Life Assurance Bond

The term 'life assurance bond' is the general term for a range of investments that are more often known by the type of underlying fund or funds which they offer. In this respect, a life assurance bond could be likened to an ice cream cornet into which different combinations of scoops of ice cream can be held. Typical names for such bonds could therefore describe a single 'flavour' of investment fund such as a Distribution Bond , With Profits Bond or Property Bond , or a selection of 'flavours' as would be found in an Investment Bond or Capital Investment Bond .

Life assurance bonds are, not unexpectedly, investments offered by life assurance companies and it is this that provides them with their unusual tax treatment. The actual life assurance element will be very small, i.e. usually, no more than 1% of the amount invested. Technically, they are 'single premium whole of life' policies. In other words, the 'premium' is the lump sum investment amount and the investment has no term , rather it can be continued for as long as you want.

The Taxes Act 1988 specifies that single premium life assurance policies cannot be 'qualifying' policies. It is not important to understand what a 'qualifying' or 'non-qualifying' policy is. However, we can say that it is because of the 'non-qualifying' designation given to life assurance bonds that determines their tax treatment under that Act .

Taxation of the Underlying Funds

No matter what type of fund is used in a life assurance bond the tax treatment of the underlying fund is always the same. We could say that no matter what flavour, or combination of flavours, of fund you choose, what you end up with is a blob of ice cream! In fact the distinction between 'qualifying' and 'non qualifying' life assurance policies only has relevance to the individual who owns the policy. The underlying funds of both are treated in exactly the same way when held as an asset of a life assurance company.

The underlying fund suffers tax on investment income and capital gains under the special rate of corporate tax applicable to life assurance companies, which from 1st April 2003 was 20%. However, the overall rate of tax on a well-managed life assurance fund could be much lower than this at around 11% to 15%. The bond (or 'cornet') which holds the different funds (or 'flavours') enables you to switch from one fund to another (i.e. change your mind about the flavour or combination of flavours you want) without a personal capital gains tax charge arising.

Tax Treatment in Your Hands

An important feature of the taxation of life assurance bonds is that the 'chargeable gains' under such products are taxed as income tax rather than capital gains tax. We use the term 'chargeable gains' because not all gains made by a life assurance bond are chargeable to tax. The Revenue has agreed that the corporation tax suffered by the underlying fund on its investment income and capital gains is roughly equivalent to basic rate income tax.

Chargeable gains made on a life assurance bond are therefore not liable for further basic rate tax in your hands. The fact that a well-managed life assurance fund could actually be paying much less, than 20% creates a tax advantage for both basic rate and higher rate taxpayers, particularly when investments are held for the longer term.

Furthermore, for many people, particularly those who are not higher rate tax payers, using a life assurance bond means that they do not have to worry about accounting for tax either on the 'income' they receive from the investment or on any gains when the bond is encashed.

When a life assurance bond is encashed, or withdrawals are made from it, there may be a higher rate tax charge of 20% on the chargeable gain. However, this will not be of concern to anyone who income is not close to the level at which higher rate tax is required. Furthermore, even for higher rate tax payers there may be no additional tax on a gain, which is less than a cumulative rate of 5% a year of the original investment.

We can consider the implications for different types of taxpayers.

Basic Rate Tax Payers

If you are a basic rate taxpayer, the issues concerning life assurance bonds can be summarised as follows:

You may be in a neutral position from a pure tax point of view . Tax equivalent to basic rate tax is deducted from your investment in the underlying fund or funds. Therefore, neither regular withdrawals of 'income' from the bond, nor the partial or full encashment of the bond will be taxable unless the chargeable gains on such withdrawals are sufficient to push you into the higher rate tax band.
You have the convenience of being able to withdraw a regular amount of 'income' without worrying about the tax implications.
You have the availability of the With Profits concept not found in ISAs or unit trusts.
You have the flexibility of being able to switch funds at any time , and as is the case with many life assurance bonds, without any charge.
You have the ability to place the life assurance bond under trust for your heirs and possibly avoid Inheritance Tax .

Where you simply want to invest for capital growth in the long term, you may first wish to consider using Stocks and Shares ISAs and unit trusts . Stocks and Shares ISAs do not need to deduct capital gains tax within the fund, or in your hands, although there will still be a 10% tax charge on the dividend income which cannot be reclaimed.

Unit trusts do not need to deduct capital gains tax within the fund but gains are liable to capital gains tax on encashment of the units. Relatively few investors are subject to capital gains tax , however, because of the annual exemption.

As a basic rate taxpayer, you may still have relatively large amounts of money invested elsewhere such that your annual capital gains tax allowance is normally exceeded. In such a situation, a life assurance bond can be an extremely useful investment simply because there is no capital gains tax liability on such bonds.

Non-Tax Payers

If you are a non-taxpayer, the issues concerning life assurance bonds can be summarised as follows:

You may be in a worse position from a pure tax point of view . Tax equivalent to basic rate tax is deducted from your investment in the underlying fund or funds. This tax cannot be reclaimed by you even though you are a non-taxpayer.
You have the convenience of being able to withdraw a regular amount of 'income' ; however, you may have paid tax unnecessarily on this income.
You could use a life assurance bond offered by an offshore company . Such companies are outside of the UK tax jurisdiction and they do not have to deduct tax from the underlying fund.
You have the availability of the With Profits concept not found in ISAs or unit trusts.
You have the flexibility of being able to switch funds at any time , and as is the case with many life assurance bonds, without any charge.
You have the ability to place the life assurance bond under trust for your heirs and possibly avoid Inheritance Tax .

Where you simply want to invest for capital growth in the long term, you may first wish to consider using Stocks and Shares ISAs and unit trusts for the reasons mentioned under the previous heading 'Basic Rate Tax Payers', or you may wish to consider using an 'offshore' life assurance bond.

Higher Rate Tax Payers

If you are a higher rate taxpayer, the issues concerning life assurance bonds can be summarised as follows:

You may be in a neutral position from a pure tax point of view. This is because the basic rate tax is accounted for at source and there is a further 20% tax charge on the chargeable gains .
you may achieve a tax planning benefit if you are a higher rate tax payer now but hold the bond until, say, your retirement if, at that time, you are no longer a higher rate tax payer. The whole of the chargeable gain from the bond could then escape any further tax charge unless the chargeable gain pushes you into the higher rate tax band. Furthermore, chargeable gains are 'top-sliced' by the number of complete years which the bond has been held and this may help to avoid pushing you into the higher rate tax band, or at least limit the amount of the chargeable gain on which higher rate tax has to be paid.
You may have an advantage if you are looking for income, as the first 5% pa of regular withdrawals of 'income' from the bond will not involve you in any further tax at the time . This is because an allowance of 5% is given for each year that the bond is held to a maximum of 20 years. The 5% a year allowance can be taken without any higher rate tax charge as an 'income', or count towards occasional lump sums, or a final encashment. 'Income' and gains in excess of the 5% a year are only taxable at a further 20% .
The partial or full encashment of the bond may involve you in a 20% tax charge although this may not be the case if you are no longer a higher rate taxpayer at that time. Furthermore, whilst it would seem that the total tax on the gain on a life assurance bond, if you were to remain a higher rate tax payer, would be identical to the treatment of interest from a deposit account , that is not quite the case. Let us consider £1,000 of gross interest generated by a deposit account . You would actually receive a payment of £800 net interest. To account for the rest of the tax on this (as you are assumed to be a higher rate tax payer) this amount is grossed up to £1,000 and a further 20% tax is charged on the grossed up amount, making a tax charge of £400 in all (i.e. 40%) . If we now consider £1,000 of capital gain in a life assurance bond , we have seen that this is taxed in the hands of the life assurance company at 20%. You (as a higher rate taxpayer) would then be required to pay 20% tax on the £800 gain which you have actually received (i.e. £800 x 20% = £160) rather than on the nominal gross amount. This makes a tax charge of £360 in all (i.e. 36%) .

You have the convenience of being able to withdraw a regular amount of 'income' of up to 5% pa without worrying about accounting for tax at the present.
You have the availability of the With Profits concept not found in ISAs or unit trusts.
You have the flexibility of being able to switch funds at any time , and as is the case with many life assurance bonds, without any charge.
You have the ability to place the life assurance bond under trust for your heirs and possibly avoid Inheritance Tax .

Where you simply want to invest for capital growth in the long term, you may first wish to consider using Stocks and Shares ISAs and unit trusts for the reasons mentioned under a previous heading 'Basic Rate Tax Payers'.

As a higher rate taxpayer, you may have relatively large amounts of money invested elsewhere such that your annual capital gains tax allowance is normally exceeded. In such a situation a life assurance bond can be an extremely useful investment both from the point of view of obtaining up to 5% pa 'income' on a tax deferred basis , and because there is no capital gains tax liability on such bonds.

The Benefits of Top Slicing

In view of the fact that any chargeable gain on a life assurance bond will have arisen over a period of years , a measure of relief is allowed rather than simple attributing the chargeable gain as additional income in the year of encashment. The process is known as 'top-slicing'. Top slicing requires calculation of the appropriate fraction, or 'slice' of the chargeable gain by dividing the chargeable gain by the number of complete policy years that the bond has been in force. This slice, rather than the whole of the chargeable gain is treated as the top part of your income for tax purposes, and the average rate of tax applicable to the slice (less the basic rate) is calculated.

That tax rate (which may be zero if the slice did not push you into the higher rate tax band) is then applied to the whole of the chargeable gain to determine the actual tax liability on the gain.

The result is that relief is given to you if the level of your other income would mean that you pay tax at no more than the basic rate , but where you would be taken into the higher rate of tax if the whole of the chargeable gain were added to your income.

Where the chargeable gain is caused by a partial surrender , top slicing is determined by dividing the chargeable gain by the number of complete policy years since the last chargeable gain (i.e. over the cumulative 5% pa) caused by a partial surrender. If it is the first partial surrender then the top slicing uses the number of complete years for which the bond has been in force.

Taking an 'Income' From the Bond

You can arrange to receive automatic regular withdrawals of capital on a monthly, half-yearly or annual basis. If these are within the level of growth that is being achieved on the bond, these regular withdrawals of capital will effectively provide 'income' to you . You can amend the level of such withdrawals at any time , to suit current income needs irrespective of the actual growth of the bond. There is therefore a known 'income' at any time, the level of which is fully controlled by you.

The first 5% a year paid as regular withdrawals suffers no tax at that time. However, the cumulative withdrawals up to 5% a year are deemed to be added back into the value of the life assurance bond when it is fully encashed. If you are a higher rate taxpayer when your life assurance bond is fully, therefore, you will effectively pay a further 20% tax on the withdrawals that you have made over the years .

Even a basic rate taxpayer might find him or she pushed into the higher rate tax band when the bond is fully encashed and has to pay up to 20% tax on these withdrawals. As we have seen, however, the ability to use top slicing reduces this likelihood. Withdrawals in excess of the 5% cumulative annual allowance will suffer tax at the higher tax band rate of 20% if you are a higher rate taxpayer at the time, or the withdrawal pushes you into that band.

The Timing of Taxation

Life assurance bonds are usually segmented so that an investment of, say, £40,000 might actually be set up as 20 separate bonds of £2,000 each. This gives greater flexibility to you in order to try to reduce or remove any tax liability. The tax treatment of the full encashment of a bond can be favourable compared to the partial encashment of a bond. If, therefore, you want to make a partial encashment from your life assurance bond you might be better off making a full encashment of a number of segments of your bond.

The timing of the taxation of chargeable gains can also be used to good effect. Where the chargeable gain is as the result of the full encashment of your bond (or complete segments) the gain is treated as arising at the time of the encashment, that is, in the current tax year. That may be beneficial, for example if your current year's income is low for any reason.

Where the chargeable gain arises from a partial withdrawal, it is regarded as arising at the end of the policy year in which the withdrawal occurs. The reason for this is quite simple. You might make further partial withdrawals and it makes things tidy for the Revenue to have them all regarded as happening on one date. The policy year might end in your next tax year and if that is the case, you will want to think through whether it is likely to be a higher earning year or a lower earning year.

If the next tax year is going to be a high earning year then it might be better to fully encash segments of your bond and have them taxed in the current year.

The Security of Your Bond

As life assurance companies issue such bonds, there is usually no question of there being any difficulty in realising the investment. Most bonds do, however, have redemption penalties during the first five years, although these do not normally apply on death. On your death, the current value of the bond is available to your estate. Where the underlying investment is in commercial property there may be additional restrictions on encashing your investment and these should be fully taken into account before you invest.

Investments into life assurance bonds taken out via independent financial advisers (IFA's) are protected by the Financial Services Compensation Scheme (FSCS), which provides compensation of 100% of losses up to £30,000 and for 90% of the next £20,000 making a maximum payment of £48,000.

Investors in UK authorised insurance companies are further covered by the Policyholders Protection Act, which gives 90% compensation without limit.

Life Assurance Bonds and Age Allowance

Once you reach age 65 you enjoy an enhanced personal allowance, known as the 'age allowance'. This is £7,090 in the 2005/06 tax year whereas the standard personal allowance is only £4,895. However, the full amount of the enhancement for age allowance is only available where your total income for the tax year is below a certain amount - currently £19,500.

Your age allowance is reduced by £1 for every £2 by which your total income exceeds £19,500, until it falls backs to the standard personal allowance for the under 65s. Within this band, every £2 of income can cost 66p in tax (44p on the £2 itself, plus 22p on the £1 of allowances withdrawn). This is an effective tax rate of 33%.

For those who are caught in the 'age allowance trap' it may be possible to improve the situation by using the right kind of investments. For example, the income from certain National Savings Certificates is tax-free and does not count towards age allowance, as is the income from PEPs, TESSAs and ISAs.

More of interest to us currently, however, is the fact that the first 5% of regular withdrawals from a life assurance bond does not count as income for age allowance purposes. Simply by moving capital from, say, a deposit account to a life assurance bond, you could regain a lost age allowance and pay a lot less tax. There is a potential drawback, however, in that any chargeable gain that you take from your bond will count in full towards your income for age allowance purposes with no allowance made for any top slicing relief.

Inheritance Tax Provision

A life assurance bond is ideally suited as a vehicle to be used for the mitigation of Inheritance Tax because the bond can very easily be written under trust. There are a number of 'estate planning bonds' available from insurance companies. The main types are the Gift Trust, the Discounted Gift Trust and the Loan Trust.

Assignment of Bonds

Where a life assurance policy is owned by a higher rate taxpayer, it is possible to assign the bond to a spouse or child, or indeed any other person, prior to it being encashed. The advantage of this is that if the new owner of the bond is not a higher rate tax payer there may be not tax to pay on the gains made during the life of the bond, particularly when 'top slicing' is taken into account.

This is fine if you are genuinely intending to give the bond to the other person so that they can use the capital for their benefit. If, for example, you wish to gift the bond to your child or children for their use then the Revenue are unlikely to have any problem with this.

However, if you gift the bond to your non-tax paying spouse so that he or she is able to encash it without suffering a tax charge and then the money is subsequently invested in a new investment in your name or even in your joint names then beware.

In such a situation, the Revenue would content that your gift by assignment of the bond was not a genuine gift but was merely a sham and an effort to evade tax.

An Additional Benefit Later in Life

When investors first retire, their thoughts are naturally centered on themselves and their future income needs. With the passage of time, however, they may start to think in terms of leaving capital to their children or grandchildren or other members of their family.

Inheritance Tax is one issue to be faced as this can reduce their estate by up to 40% of its value. For some elderly investors there is another, potentially more damaging, drain on their assets, however, the possibility of needing to pay for residential nursing care over a long period.

The proper use of life assurance bonds as part of a balanced portfolio of investments can be very beneficial in helping more of the portfolio to survive the damage done by expensive residential nursing care costs. The Charging for Residential Accommodation Guidelines (CRAG) sets out the basis under which local authorities must apply the means testing system.

The objective of the means test is to determine the extent, if any, to which individuals are required to contribute towards their care costs when care is arranged by the local authority. Many local authorities have sought to include life assurance bonds as assessable assets under the means test, on the basis that the life assurance element is not their primary purpose.

However, a recent update to the CRAG guidelines makes it clear that 'if an investment bond is written as one or more life insurance policies that contain cashing-in rights by way of options for total or partial surrender, then the value of those rights has to be disregarded as a capital asset in the financial assessment for residential accommodation'.

If you were to transfer your assets into life assurance bonds to deliberately try and obtain assistance for residential nursing care fees from a local authority this would be unlikely to be an effective strategy as it would almost certainly be classified as 'deliberate deprivation'. However, by making use of life assurance bonds as part of your overall investment planning well ahead of any need for nursing care the possibility of having them disregarded under a local authority means test could be a valuable additional benefit for you in later life.

Types of Life Assurance Bond

Distribution Bond - Here the underlying investment would be a Distribution Fund. This is so called because it distributes the dividend income from the various shares that are being invested in to the bondholder, usually twice a year. The underlying investments are usually a combination of equities (i.e. stocks and shares) and bonds (i.e. fixed interest investments) and in some cases property. If you are seeking income this can be preferable to taking regular withdrawals from the bond because under a Distribution Bond the capital is not used to provide income. This does not mean that the capital is secure, however, because it is still invested in an equity-linked fund with daily price movements. You will find further information under Distribution Fund Information.

With Profit Bond - Here the underlying investment would be a With Profit Fund. In such a fund, the daily price movements inherent in an equity-linked fund are exchanged for an annual bonus, which is declared by the life office. This process attempts to smooth the volatility associated with an equity-linked investment and provides a lower risk option. With Profit Bonds are particularly suitable for investors who wish to receive a known level of 'income' or for investors that are more cautious. You will find further information under With Profits Fund Information.

Property Bond - Here the underlying investment would be a Property Fund. This type of fund invests in a range of commercial rather than residential properties, or in commercial property shares. Over the last decade commercial property, as an asset class, produced real returns ahead of equities, corporate bonds, gilts and cash. Furthermore, it was only just beaten to first place by equities over 20 years. It is a very useful part of any investment portfolio because commercial property behaves in a way that is unrelated to the movements of other assets. You will find further information under Commercial Property Fund Information.

Capital Investment Bond - Here the underlying investment would be one or more unit-linked funds set up and managed by the life office, or it could include a number of external fund managers. The value of units in such funds can fall as well as rise daily. There is no underlying security of capital, therefore, in such a bond but it can make an excellent investment when held for the longer term. The choice of funds is quite wide although most people prefer to put a reasonable portion of their investment into one or more managed funds where the investment choices are made entirely by the professional fund manager. Other funds are usually specific to a particular market, for example European Fund, North America Fund or Far East Fund or type of investment such as Smaller Companies Fund, Ethical Investment Fund or Technology Fund.

Risk Factors

An investment into a life assurance bond is intended as a long-term investment. Where past performance is mentioned, please note that the past is not necessarily a guide to future performance. Because this investment may go down in value as well as up, you may not get back the full amount invested.

The return on a With Profit Bond depends on the profits made by the life office and on its policy as to their distribution (whether on early encashment or in adverse market conditions or other circumstances). Bonuses come from profits, which are yet to be earned; there is therefore no guarantee that current rates will be maintained beyond any special offer period. If you surrender the contract, especially during the early years, you may get back less than the amount originally invested.

The price of units in a Distribution Fund can go down as well as up, as too can the 'income' distributions from them. The value of the investment, therefore, and the income from it will fluctuate and is not guaranteed.

For funds that are wholly invested in, or have an element of property, it may be necessary to defer encashment during periods when property is not readily saleable. The general market for commercial property may during the period of any investment in shares in a property fund with the result that the value of the fund's property investment portfolio falls. The value of any individual property may fall, for example, due to the insolvency of a tenant. The monthly valuation of the fund will be predominantly based on the opinion of the valuer of the fund of the current market value of the fund's property portfolio.

Distribution Fund Investments

A Distribution Bond is at the lower risk end of the investment spectrum. The bond invests in a wide range of assets including UK company shares (normally between 20% to 50%), gilts and other fixed interest securities (normally between 20% to 50%), index-linked stocks (normally between 0% to 30%) and commercial property (normally between 0% and 30%).

Gilts and fixed interest securities will play a major part in producing the income of the fund . Property will provide a stable rising income if rents rise over time. Although the main aim of the property investments will be to produce income, property also offers the potential for capital growth. Equities (i.e. stocks and shares) will provide most of the growth in the fund . The shares will normally be high yielding shares and will generally but not always be blue chip companies.

Distribution Funds will also invest in index-linked stocks as appropriate. The actual investment mix at any time will depend upon the fund manager's views as to which assets will give the best prospects of maximising income and capital growth within an acceptable level of risk.

Natural' Distributions

You can normally elect to receive the 'natural' distributions on the bond. Such distributions are typically around 3.5% to 4.5% but this amount is already net of basic rate tax . The level of income therefore compares favourably with both the net interest available on deposit accounts and the dividends available on shares. You can normally take the natural distributions half yearly, or arrange to have them paid monthly or quarterly. Where they are paid more frequently than half yearly you are still taking the actual half-yearly distribution but it is simply divided into monthly or quarterly amounts for the convenience of your income needs.

Whilst there are many types of investment bond, the particular advantage of the Distribution Bond is that by taking the natural distributions from the bond you are not disposing of units from the main Distribution Fund holding. The income is therefore achieved by effectively passing on the income received within the fund itself in an efficient manner.

By leaving the capital within the fund intact, the idea is to reduce the risk of capital erosion . Furthermore, the level of risk adopted by the fund managers is usually a little lower than that of the average managed fund, as a higher proportion of the fund is held in more secure, fixed interest investments and sometimes also in property. As with any equity-linked investments, the value of units can fall as well as rise. In addition, because this investment may go down as well as up, you may not get back the amount invested.

Other Regular Withdrawals

Automatic regular withdrawals of capital can also be set up on a monthly, half yearly or annual basis. If these are within the level of natural distributions and growth that is being achieved on the bond, these regular withdrawals of capital will effectively provide 'income' . You can amend the level of such withdrawals at any time , to suit current income needs irrespective of the actual distributions and capital growth of the bond. There is therefore a known 'income' at any time, the level of which is fully controlled by you.

A Distribution Bond is particularly useful for clients who have some years to go before retirement and can allow the distributions to accumulate before taking a regular income in retirement.

Capital Growth

A Distribution Bond holds out the prospect of capital growth , albeit at a fairly low level. Such growth would have the effect of increasing the level of distributions, whereas capital left on deposit is likely to lose its value over the longer term as a result of inflation.

Where They Fit In

A Distribution Bond cannot guarantee a particular level of return , as both the level of distributions and the underlying capital value will fluctuate. A Distribution Bond fits in somewhere between the security of a deposit account and the volatility of a wholly equity linked investment. Its closest neighbour in the investment spectrum is the With Profit Bond, which should be seen as a lower risk investment than the Distribution Bond because a With Profit Bond offers the comfort of bonuses having once been added not able to be taken away.

A Distribution Bond could be considered as a low to medium risk investment depending on the breakdown of the underlying investments. It is certainly not a direct replacement for a building society deposit account or a National Savings account, but it should be able to provide a higher return than such accounts where you are unlikely to require access to your capital for five years or more.

As with any long-term investment, a period of at least five years should be envisaged for a Distribution Bond before any planned capital withdrawals of any magnitude are required. It is possible to access money in an emergency but there can be circumstances in which such withdrawals would result in a loss of part of the capital. Having said the foregoing, it is possible to receive distributions from the bond from the outset.

A Distribution Bond does not suffer from one important aspect of a With Profit Bond, in that there is no ability for the Distribution Bond product provider to use its discretion to apply a Market Value Reduction.

The Taxation Advantages

Where your need is for growth with a greater measure of security , or your main need is for income , the Distribution Bond is likely to be appropriate for you. Neither 'income' from the bond, nor its final encashment, should be taxable to most basic rate taxpayers. This is because the Distribution Fund itself will have suffered tax on income and capital gains under the special rate of corporate tax (not exceeding 22%) applicable to life assurance companies. The Revenue has agreed that this tax is equivalent to basic rate income tax and the growth on the bond is therefore not liable for further basic rate tax in your hands.

For basic rate taxpayers who have relatively large amounts of money invested elsewhere such that their annual capital gains tax allowance is exceeded, a Distribution Bond can be an extremely useful investment. This is because there is no capital gains tax liability on a Distribution Bond.

Clients who are higher rate taxpayers and are looking to reduce the tax on their investments can benefit from a Distribution Bond. This is because an allowance of 5% is given for each year that the bond is held to a maximum of 20 years. The 5% per annum allowance can be taken as an 'income' or count towards occasional lump sums, or a final encashment. In addition, 'income' and gains in excess of the 5% per annum are only taxable at the higher rate band level , which will be a further 20% from April 2004. In no circumstances will a higher rate taxpayer pay tax on a Distribution Bond at the basic rate tax of currently 22%.

Other tax planning benefits can be achieved for higher rate tax paying clients who hold a Distribution Bond until their retirement. If, at that time, they are no longer higher rate taxpayers the whole of the gain from the bond can be tax-free.

The Security of Your Bond

As life assurance companies issue such bonds, there is no question of there being any difficulty in realising the investment . Most bonds do, however, have redemption penalties during the first five years, although these do not normally apply on death. On your death, the current value of the bond is available to your estate.

Investments into Distribution Bonds taken out via independent financial advisers (IFA's) are protected by the Financial Services Compensation Scheme (FSCS), which provides compensation of 100% of losses up to £30,000 and for 90% of the next £20,000 making a maximum payment of £48,000. Furthermore, investors in UK authorised insurance companies are further covered by the Policyholders Protection Act, which gives 90% compensation without limit.

Inheritance Tax Provision

A Distribution Bond is ideally suited as a vehicle to be used for the mitigation of Inheritance Tax because the bond can very easily be written under trust. We would be very happy to provide further information on the options available.

Distribution Funds via an ISA

Any investment is only appropriate for a particular client if the taxation situation is favourable. Clients who want the benefits of a Distribution Bond but have not yet used their ISA allowance for the year should first look at investing into a distribution fund via a Stocks and Shares ISA.

Where a distribution fund is 'wrapped' in an ISA, it can have the advantage of providing the distributions completely free of tax . The ISA has to hold a minimum of 60% of the fund in corporate bonds and it will then be able to pay out the total income from the fund without deduction of tax or liability for tax in your hands. Not all distribution funds obtain this advantage so it is important to make sure that you investigate this point before investing.

Distribution Funds via an 'Unwrapped' Unit Trust

Clients who are not taxpayers may wish to look at investing into a distribution fund via 'unwrapped' unit trusts before they consider investing into a Distribution Bond. Although tax at the investment rate, currently 20%, has to be deducted at source where the distribution fund is not 'wrapped' in an ISA, a non-taxpayer is able to reclaim the tax deducted at source from the Revenue . Again, it is important to make sure that the particular unit trust maintains the 60% minimum in corporate bonds to gain this advantage.

If you would like to receive a personal illustration of a suitable Distribution Bond or discuss whether an ISA or 'unwrapped' unit trust might be of benefit to you please contact your usual adviser, email us on info@hirstandcompany.co.uk or telephone 0870 220 2243 .

Risk Warnings

An investment into a Distribution Bond is intended as a long-term investment. The Distribution Bond is unit linked. The price of units in the fund can go down as well as up, as too can the 'income' distributions from them. The value of the investment, therefore, and the income from it will fluctuate and is not guaranteed. Where past performance is mentioned, please note that the past is not necessarily a guide to future performance. For funds that have an element of property, it may be necessary to defer encashment during periods when property is not readily saleable. The value of property is generally a matter of valuer's opinion rather than fact. If you surrender the contract, especially during the early years, you may get back less than the amount originally invested.

An investment into an ISA, PEP, unit trust, OEIC or other collective investment scheme is intended as a long-term investment. It is important that you are aware that the value of units in a unit-linked investment such as an ISA, PEP, unit trust, OEIC or other collective investment scheme, as well as any income, which they generate, can fall as well as rise. If you surrender the contract, especially during the early years, you may get back less than you have invested. Where past performance is mentioned, please note that the past is not necessarily a guide to future performance.

With Profit Investments

A With Profit Bond invests in a wide range of assets such as UK and overseas company shares, gilts and other fixed interest securities, index linked stocks and commercial property. In view of this, the bond should outperform deposit-based investments over the longer term .

Such a portfolio of investments would normally be considered as a medium to high-risk investment, depending on the percentage held in equities (i.e. stocks and shares). However, the main attraction of a With Profit Bond is that the value of the investment should grow steadily each year rather than exhibit the volatility of many investments. This is because the growth is achieved by means of bonuses, which the life office declares each year rather than being related directly to stocks, and shares etc. This feature changes the nature of a With Profit Bond to a low to medium risk investment .

The widespread use of Market Value Reductions in exceptionally difficult market conditions has shown, however, that the value of such bonds can fall and that this can create great difficulty for people who need to access their capital at such times.

The Bonuses

There are two forms of bonus payments that can be added to a With Profit Bond. All With Profit Bonds will have an annual bonus that is declared by the life office. Currently a typical annual bonus would be around 1.50% to 3.5 % but clients need to be aware that future bonus levels are not guaranteed.

The initial bonus level quoted by the life office, whilst a factor to be considered, has also to be viewed in conjunction with the general level of performance that the life office has achieved over many years with its With Profit Fund. The general strength of the life office is another very important factor in making sure that future bonus levels can remain competitive.

In addition to the annual bonus, some life offices also give a terminal bonus . Any figures quoted for such terminal bonuses should be largely ignored as they are much more susceptible to current market conditions. Nevertheless, if a good performing life office is chosen this could be an additional benefit to receive on final encashment of the bond.

Taking an 'Income' From the Bond

Automatic regular withdrawals of capital can be set up on a monthly, half yearly or annual basis. If these are within the level of growth that is being achieved on the bond, these regular withdrawals of capital will effectively provide 'income' . At present, we would not recommend that regular withdrawals be set up in excess of 3.0% pa. You can amend the level of such withdrawals at any time , to suit current income needs irrespective of the actual growth of the bond. There is therefore a known 'income' at any time, the level of which is fully controlled by you.

Provided that the amount of capital withdrawn is less than the bonuses, which have been added to the bond the capital value will remain intact, so long as a Market Value Adjustment is not imposed. It is for this reason that 'income' should, where possible, be delayed until any initial charges on the bond have been covered by the addition of bonuses or the capital value may suffer.

The With Profit Bond is particularly useful for clients who have some years to go before retirement and can build up bonus values before taking a regular income in retirement .

Where They Fit In

A With Profit Bond cannot guarantee a particular level of return , as bonuses paid by life offices are dependent on the returns, which they receive on their investments. Unlike a unit trust or other unit-linked investment, however, the bonuses once added cannot be taken away (except temporarily by the imposition of a Market Value Reduction).

A With Profit Bond is therefore much higher risk than a deposit account but is lower risk than a typical equity investment and should be considered as a medium risk investment. It is not a replacement for a building society or bank deposit account, or a National Savings account, but it has the potential to provide a higher return than such accounts over the longer term.

As with any long-term investment, a period of at least five years should be envisaged for a With Profit Bond before any large planned capital withdrawals are required. It is possible to access your money in an emergency but withdrawals in the early years should be expected to result in a loss of part of the capital . It is, however, possible to set up regular withdrawals of capital (usually up to a maximum of 5% pa) from the bond once the initial charge is covered. Such withdrawals will effectively provide an 'income' so long as they are realistic bearing in mind current bonus levels.

The Security of Your Bond

Investments into With Profit Bonds taken out via independent financial advisers (IFA's) are protected by the Financial Services Compensation Scheme (FSCS), which provides compensation of 100% of losses up to £30,000 and for 90% of the next £20,000 making a maximum payment of £48,000. Investors in UK authorised insurance companies are further covered by the Policyholders Protection Act , which gives 90% compensation without limit.

The Most Competitive Bonds

We recommend the most competitive With Profit Bonds to our clients based on a number of tools at our disposal together with ongoing research.

We use research software , Aequos, provided by Defaqto Limited, acknowledged leaders in the field of financial product research. One of the most important factors when choosing a With Profit Bond is the underlying strength of the product provider and we rely on agencies such as the internationally recognised Standard & Poor's to provide such information to us. The strength of the product provider is far more important than the current bonus level , or the bonus history of the product provider, as this can be manipulated, particularly in the short term.

Market Value Reduction

You need to be aware that when you wish to encash part, or all, of your investment in a With Profit Bond the product provider may apply a Market Value Reduction (MVR). The usual reason for applying an MVR is if the actual investment performance of the fund has not matched the bonuses declared . The application of an MVR is done in order to prevent medium to long-term investors remaining within the fund from being disadvantaged by other investors who encash their investments when the underlying securities would have to be sold at a loss.

Each product provider will have their own rules for applying an MVR. In practice, most product providers guarantee not to apply an MVR on death, or on automatic withdrawals within certain limits . This is particularly of benefit to retired people who wish to use their With Profit Bond to produce retirement 'income'. Some product providers guarantee that no MVR will be applied if the bond is fully encashed on a certain policy anniversary, usually after 10 years.

If you would like to receive advice on an investment into a With Profit Bond or a bond that you already own please contact your usual adviser, email us on info@hirstandcompany.co.uk or telephone 0870 220 2243

Risk Factors

An investment into a With Profit Bond is intended as a long-term investment. Where past performance is mentioned, please note that the past is not necessarily a guide to future performance. The return on a With Profit Bond depends on the profits made by the life office and on its policy as to their distribution (whether on early encashment or in adverse market conditions or other circumstances).

Bonuses come from profits, which are yet to be earned, there is therefore no guarantee that current rates will be maintained beyond any special offer period. If you surrender the contract, especially during the early years, you may get back less than the amount originally invested.

Commercial Property Investments

In our experience most investors, be they individuals or large pension funds, are seriously underweight in this sector. For our part, the dramatic fall in the value of equities and our increasing use of model portfolio tools, have combined to encourage us to make more use of commercial property funds.

Commercial property is particularly useful in an investment portfolio as its volatility is similar to that of bonds (i.e. fixed interest investments) but it has very little correlation with either equities or bonds; making it a very good alternative asset within a well diversified portfolio.

Under the heading 'Property more prominent', James Smith wrote an article in the pensions section of Investment Week of 12 July 2004 , from which we quote the following:

'Two-thirds of pension fund managers are anticipating both a short and medium-term increase in their overall allocation to property, according to a study by PricewaterhouseCoopers (PwC). Although the average pension fund's allocation to property decreased significantly from the 15% to 20% highs of the mid-1970s to about 5% by 1999, this figure has begun to climb back up towards 10% of late.

The move away from property for much of the 1990s is particularly glaring considering figures showing if pension and insurance funds had continued to hold 20% of their portfolio in the asset class, as in the early 1980s, they would be cumulatively wealthier by around £14bn today. A figure of this magnitude would have meant significantly lower deficits in the majority of pension funds, according to PwC. Historical evidence shows property has low correlations with equities and bonds, meaning the asset class brings twin benefits of diversification and reducing the volatility of the scheme's funding level. With that in mind, the optimal allocation to property is often in the region of 25% to 30% for a pension fund, significantly above that currently held in the majority of portfolios.'

We would highlight two points raised by the article that could affect your own investment planning:

Although the article was concerned with the level of commercial property investment in pension funds, the need that such funds have to outperform inflation and meet future income liabilities is not dissimilar from the needs of many investors, particularly those who have already retired or are close to retirement.
Any move by large pension funds to increase their percentage investment in commercial property is likely to be a positive factor in holding up values in that sector.

Investment Vehicles to Use

It is, of course, possible to invest directly into a commercial property either on your own or with others. For this, you would typically need to invest or borrow hundreds of thousands of pounds, or even millions. This is not something on which we are regulated to advise you. Furthermore, we would point out the dangers of having 'all your eggs' in a single commercial property 'basket'.

Commercial property does not behave in the same way as residential property and you would need vastly more experience to invest safely in a single commercial property than you would when buying a single residential property.

For the majority of investors we believe that an investment in a commercial property fund that is set up as a collective investment scheme is the most appropriate way to proceed. Such funds are accessible to anyone with £1,000 or more to invest.

These are divided into two general types of investment. The first would be classified as unit trusts, OEICs (Open Ended Investment Companies) or ISAs. The second would be classified as life assurance bonds, or Property Bonds, where the only fund used is a property fund.

All of these investments provide major benefits to commercial property investors.

diversification of risk through investing in a portfolio of different commercial properties or property shares
professional fund management
easier access to your capital
ease of administration

The main difference between the general types of property funds mentioned is their tax treatment. Which is the most appropriate for you will therefore depend on your own tax position.

Investing in Unit Trusts and OEICs

When you use a unit trust, or OEIC or similar product, the tax situation is as follows:

there is no capital gains tax (CGT) on property transactions within the fund. Instead, you are liable for CGT when you take money from the fund.
you have control over when you make a withdrawal from the fund and you may be able to adjust this to take account of your likely tax situation at any time.
you have an annual CGT allowance to reduce any gain, which is currently £8,200. If you have a spouse or partner, you can double the CGT allowance available to be set against any gain by putting the unit trust into joint names. Please note, however, that a transfer of half of your investment into a partner's name would raise a liability for CGT, but a transfer into a spouse's name would be free of any CGT liability.
an advantage of using a unit trust is that capital gains will be reduced for tax purposes by taper relief.

Another benefit of using a unit trust is that the charges tend to be fairly standard, i.e. around 5% of the initial investment and 1.5% per annum fund based. There are usually no termination penalties.

A number of unit trust property funds are now set up as offshore funds so that the income can be paid gross.

Investing in an ISA

Commercial property is not eligible for inclusion in a Stocks and Shares ISA. However, one commercial property fund is available with an ISA wrapper because it only invests into property shares rather than actual bricks and mortar.

This makes it much more volatile than a typical commercial property fund but provides the advantage that there is no tax on any capital gains and the income, although suffering 10% tax at source, is not taxable in the hands of the investor.

Investing in a Life Assurance Bond

A Property Bond is a form of life assurance bond and the tax treatment of these is dealt with in some detail under Life Assurance Bonds .

When you use a life assurance bond, the tax situation is as follows:

The underlying fund suffers tax on investment income and capital gains under the special rate of corporate tax applicable to life assurance companies, which from 1st April 2003 was 20%.
'Chargeable gains' under life assurance bonds are taxed as income tax rather than capital gains tax. The Revenue has agreed that the corporation tax of 20% suffered by the underlying fund on its investment income and capital gains is roughly equivalent to basic rate income tax. Chargeable gains made on a life assurance bond are therefore not liable for further basic rate tax in your hands.
An 'offshore' life assurance bond may be a more suitable investment for a non-tax payer as the 20% tax deducted from on onshore life assurance fund cannot be reclaimed.
If you are a higher-rate taxpayer, you will have a further 20% tax charge on the chargeable gains from an onshore life assurance bond. You could, however, withdraw 5% of the value of your bond each year without any higher rate tax charge at the time, for up to 20 years. On final encashment of the bond, the tax charge will depend on the actual gain the bond has made and your tax position at the time. If, for example, you were then no longer a higher rate taxpayer because you had retired there might be no further tax to pay.

One potential disadvantage of using a life assurance bond is that there will usually be an early termination penalty during the first five years of the plan. This may not be a problem as you should not plan to invest for less than five years anyway, but it could be a nuisance in the event of a financial emergency.

Be Aware of Gearing

Some commercial property funds have an element of gearing. This is not necessarily a bad thing but you need to be aware of it.

People use gearing when they buy their own home with the help of a mortgage. If, for example, you have purchased a property for £200,000 with the aid of a 75% mortgage (i.e. £150,000) the gearing is said to be 1 to 3, i.e. the relationship between the money that you invested in the property and the money that you borrowed is 1 to 3.

If, over time, the price of your property increases by 25% then your gain is geared, i.e. instead of being 25% of the money you invested (i.e. 25% of £50,000 = £12,500), it is four times that amount (i.e. 25% of £200,000 = £50,000).

By the same token, if your property falls in value by 10% then your loss is also geared, i.e. instead of being 10% of the money you invested (i.e. 10% of £50,000 = £5,000), it is four times that amount (i.e. 10% of £200,000 = £20,000).

If you invest £50,000 in a property fund, which is geared 1 to 2, then your investment is based on £150,000 of property within the fund, the balance of £100,000 being made up of a loan taken out by the fund manager.

Your potential profit is therefore based on an investment in commercial property of three times your actual investment although the interest paid for the loan has to be deducted from this. Your potential reward is increased in such a fund but so is your risk of loss. A geared property fund will exaggerate the general gains from commercial property and also exaggerate the general losses.

If you would like to receive advice on an investment into a Commercial Property Fund please contact your usual adviser, email us on info@hirstandcompany.co.uk or telephone 0870 220 2243

Risk Factors

The general market for commercial property may during the period of any investment in shares in the fund depreciate with the result that the value of the fund's property investment portfolio falls. The value of any individual property may fall, for example, due to the insolvency of a tenant. The monthly valuation of the fund will be predominantly based on the opinion of the valuer of the fund of the current market value of the fund's property portfolio.

The cash resources immediately available to meet applications for redemptions of shares in the fund are limited and if net redemption requests on any subscription day exceed those resources investment properties may need to be sold in order to redeem such shares. As land and buildings may be difficult to sell on these occasions, there may be times when the shares cannot be immediately redeemed.

Investors need to understand the possible downside effect of a geared property fund. That is, if all or part of the portfolio should need to be sold at a time when commercial property values had fallen, the banks would first be paid the money that had been borrowed from them.
This could translate into a higher capital loss than the actual fall in commercial property values would appear to warrant.

It is intended that an investment in the shares in the fund will procure regular income for the investors who should be aware that this income will fluctuate. In addition, it should be noted that the tax treatment of the fund may change.

Charges and expenses in connection with the fund are not made uniformly throughout its life and it is possible that an investor may not receive back the full amount of its investment especially if it is redeemed within the first few years

Redemption of the shares in the fund is at the discretion of the fund's manager and there may be circumstances in which it is decided not to permit redemption. Your attention is drawn to the provisions for redemption in the key features document or prospectus.

An investment into a property fund is intended as a long-term investment. Where past performance is mentioned, please note that the past is not necessarily a guide to future performance. The value of units may go down as well as up and you may receive back less than the amount you have invested. The tax treatment of any income payments depends on individual circumstances and tax rates and laws may change in the future.

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