Why Profit
Bonds?
The answer is simple really – they have the potential to give higher returns
than money held in deposit accounts, particularly for higher rate tax payers. However, a deposit account allows instant access without
penalty whereas a with profits bond usually imposes a penalty if
investments are withdrawn during the first 5 years. A regular
income is allowed without any penalty.
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How do They Work? |
Money paid into such bonds becomes part of the life assurance
company’s “with profits” fund. This holds a
wide range of investments, usually 30-60% invested in stocks and
shares, which give attractive returns when held over the medium
to longer term.
Unlike holding such investments yourself, the ups and down of
investment markets are evened out for you by the insurance
company adding a regular “bonus” to the value of your
bond, which forms a permanent increase in its value.
This is achieved by keeping some of the profit made by the
fund in reserve. These reserves are then used in two ways.
1. If investments fall in value, reserves built up in past
years are drawn on to add “bonuses” until markets
recover.
2. When you withdraw money from the bond, an extra
“terminal bonus” is added to the value of the bond if
there are unused reserves from the period of your investment.
3. Under certain circumstances there can be penalties for cashing in if
investment markets fall. This protects continuing investors - see "What are
the drawbacks" below.
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What if I Need Income? |
If you need income, this can be taken from the bond from the
outset or when needed in the future. Most allow withdrawals of up
to 7.5% of the value of the bond to be taken on a regular basis
– monthly or less regularly if required. This is done by
cashing part of the bond, so attention must be paid to the rate
of “bonus” being added otherwise you may be drawing
out your capital.
It is important to choose carefully when buying a with profits
bond for income, as some pay a “terminal bonus” from
day one – others don’t. Currently,
“bonuses” being added are in the range of 1-4%, some
companies adding a further 2% or more as a “terminal
bonus”. These bonuses are net of basic rate tax.
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What About Tax? |
Bonuses added to the bond are deemed to have had basic rate tax
deducted. This means that basic rate taxpayers should not have
any further tax liability. Lower rate or non-taxpayers are not
able to reclaim the tax that has been deducted.
Higher rate taxpayers benefit from only having basic rate tax
deducted before bonuses are added to the bond. If the bond is
cashed in a year when income is lower, such as after retirement,
it may be possible to avoid liability to higher rate tax
altogether.
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What if I Die? |
The full value of your bond is repaid as a minimum. As it is
technically a life assurance contract, most companies add a
further 1% on top.
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What are the Drawbacks? |
There is a safeguard build into the bond to protect investors
who remain invested during periods of investment falls –
known as “Market Value Adjustment” (MVA).
MVA reduces the value of a bond if it is cashed in whilst
investment markets are severely depressed. It does not affect the
value of a bond that remains invested, payments on the death of
the bondholder, or regular “income” payments already
running.
MVAs have been implemented in recent years and can significantly
reduce cash in values.
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