With-profits bonds are secure and attractive
FALLING INTEREST rates and volatile stockmarkets have made with- profits bonds even more attractive than ever to the cautious investor. Although not as attractive as they were 18 months ago, these bonds still offer tax-payers better returns than building society accounts, and better returns than other low risk investments such as guaranteed income bonds.

With-profits bonds are typically offering a tax-free yield of 6 to 7 per cent a year and on top of this there is the prospect of a terminal bonus on the bond. While the returns on with-profits bonds are not guaranteed, these investments have built-in security measures which means they are lower risk than most stockmarket funds, says Patrick Connolly, investment manager at independent financial advisers Chartwell Investment Management.

"In the last few months we've seen a much larger demand for with-profit bonds from typical equity investors who are looking for added security," he says. With-profits bonds are offered by life insurance companies. Your lump sum investment, which can be as little as pounds 1,000, is invested in the insurance company's with-profits fund which invests in a range of shares, fixed interest investments and property.

Each year the fund pays an annual bonus (also known as a reversionary bonus) which is added to your investment. The rate is based on how well the fund has performed and will currently be around 6.5 per cent, although often an extra 2 per cent is offered in the first year. All returns on with profits bonds are net of basic-rate tax.

If the fund has done particularly well the insurance company may keep back some of the profits and use these to bolster bonuses in years when the fund does not do so well.

For the investor, this means that the value of their investment will always be rising, explains Mr Connolly. "Once the annual bonuses have been declared they cannot be taken away. So your investment will only ever go in one direction and that is upwards," he says.

On top of the annual bonuses, the fund may pay out a terminal bonus when you cash in your bond. This can be worth up to another 2.5 per cent a year on the value of the bond. To qualify for a terminal bonus you usually have to hold the bond for a minimum of five years, if you cash in before this not only will you get no terminal bonus but you also are likely to face exit penalties.

Investors should also be aware of the market value adjustment (MVA). If the stockmarket is performing very poorly, the life company may impose this exit penalty to deter investors from cashing in during this period. MVAs are not common, but if one is introduced you should keep the bond for the few months the MVA is in place before cashing in. In this way it will not affect your final pay out.

These bonds are suitable for cautious investors, whether they want income or growth. But they are most likely to appeal to people approaching retirement who plan in the near future to take an income from their investment.

Basic rate tax payers in this position can draw income from their bond and there is no tax to pay. While higher-rate taxpayers and those over 65 can take up to 5 per cent income from their bond and do not have to declare this to the Inland Revenue.

For the income seeker, with-profits bonds are highly flexible. You can draw income from the bond when it suits you, so that could be just occasionally or on a monthly basis. And there are no restrictions on the amount of income you take. However, if you take too high an income you will not only see no growth in the value of your bond but you could start to eat into your capital. However, those taking an annual income of 5 per cent or less are unlikely to have to worry about this.

These bonds are less likely to appeal to younger people, however, says Andrew Jones, investment partner at independent financial advisers David Aaron Partnership. He points out that young people are unlikely to have a lump sum available to invest in these bonds as they are more likely to invest in tax-free investments such as Tessas and PEPs first. They also have a longer investment horizon than older people and so can afford to invest in higher risk alternatives such as unit trusts which offer potentially superior returns over the longer term.

When it comes to choosing a with-profits bond, you should look at the following:

l Financial strength of the life company. With-profits funds run by financially strong companies have more money to invest in equities and so tend to perform better over the long term.

l Past record. The top with-profits bond providers have a track record of paying out good terminal and annual bonuses.

l Charges. The charging structure on some bonds hits small investors harder than larger investors. Some bonds have an initial 5 per cent fee, others will charge an exit fee which can be more cost-effective as all of your money is invested on day one with charges only coming out at the end.

l Allocation rates. This is the amount of your money which is invested in units in the bond. This can range from 95 per cent to 102 per cent. A high allocation rate is attractive but often is only offered to those investing a large amount.

With-profits bonds currently favoured by financial advisers include those offered by Prudential, Scottish Widows, Scottish Equitable, CGU Life (Portfolio), and Royal & Sun Alliance.

Chartwell has published a free guide to with-profits bonds which is available by calling 01225 446556. David Aaron Partnership has published a survey on with-profits bonds (free but pounds 2 is required for p&p), call 01908-281544