Profit from Victorian values

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WITH-PROFIT policies are out of fashion and may be overlooked by those seeking tax-efficient savings. Often used as a vehicle for repaying mortgages or other loans, these contracts combine investment with life insurance. The idea evolved during the 19th century and they still embody the Victorian idea that it is morally good to make regular savings.

Proceeds from maturing policies are paid net of basic-rate tax, and higher- rate taxpayers do not have to pay any extra income tax as long as they have been paying into the policy for a certain period - the usual minimum is 10 years.

If you take out a with-profit policy, your money will be invested in a wide variety of assets including shares, property, gilts and deposits. The fund manager makes a conservative estimate of the long-term growth needed to cover the death benefits attached to the policies, otherwise called the "basic sum assured". This is the guaranteed minimum amount paid out on maturity or earlier death.

The insurer hopes to do better than this and some of the excess is used to provide an annual or "reversionary" bonus that is added to the policy each year and cannot be taken away. Because assets can fluctuate in value, and there are some bad investment years, part of the profit is held back to maintain the bonus rate in the future.

Over the past few years, as inflation has fallen, the rate of growth in annual bonuses has declined. Most insurers feel that this trend has now stabilised.

At the end of the policy's life, a "terminal" bonus should be paid. This equates to the remainder of the profits made over the years. As much as 50 to 60 per cent of the final payout can come in the form of this bonus.

There are two types of with- profit life fund. Those used for pension planning invest on a tax-free basis. Because of these generous breaks, pension policies cannot be surrendered. When you retire, your pension is liable to income tax.

The other type of fund is taxed "but the life assurer only pays basic- rate tax on the investment returns," says Peter Telford, head of life assurance at Legal & General. "This means that a higher-rate taxpayer can get a better rate of return by saving through an insurance policy. To qualify, the policy must be for a minimum of 10 years and have a minimum death benefit of 101 per cent of the premiums."

Endowments are the most common type of with- policy. These are fixed- term contracts for 10 or more years where you are committed to paying regular, usually monthly, premiums. Whole life plans exist but are not popular. Few people want to go on paying premiums into a savings vehicle that only pays out on death. They are sometimes used for inheritance tax planning by the mega-rich - the only ones who can afford the premiums.

Over time, the best with-profit returns have come from companies with the highest proportion of the fund in shares. Looking at past performance, the best policies now maturing show growth rates of around 9 per cent a year for 10-year endowments, and almost 13 per cent over 25 years. Standard Life, Scottish Widows, Friends Provident and Equitable Life are usually among the top buys.

The difference between the best and the worst policy can amount to many thousands of pounds, so look carefully before choosing a life company.

An independent financial adviser (IFA) will help but watch out for charges - including commission payments to whoever sells the policy - and high surrender penalties.

Contacts: IFA Promotions, 0117-971 1177; Standard Life, 0131-225 2552; Equitable Life, 0171-606 6611; Scottish Widows, 0131-655 6000; Legal & General, 0171-528 6200.