Tax planning: Find yourself some new friends

Harvey Jones looks at savings plans for investors who don't want to take risks
Insurance-based savings plans and friendly society bonds may have been overshadowed by PEPs but they still offer some tax advantages to cautious savers.

If you have a qualifying endowment policy from a life company there is no extra tax when the policy pays out on maturity. For other ("non-qualifying") with-profit funds, higher-rate payers may have to pay an extra 20 per cent tax on the lump sum they receive when the policy pays out.

Friendly society monthly pounds 25 with-profits savings plans offer a small tax-free saving opportunity that can be taken on top of the individual savings accounts, launched from 6 April.

Endowment policies are a combination of life assurance and investment. The investor pays a regular premium for a fixed term, usually 10, 15, 20 or 25 years. The policy pays out at the end of the term, or if the owner dies.

Most people know about endowments because they have a policy to back up their mortgage. Around one in three new mortgage holders still opt to repay the interest on their loans and invest regular sums in an endowment policy, which aims to repay the capital at the end of the mortgage term. The idea is that you should get an extra lump sum as well as covering your mortgage. In practice, returns from with-profits funds are dropping and some home owners are having to "top up" their endowments to make sure they generate enough to pay off the loan.

The traditional endowment policy invests in a life company's with-profits fund. This is a relatively secure investment that pays annual "reversionary" bonuses that the investor keeps, regardless of future performance. A terminal bonus dependent on overall performance is paid when the bond is cashed in.

Your money is invested in a mixture of stocks and shares, with a smaller element of property, fixed-interest investments such as gilts, and cash.

Philippa Gee, fee-based IFA with Gee & Company, says some endowments, known as unit-linked endowments, are closely tied to the stock market. "Most endowments are with-profits bonds. If you are considering going for a unit-linked endowment, you might be better off simply going for a unit trust, which is more flexible."

Ms Gee says that endowments are inflexible. If you cash your policy in early you could get back less than you put in. Generally it takes about five to seven years for a 25-year endowment to be worth more than you have paid into it. "They also have a high level of charges and a high level of commission. If an endowment is being recommended against a different type of policy you should ask what these charges and commission are. You need to make sure this is not the reason why it is being offered," Ms Gee says.

Commission rates can be avoided by buying through a discount house such as Chartwell Investment Management.

Endowment policies demand a regular premium. A more useful investment alternative is with-profits bonds. These invest in the same underlying funds but you can pay in a one-off investment of pounds 5,000 upwards. Again, charges and commission are high. Initial commission paid to an adviser recommending a particular bond can be more than 5 per cent. You can avoid this by going through a discount broker: Chartwell, TQ Choice Direct and Financial Discounts Direct rebate almost all their commission on with- profit bond sales.

In the recent years of sometimes spectacular stock market growth PEPs have had better performance, as well as lower charges. However, endowments and with-profits bonds are designed for more cautious investors and should be a safe haven when markets struggle.

Annual bonus rates on with-profits bonds are nevertheless being cut. Norwich Union has cut its rate from 6 per cent to 5.5 per cent and Scottish Widows has cut its rate from 6.25 per cent to 5.5 per cent.

With investment returns falling generally, such reductions are probably inevitable. This type of investment is relatively safe when markets are turbulent, because the annual bonus is retained regardless of future performance.

Higher rate taxpayers may pay the marginal rate when they cash in a with- profits bond, but many cash in after they have slipped into the lower tax bracket and avoid extra tax.

Ian Harper, spokesman for insurer CGU Life, says there is a further tax advantage for people looking to draw an income on their fund, as investors buying a single premium with-profits bond can withdraw up to 5 per cent of their original investment every year tax free for up to 20 years. So invest pounds 30,000 and you can take pounds 1,500 each year. Basic rate taxpayers can withdraw more than this 5 per cent limit.

You should avoid taking more income than you receive in the annual bonus as this will eat into your capital, particularly in the early years when your bond is still trying to make up for high commission and other charges. Falling bonus rates will also hit people taking income from their fund.

Friendly societies can trace their roots back to Roman times but are the forgotten organisations where tax-free investments are concerned. They can be a handy top-up to a PEP or ISA for investors wanting to avoid tax, as you can pay a maximum pounds 25 a month into their savings plans tax- free for a minimum of 10 years (pounds 270 for an annual lump sum). Many plans allow you to save for up to 25 years. The plans have built-in life cover, although this may be no more than a few thousand pounds.

Friendly societies are mutual organisations, non-profit making and are generally exempt from income and corporation tax. However, you should still consider the effect of charges on your investment. Since you are paying in such a small monthly sum, the charges take a large chunk of your money, particularly in the early years. You really shouldn't consider one of these bonds unless you intend to pay in regularly for at least 10 years.

Family Assurance, one of the largest friendly societies, charges a fixed pounds 120 initial fee, almost half of your first-year premiums. Annual management charges are 1.95 per cent of the value of the fund and there are also charges for early surrender.

A man age 30 paying pounds 25 a month for 10 years would get life cover of pounds 2,250. If his investment grew at 6 per cent a year he would receive pounds 3,480. At 9 per cent growth he would receive pounds 4,030. If he cashed in the policy after three years he would have paid pounds 900 but would receive only pounds 800 back.

Peter Atkins, IFA sales manager with Family Assurance, says the savings plans are "a bit more upmarket than most people think. They are a tax- efficient product; and people who have understood the benefits of PEPs, Tessas and ISAs also often take out a friendly society bond."

n Chartwell: 01225 446556; Financial Discounts Direct: 0500 498 477; Direct Choice: 0800 413186.

n `The Independent' and `Independent on Sunday' have published a free guide to with-profits bonds written by Nic Cicutti and sponsored by the ISA Shop. Call 0845 2711007.


Chartwell Investment Management recommends a top 10 with-profits performers based on past performance and financial strength.

1. Prudential

2. Scottish Widows

3. Scottish Equitable

4. CGU Life

5. Royal & Sun Alliance

6. Scottish Mutual

7. Scottish Provident

8. Clerical Medical

9. Friends Provident

10.Eagle Star