With-profits bonds

With-profits bonds were once a popular way for people to put aside cash for a rainy day or to generate a tax-efficient income stream. But they have lost some of their shine in recent years, largely because of stock market falls and concerns over bonus payments and hefty exit penalties. With sales of the bonds plummeting, many wonder whether they have a future.

What are with-profits bonds?

Bonds differ from other with-profits investments, such as endowments, in that they are usually bought with a lump sum, rather than paid for in instalments. Bonds are commonly sold as “unitised” policies, which means your money buys allocated units in the with-profits fund. The bonds are frequently used to pay an income over a long period. As they are “whole-of-life” policies, they don’t have maturity dates but there may be a “defined” maturity date such as 20 years from the initial investment, or the age of the policyholder, say 75. They are often described as low to medium-risk investments but you have no guarantee that you will get your initial capital back.

How do the bonds work?
After deducting fees, the insurance company puts your money into a pool made up of the funds of thousands of other with-profits investors. The company will then typically invest in a range of higher risk assets such as equities, less volatile investments such as UK government bonds (gilts) and other fixed-interest securities. “With-
profits” are supposed to deliver capital growth over the long term through annual bonuses, which are calculated based on the performance of the underlying fund. The theory is that in the good years generous bonuses are paid and a little is held back to cover times when the fund isn’t doing so well. This process, known as “smoothing”, was attractive to cautious investors who wanted to draw a regular income and have capital growth. There is no guarantee that annual bonuses will be paid. At the end of the policy, some firms may also pay a discretionary final bonus, further boosting returns.

How have they performed?

In recent years many bonds have delivered minimal profits for their policyholders who have seen their bonuses held or cut. In spite of the “with-profits” name, the small print says that “profits” includes the possibility of losses.

Why have they had so much bad publicity?

The lack of transparency about the “smoothing” process has caused concern. Another major issue has been the imposition of hefty surrender penalties or Market Value Adjusters (MVAs) on policyholders wishing to cash in early. MVAs started becoming common in 2001, when equity markets took a turn and many investors wanted to flee failing investments. Some MVAs were as high as 20 per cent, effectively leaving investors locked into a bond which was delivering little or no income.

What are their advantages?
One of the big advantages of buying a bond is that you can withdraw up to 5 per cent of your original lump sum per year with no immediate liability to tax. You can keep doing this for 20 years – or until you have effectively withdrawn all your original capital. The payments are taken into account for tax purposes when the policy ends. Withdrawals in excess of this are termed “chargeable excesses” and are subject to income tax. If this happens there is a calculation called “top-slicing” that averages out the gain over the life of the policy. The average gain is then added to your income for the year. Top-slicing only applies to life assurance policies and favours basic rate payers who want to keep their income beneath the higher rate band.

What about the disadvantages?

The biggest downside is that if you need to cash in your bond early you will face a penalty. MVA rates have now come down to single figures but it could be a few years before they disappear altogether.

Another big disadvantage is that if the income you take is greater than the rate of growth of the bond, the value of your bond will reduce. There is also no guarantee that bonuses will be paid.

Are there times when I won’t have to pay an MVA?

Some policies have MVA-free surrender dates – usually on the 10th anniversary of the policy. Most firms will also not levy an MVA on the estate of a policyholder who has died.

Is it worth holding on to my policy?
There may be some light at the end of the tunnel. Norwich Union recently announced a hike in some bonuses and cuts in its MVA rates. This reflects an improvement in the stock market. While encouraging, don’t expect to see the same move across the board as weaker life offices may not be as generous.

Why would anyone want to buy one now?
Those considering buying a with-profits bond now may find they are offered an improved product. Norwich Union has launched a bond that “guarantees” that investors who keep all their money in the fund for at least five years will either benefit from the growth in the with-profits fund or get back what they paid in, plus inflation. It only applies to new investments in the Portfolio investment bond after January 30. Patrick Connolly, a certified financial planner with JS&P, the independent financial advisers, described it as the “best with-profits offer I have seen for some time”.