally, it is linked to overall returns from the investments held in the bond minus any charges and expenses, tax which is deducted within the life company fund, and already-attached bonuses.

What is the performance like? As one might expect from an investment in which just 50 per cent of the fund is directly equity-linked, they are unlikely, over the long-term, to match a traditional unit or investment trust, or the FTSE 100 share index.

But a pounds 10,000 investment made in the average with-profits bond in August 1993 would have grown to pounds 14,466 five years later. This is pounds 2,930 more than the pounds 11,850 paid by a typical 90-day building society account. The top-performing with-profits fund delivered pounds 15,807.

With-profits bonds are generally not as attractive, tax-wise, as PEPs. This is because they are "tax paid" investments - they are subject to a basic rate of tax within the life fund, after deductions for expenses.

Higher-rate taxpayers face an additional liability when they cash in the bond. For non-taxpayers, the fact that they can't reclaim the tax paid on the investment means with-profits bonds are not really suitable for them.

Nevertheless, bonds can still play a useful part in an individual's overall tax planning. This is because, as with any single premium life insurance bond, current tax rules allow investors to take annual "income" from the fund. This can be up to 5 per cent of the original amount invested, for up to 20 years, and is treated as a return of capital. Any tax liability is deferred until the bond is completely encashed.

Of course, if you are a higher-rate taxpayer, it makes sense to wait for a moment when you will be on a lower rate of tax (perhaps after retirement) so that encashment does not involve any additional liability.

Moreover, with-profits bonds also help to sort out a tax "wrinkle" faced by anyone over state retirement age. This is where an additional allowance of pounds 1,215 is added to the normal tax break of pounds 4,195 (plus an extra pounds 190 after 75). Yet any earnings over pounds 16,200 result in the additional allowance being lost at a rate of pounds 1 for every pounds 2 of extra earnings.

However, because the 5 per cent of annual income is not classed as such by the Inland Revenue, this allowance is not lost, delivering a small but significant gain to anyone in that "allowance trap".

Who is the typical with-profits bond investor? Amanda Davidson, a partner at Holden Meehan, London-based independent financial advisers, says: "They are likely to be someone who is relatively risk averse. They do not like to see all their money going directly into equities. They may also have a need for income, coupled with low-risk returns."

She adds that with-profits bonds can be held as part of a balanced portfolio, where an individual's overall investment also consists of normal unit or investment trusts, as well as a building society account.

`The Independent' has produced a free 24-page `Guide to With-Profits Bonds'. Written by Nic Cicutti, this paper's personal finance editor, the guide examines the arguments for and against investing in bonds. It explains the tax implications, and where to buy a bond. For your copy of the guide, sponsored by The With-Profits Bond Shop, call 0845 2711007