The mysterious world of with-profit bonds

In the past, with-profit bonds have delivered good returns but, critics warn, the storm clouds are gathering

Once upon a time there was an investment that delivered wondrous growth while being as solid as a rock. This is the tale of the with-profit bond, which over the past 10 years or so has been sold to thousands of people who have a nest egg to invest for a minimum of five years.

Once upon a time there was an investment that delivered wondrous growth while being as solid as a rock. This is the tale of the with-profit bond, which over the past 10 years or so has been sold to thousands of people who have a nest egg to invest for a minimum of five years.

But while this type of bond has delivered good returns in the past, the future outlook could be significantly different. For, as with other with-profits policies like endowments and pensions, storm clouds are gathering.

Due to low inflation and low interest rates, with-profit policies are not likely to hit the high returns, often in excess of 10 per cent, that were common at the beginning of the 1990s.

In addition to this, critics say, with-profit bonds - which often require investors to put in a minimum of £10,000 and tie up their money for five years or more - involve serious risks.

David Hanratty, investment director at the independent financial advisers Nelson Money Management, says: "With profit bonds are easy to sell because they are made to appear safe but they are not. They are marketed as being tax-free but they are taxed at source. You are told you can take an income but that is your own money."

Mr Hanratty warns that the situation will worsen, as returns in the future are likely to fall, with averages of only 6 per cent, once high front-end charges and tax treatment are taken into account. "In the end your investment could end up being less than the value of your capital," he says.

This is also the line taken by the Faculty and Institute of Actuaries,whose members determine what with-profit polices can pay out to investors both on a year-by-year basis and for their terminal bonus.

And, it warned recently, people do not understand the risks. This is particularly worrying as the group who invest £1bn a month in with-profit bonds in the UK are the very people who are looking for a safe investment.

Faculty member John Hylandssays: "The problem is people may think from the marketing of these policiesthat a certain return is guaranteed when in fact it is not. Some companies say people will get 10 per cent in the first two years, but after that the return may only be four or five per cent."

Others go further, saying that this could be the next mis-selling scandal. "Everyone says 'yes it is terrible but we are not doing it'. In reality many are doing it," an industry insider says.

With-profit bonds are considerably more risky than with-profit endowments, says Mr Hanratty. "While endowments have a sum assured, which is accumulated every year, the bonus that accumulates in a with-profit bond can be wiped out by the market value adjuster [MVA] if there is a stock market crash or something similar."

While financial meltdowns are not common, many experts think the industry is gearing up to make more use of the MVA, if stockmarket volatility seen this year becomes more common (see page 1).

Critics also say the terminal bonus could be far less in the future if overall returns continue to fall. While this would be in line with economic conditions, people are unlikely to realise this as companies usually shroud them in mystery. Mr Hylands says: "Terminal bonuses in with-profit polices have historically been very high and there is much scope for that to come down. While the problem won't be as great for with-profit bonds as for endowments, there is room for them to come down as well."

Mr Hanratty urges people to consider other investments. "It is a good idea to recommend people getting involved with equities, which with-profit bonds are partly invested in. Go for a unit trust ISA, which doesn't have the same risk as a with-profit bond."