These bonds are offered by more than 20 leading insurance companies, with the minimum investment ranging from pounds 1,000 to pounds 10,000. Your money is invested in the insurer's with-profits fund, which in turn invests in a wide range of shares, gilts and properties.
Every year the insurer will announce a bonus to be paid on your bond. The bonus rate is indirectly based on how well the fund has performed, but if it has done particularly well the insurer will store away some of the profits for future years when the returns may not be so good.
"These bonds are a good choice for cautious investors," says Graham Bates of the independent financial adviser Bates & Partners. "With-profits bonds are suitable for, typically, older people who use them as part of their retirement planning. They are like anchors to your investment portfolio because they are not subjecting you to day-to-day stock market fluctuations."
Investors can withdraw as much income from their bond as they like but may be penalised if they take more than a certain amount each year. Typically, you can withdraw up to 7.5 per cent a year in the first five years without incurring any penalties. The size of the penalty falls as time goes by and after five years there is often none at all.
"Large withdrawals can affect your overall return," warns Mr Bates. "Anyone taking 5 per cent a year should be absolutely fine and should even see some capital growth. If you take more than is being added by the bonuses, your capital is being depleted."
Income payments are tax-free and can be paid monthly, quarterly, half- yearly or annually. Whenever income is required, the bond provider will cash in some of the units in your bond to pay out the income.
Bonus rates vary but typically are around 6.5 per cent net of tax. Often bonds will offer an extra 2 per cent in the first year. Higher bonus rates may also be paid on large investments.
As well as annual bonuses, the funds often pay out a terminal bonus. This can be worth the equivalent of up to another 2.5 per cent a year on the value of the bond. To qualify for this bonus you may have to hold the bond for a minimum period which could be up to five years.
Rarely do with-profits bonds have a fixed term, so you can cash in the bond whenever you like. But watch out for encashment penalties in the first five years. For example, if you cash in Friends Provident's bond in the first two years there is a 7 per cent penalty. This falls to 5 per cent in year three, 3.5 per cent in year four and 2 per cent in year five. After that there is no penalty.
Early encashment can therefore result in you not getting back all your original investment. You should also avoid cashing in when a market value adjustment (MVA) is in place. An insurance company may introduce this device if the stock market is performing very poorly. Cash in during this period and there can be a large penalty to pay.
When choosing a with-profits bond, look at its track record of annual and terminal bonuses. Also look at charges. Many bonds have an initial 5 per cent fee; if they don't then usually there is an annual fee.
You should also look at allocation rates. This is the amount of your money that is invested in units in the bond, and can range from 95 to 102 per cent. A high allocation rate is attractive but is usually offered only to those investing a large amount.
In a recent survey of with- profits bonds by Money Management magazine, Prudential came top for consistent results. Axa Equity & Law produced the top five-year result by turning a pounds 10,000 investment into pounds 16,453, equal to an average annual return of 10.5 per cent. Equitable Life was a top performer over one, two and three years, as was Legal & General.