Stay off the danger list

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EQUITY INVESTORS probably feel like heading for the hills as they contemplate the downturn in share prices. In these circumstances, with-profit bonds have become more popular as a lower-risk investment for those looking for a better return than a bank or building society account, but with less risk than a purely share-based investment.

As well as being reasonably low risk, with-profit bonds can be used to provide a regular income or for capital growth. However, investors need to be able to tie up a lump sum of pounds 1,000 upwards for a minimum of five years to benefit from them.

With-profit bonds are part of the same investment funds used to back endowment policies. These giant funds are run by the big life companies and they give exposure to a mixed basket of investments without the volatility of direct investment. A with-profit fund contains equities (shares) in United Kingdom and overseas companies, fixed interest investments, property and cash.

The attraction of with-profit investment is that returns on the investment are "smoothed out", meaning that in good investment years, not all of the investment return is passed onto the policyholders. This builds up a reserve to provide a return in bad times when assets under-perform.

Consequently, with-profit bonds will not match the performance of share- based investments, such as unit trusts, when markets are rising, but they do provide reasonable returns when markets suffer.

Justin Modray, who is an independent financial adviser (IFA) at Chase de Vere, says: "When the FTSE 100 index is rising by 20 per cent a year, people wonder why we recommend with-profit bonds, but when the market falls and they still get a 7 per cent bonus, they appreciate them."

Investors can expect annual growth of around 7 per cent a year from with-profit bonds, which is added to their original investment as an annual bonus.

When investors cash in the fund, they may also receive a terminal bonus. But if the investor has to cash the bond within a few years of taking it out, or if investment performance has been very poor over the period the bond was held, a nasty surprise called a market value adjustment (MVA) may be applied. MVAs are used to reduce the payout on the bond to protect the remaining investors.

Christopher Wicks, managing director at Bridgewater Financial Planning, says: "If markets continue to be dreadful and investors cash with-profit bonds next year, they may have a MVA applied." For this reason he advises bond holders to sit tight.

Most with-profit bonds allow you to take an annual income, which is usually limited to 5 per cent of either the original investment or the bond's value.

Returns and income are paid net of basic rate (23 per cent) tax, so only higher rate tax payers have any extra liability on their investment.

Most major life insurance companies sell with-profit bonds, but it can be hard to do straight like-for-like performance comparisons. Moneyfacts' Sylvia Waycot comments: "A lot of firms do not have a five year last performance record because they have changed their product terms over time, so we can't give consistent past performance figures."

Mr Wicks likes Prudential, Scottish Equitable and Scottish Mutual bonds.

One IFA, Chartwell Investment Management, has come up with a top 10 list of recommendations based on such factors as bonus rates, charges and past performance. Prudential is top of the list, followed by Scottish Widows, Scottish Equitable and Royal SunAlliance.

Like many traditional life company investments, with-profit bonds are expensive. Things are improving as many bonds are now moving from a 5 per cent initial charge to a "no load" structure. This means charges are replaced by penalties for cashing in the bond during the first few years, or lower early bonus rates.

Independent financial advisers are often keen on with-profit bonds: this is partly explained by the fact they are paid high commission rates of up to 7 per cent of the amount you invest.

Investors can choose to pay a fixed fee to an IFA and have the commission paid back as cash or rebated into their plan. Some discount PEP brokers also sell with-profit bonds.

Fee-based IFAs Chartwell Investment Manangement (01225 446556) offer an excellent free guide to with-profit bonds.

Matthew Craig is deputy editor of 'Pensions Management' magazine.