Ready for the rainy day

PERSONAL EQUITY PLANS Corporate bond investments may prove ideal for meeting your needs later in life. Patrick Collinson explains

IN SAFEGUARDING your income from tax, PEPs can play a crucial role, and now that corporate bonds may be added to a PEP, the options for income investors are multiplying.

Since their launch, PEPs have become an essential part of planning for income. Free of both income tax and capital gains tax, they are one of the most tax-efficient investments available. But the generous tax advantages mean that the amounts that may be invested are limited. However, the pounds 6,000 annual limit on general PEPs, the pounds 3,000 single-company allowance, and the fact that spouses may take out separate PEPs, should ensure this is not a real problem for most.

To pick the right plan, it is important to decide in advance what your objectives are and what level of income you want to take out. The greater the income taken today, the less capital will be available tomorrow.

The astute investor should carry a checklist to consider when buying an income PEP.

q Will the income be static or does it have the potential to rise?

q Does the PEP offer monthly, quarterly or half-yearly income payouts?

q What are the charges - initial, annual, and other?

q Is the annual charge taken from capital, in turn making a fund's yield look more attractive but hitting the capital?

Many advisers see corporate bond PEPs as suitable for investors who need high income right away.

It was derivative-based funds that were seen as the much-hyped answer to income needs when they first appeared in 1993. Hypo Foreign & Colonial stunned the PEP industry with a unit trust PEP promising an income of 10 per cent plus some of the upside in the stock market. Small investors put pounds 500m into the fund, which became one of the most popular unit trust launches ever. Two years later, confidence in the fund has been severely dented. Not only has the yield figure been cut, but it has enjoyed little of this year's rise in the stock market.

Few other notable investment houses have copied HF&C's product, which has effectively been superseded by the corporate bond PEP.

The Chancellor's go-ahead for corporate bond PEPs sent the unit trust industry into a lather of excitement, with some predicting that pounds 2bn would flood into the new funds. The first funds were unveiled in July, but apart from a controversial launch by Legal & General, they have yet to excite the investing public.

Corporate bond PEPs bridge the gap between leaving money on deposit in a building society and moving to the higher-risk world of equity investment.

Corporate bonds are issued by most large companies and promise to pay a fixed rate of interest until a given date, when the money will be repaid.

But bonds are not altogether risk-free. Money invested in a a corporate bond is only as secure as the company that has issued it: if the company goes under, so does your money. The yield on the bond in part reflects this risk. If the yield is high, then the stock market is saying that the issuer is more likely to default. And, most importantly, a rise or fall in interest rates will affect the underlying capital value of a bond or bond fund.

Corporate bond PEPs can be suitable for investors who need a high income now, such as pensioners or those approaching retirement. They are less risky than equities, but are much less suitable for anyone wanting to save for the long term and build a nest-egg.

There is also another option that sits between bonds and equities on the risk spectrum - convertibles. Like corporate bonds, convertibles pay a fixed rate of interest. However, they can also at some stage be exchanged for ordinary shares according to a set formula. They are riskier than straightforward corporate bonds, but they offer more opportunities for capital growth.

There is a range of unit trust PEPs offering investment in corporate bonds or convertibles. Investors can also simply buy a bond (or convertible) direct and put a self-select PEP wrapper around it. This potentially gives a higher yield and saves on charges, but loses the benefits of a managed portfolio.

Stephen Lansdown, at Bristol adviser Hargreaves Lansdown, says: "The self-select PEP is the cleanest way into the market. The client gets the benefit of the full yield of around 8-8.5 per cent and only pays a small administration and stockbroking fee."

With unit-trust plans, most corporate bond PEP providers take the annual charge from the fund yields, but it is within the rules for the fund manager to levy the charge against the capital. Already a price war has broken out over the overall level of charges. The latest salvo has been fired by Legal & General, which has followed M&G and Fidelity by dropping initial charges in favour of exit charges on its latest corporate bond PEP. Annual charges are also under the spotlight, and investors should be cautious about funds with an annual charge above 1 per cent.

Most advisers are still recommending equity income PEPs as the best solution for a steady and rising income. Equity income PEPs aim to offer an income slightly ahead of the average yield on the stock market, currently around 4 per cent. Although the income on these PEPs will start lower, over time they produce higher incomes in cash terms than will a building society account or corporate-bond investment.

IFA tips

Stephen Lansdown, Hargreaves Lansdown

Perpetual High Income, Schroder Income, Newton Higher Income. "They are all first-class managers with funds that offer a good yield plus a good record for capital growth."

Helen Richardson, Unitas Jupiter Income, Perpetual High Income. "The individual fund manager is vital, and William Littlewood has done an excellent job on the Jupiter fund over the past six or seven years. My only concern with Perpetual High Income is its [large] size."

Amanda Davidson, Holden Meehan

Perpetual Income, Schroder Income. "Even with income as your prime concern, you have to be concerned with the underlying growth of the unit trust."

Graham Hooper, Chase de Vere

Perpetual High Income, Morgan Grenfell UK Equity Income. "Perpetual has a good solid stable of funds and a great track record. For a corporate bond PEP I would go for Commercial Union or Whittingdale."

Roddy Kohn, Kohn Cougar: None. "Don't buy now - you will get better value for your money waiting until February or March when competition will be intense."