You'll stay in pocket but will you profit?

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The Independent Online
The Steady fall in interest rates throughout the 1990s has had a big impact on returns from building society deposit accounts. And for those who rely on building society interest to boost their spending power, the promise of higher payouts from income-paying guaranteed stock market bonds is attractive.

But as with their growth-based counterparts, the high income from guaranteed products may not come without a risk.

One problem with some high-income investments is that the extra income may turn out to be a mirage. This can happen, for example, if the value of your original capital falls over the investment period. In this case, the extra income can be viewed as nothing less than the return of your own capital. Depending on the nature of the investment, getting some of your own money back as taxable income is a complete nonsense.

Some financial advisers are cynical of the belts-and-braces approach of guaranteed funds. "Income-paying stock market bonds were developed because building societies in particular were afraid of people moving their cash out of deposits and into a unit trust or other share-based investments," says Mark Bolland of independent advisers Chamberlain de Broe.

"These things are supposed to have no risk, but there is the basic risk of losing interest and the value of your money being eroded by inflation if all you get is your money back. I take the view that if you expect the stock market to go up, you are better off investing in the market itself. You get the yield from it, the potential growth and the flexibility of moving in and out as you see fit rather than being locked in."

An example of an income-paying investment bond currently on the market is Financial Assurance's Higher Income Bond. It pays 10. 6 per cent a year (or 0.83 per cent a month) net of basic-rate tax for four years. That is far more than can be got from the building society. "If someone wants a steady level of income guaranteed and they are not worried about what happens to the capital, it is pretty attractive," says Mr Bolland.

But there is a risk to capital that investors may not understand. Both the FT-SE 100 index and the American S&P 500 index have to be at least at the same level in four years' time. If either is down, the capital return is reduced. You have a money-back guarantee - but, if the worst comes to the worst, you will get all your capital back less anything you have received in income. And you will not get anything more if the indices go up over the life of the bond.

In practice, the indices will not usually end up at a lower level than four years previously. But it can happen - and there is more of a danger at the moment with stock markets on both sides of the Atlantic at record highs.

It is also generally a good rule of thumb to avoid any investment if you do not understand exactly how it works. Unfortunately, that is not easy with guaranteed stock market investment bonds, which invariably make use of the world of derivatives. That is not to say that all derivatives are high risk; they can in fact be used as part of a lower-risk strategy. But few people really understand them, and few investors understand the mechanics of how a guaranteed stock market bond works.

A different type of investment that is easier to understand is the bond that uses part of your money to buy an annuity and part to invest in a with-profits or unit-linked fund. With these, you get a fixed income from the annuity for a set number of years, but there is no guarantee you'll get your capital back.

What you end up with will depend on how well the with-profits or unit- linked fund performs. Bonuses on which with-profits funds depend have been falling in recent years, suggesting some investors may be in for a shock further down the line.