Clobber the taxman

With-profits bonds from life insurance companies are an attractive option for investors who want to earn higher income than they would from a building society deposit, while steering clear of the volatility associated with direct equity investments.

A with-profit bond generally requires a minimum lump-sum investment of £5,000. There is no fixed term, although there are often early-surrender penalties during the first five years. This means that with-profits bonds should be considered for longer-term investments.

Last year more than £12bn was invested in with-profits bonds in Britain.

Life assurance companies invest with-profits funds in a range of assets including equities, property, gilts and cash. The returns from the highs and lows of these investments are smoothed out by holding back some of the profits when investment conditions are particularly good, thereby building up reserves for when markets are less lucrative.

Regular withdrawals can be taken without incurring an immediate tax bill and most with-profits bonds offer a range of payment frequencies, including monthly, quarterly, half yearly or annually. The withdrawals can be stopped or started at any time to meet changing requirements.

Ian Beestin, a director at the Nottingham-based With-Profits Bond Shop, reckons with-profits bonds are most likely to appeal to those at the early stages of retirement, who have probably just received a lump sum from their pension.

Kevin Minter, financial planning manager at the Woburn Sands-based David Aaron Partnership, says with-profits bonds also appeal to taxpayers, who receive generous tax treatment thanks to the bond's life assurance base. Investors can withdraw up to 5% a year free of further tax. This is particularly advantageous for higher-rate tax payers who can defer declaring gains for 20 years, or until the bonds are sold and then pay only 18% tax on any extra amount taken each year.

Most providers offer current annual bonus rates of between 5% and 6.25% net of basic-rate tax. Virtually all providers also offer a terminal bonus, which depends upon how well the investment has performed over the term of the policy. Terminal bonuses are not guaranteed.

According to Mr Beestin, the average rate of return over five years, after charges and net of basic-rate tax on with-profits bonds, was 10.3% a year. But this high level of return is unlikely to be sustained over the next five years as interest rates and investment returns are expected to fall.

"For investors wanting a higher level of income, there are some products which enable the withdrawal of both the annual bonus and what would normally be the terminal bonus," Mr Beestin said. "This was pioneered by Legal and General and more recently CGU has introduced a similar facility."

The main disadvantage of with-profits bonds, according to Mr Minter, is that most have an early encashment penalty, which is around 5% in year one and runs down to around 1% in year five and zero thereafter.

Another disadvantage to bear in mind is the market value adjustment factor, which means that if investment conditions are poor over a period of time, the actuaries at the life companies can reduce the policy's cash-in value to be "fair" to other with-profits investors.