Financial Investment Products

This part of the guide will help you if you need a bit more information about investment products. It will cover endowments and Investment Bonds aka Single Premium Investment Bonds aka Insurance Bonds and sometimes known as With-profits Bonds.

In 1774 the Life Assurance Act provided the framework legislation for all the types of insurance policies we still have today.   Single Premium Investment Bonds are just one type of insurance policy, they exist alongside endowment policies and life assurance policies, depending whether investments, savings or life assurance/critical illness protection is needed.

 

Endowment Policies

Let’s say that you want to save up for your daughter’s wedding in 20 years, you want the full hit, big white dress, country house, lots of guests, massive old-school cake and you set a budget of £50,000. One way to save for this event could be with an endowment policy, you daughter gets her big day even if you’re not there to see it.  You save £208 every month for 20 years, you will have put in £50,000 by then, so the investment should be worth quite a lot more than you need by the end of the term.  We build our portfolios on an expected return of 5.5% – 9.5% year on year, depending on your attitude to risk.

The most well-known form of insurance policy that is used for investment is the endowment policy.  Forget, for a moment, the low-cost, low-start unitised endowment policy that has become unpopular for failing to repay mortgages.  Think, instead, about endowment policies used as a means of tax-efficient saving.

What makes endowments distinct from other forms of investment is the inclusion of insurance designed to enable you to hit your target if you die before the end of the policy.  By including insurance in the policy, the endowment combines the savings you need with covering the risk that you do not survive to complete the saving, this is essentially a form of hedging.  The insurance policy also bestows some tax advantages.  If the policy has a term of at least 10 years, and the premiums do not change substantially, the proceeds of the endowment are not subject to tax.  Endowments are not tax free, the insurance company will pay the tax during the investment.  So if you have used up your Capital Gains Tax allowance, you have invested in an ISA and your pension is tip-top, an Endowment could be for you.

In the last budget the chancellor paid special attention to regular premium endowment policies.  Previously, anybody could start a regular savings endowment policy with any premium they liked.  That has now been limited to £3,600 per year.  There are some other rules, so if this affects you, visit this part of the website.

Why did the government bother to change those criteria, given that very few people use this policy for a saving purpose these days?  Most people find that their ISA allowance is sufficient.  The reason, in one word, is “footballers”.  Well, footballers and other people with very high levels of income.  As mentioned above Endowment policies offered very high earners the possibility to make very high levels of regular saving.  There is no immediate tax advantage to using an endowment policy and the investment fund itself is taxed but the proceeds available at the end of the policy are tax-free so the chancellor wanted to limit that amount.

 

Should I have an endowment policy?

Saving up with an endowment policy might suit you…

  • If you have used up the tax breaks provided by ISAs and Pensions.
  • If you are looking to save to cover the cost of a future event and you the reassurance that the debt will be covered in the event of you death.

 

Single Premium Investment Bonds

Let’s consider you are in the enviable position of having used up all of the tax breaks offered by other investments such as ISA, unit trusts and pension and you just sold your company for £5,000,000 and you want to invest to secure your future.  Part of the solution will probably be a Single Premium Investment Bond.

Officially called Single Premium Investment Bonds but often called an Insurance bond or an Investment bond they were created in the same piece of legislation as Endowments, the Life Assurance Act of 1774.  Like an Endowment policy, a Single Premium Investment Bond is an insurance policy and so includes elements of life assurance and elements of investment.  Over the years they have gradually evolved – the life assurance has reduced to its minimum and now people generally use Single Premium Investment Bonds for investment.  The main reason people use then is that they offer some neat benefits, which we’ll cover later.

Single Premium Investment Bonds provide at least 101% of the prevailing investment value as a life assurance amount.  Their name suggests that no money can be added once the investment has been made, but they can be topped up.  This is an understandable misconception, given that they are called Single Premium Investment Bonds.  The “Single Premium” part of the title refers to the fact that, unlike Endowment Policies, Single Premium Investment bonds do not involve a contract for regular savings.

They also do not always have a fixed term and their proceeds are subject to tax.

The investment term is often open-ended.  Sometimes investment bonds can out-live the person who originally made the investment if there are multiple lives assured.  Like any investment, you should regard them as a long-term part of your financial planning; we prefer to use them when the money will not be needed for 10 years.  However, there is not usually a fixed end date.

That said, there is one date you might need to be aware of.  With-profits, single premium investment bonds, usually impose a market value reduction penalty in poor market conditions.  That means you get a bit less back if you want to cash-in your plan when markets are low.  Some With-profits, single premium investment bonds lift the penalty, for one day only, usually on the 5th anniversary of the investment date.  On this day the market value reduction penalty is lifted and you are free to reinvest without penalty but this is not mandatory and you may feel the investment is worth the paying the penalty at some later date, see How single premium investment bonds taxed?

Also, some structured investment products are built as Single Premium Investment Bonds, and they usually do have a fixed investment term.

 

How are single premium investment bonds taxed?

The policies are liable to tax but the tax may not work as you would expect it to, and there are some opportunities for tax planning in the hands of an expert.

For example, if the investment goes up from £100,000 on 1st January to £110,000 on 31st December, and let’s say that half of the increase is due to capital growth (i.e., the units themselves become 5% more expensive) and the other half is a dividend that has been re-invested, i.e., a 5% dividend has bought more units instead of being paid out.  None of the increase needs to go on your tax return and none of it is liable for immediate tax, even if you are a 50% tax payer.  In contrast, if you had had the same investment returns in a unit trust, or in one individual share, the dividend would need to be declared on your tax return and tax would need to be paid on it as part of the self-assessment regime, even though you didn’t spend it.

As long as the investment remains intact and undisturbed, it can grow without any accounting for tax.

If you have one of the with-profits policies that waive their market value reduction for one day only, you might be tempted to take advantage of this feature, in other words cash in and reinvest on that special day.  You had better make sure that the new policy is so much better that you can overcome the tax bill and the setup cost of the new policy.

 

So what happens when you need to withdraw a few pounds?

These days, Single Premium Investment Bonds are usually established with a lot of policy numbers, even if you have only made one investment.  If you have one, you may see the policy numbers run 1to19, 1to199 or even 1to999, depending which company you have used and how much you have invested.

This structure of mini policies is all there to give policy holder’s more flexibility when they need to cash in the investment to decide what’s the most tax efficient way to take their money out.

This has also become an important topic recently, as the recent recession has seen people needing to cash in investments in poor market conditions and as they have not taken the necessary advice before instructing the insurance company, they have landed themselves with a rather unwelcome tax bill.

So if you do what to make a small withdrawal how do you avoid paying too much tax?  Withdrawals from an investment bond can be assessed for tax in one of three ways:-

  1. A Tax free withdrawal

You can withdraw up to 1/20th of your investment in any policy year without paying tax

  1. A Partial withdrawal

If you take out more than 1/20th of the initial investment you will be liable for the tax.  However, you can use the allowance you have not used in previous years. For example, if you have an investment of £100,000 and over the first three years, it has grown to £120,000, then decide to withdraw £36,000, the first £15,000 ((£100,000 * 20%) * 3) is tax-free.  The remaining £21,000 is taxable as a “chargeable event gain”, however the tax bill might be £0 if your other income is low enough that an additional £21,000 does not push you into the 40% tax band.  If it does, top-slicing might help.

  1. A Partial withdrawal, utilising clusters

We will stick with the same example, £100,000 has grown to £120,000 after three years and you need £36,000.  Your Policy has 10 clusters, sometimes called segments or mini policies.

In this example each cluster, are now worth £12,000 each (i.e., ten times £12,000 = the full policy value of £120,000).

You surrender three of those policy segments, giving you the £36,000 that you need.

This time the taxable gain £2,000 on each of the three policies that you cashed in.  This means a total gain of £6,000, that is £15,000 lower than the example, which does not use clusters.

The possible difference in tax between option 2 and 3 is £5,000.  It is worth taking advice and this section is intended as information and comment, not advice.

 

Top-Slicing

Another useful benefit of Single Premium Investment Bonds is “top-slicing”.  On withdrawal, the gains made from Single Premium Investment Bonds are taxed as income.  Top-slicing allows you to slice a little of the top your taxable gain which could potentially bring you back under the 40% tax range and so reduce your tax bill to zero.

If the gain you make was simply added to your income, the result would be an unfair tax because it would take no account of inflation over time.  Investment bonds do not use an indexation allowance to reduce the effects of inflation.  Instead, they divide the bond gain by the number of years the policy has been in place.

Using our example from earlier, we worked out that your gain was £6,000 and the investment had been in place for three full policy years, because of the way Single Premium Investment Bonds are adjusted.  We can divide the gain by the three full years the money has been invested, this produces a top-sliced gain of £2,000.  It is this figure, the top-sliced gain figure, which is added to you income to decide the rate of tax you pay.

If you do have to pay tax, the tax rate will be the difference between the tax you have already paid within the investment – currently 20% – and your top rate.  So, in our example with the £6,000 profit, the tax bill would range from £0 to £2,000 (£2000 if you are already a 50% tax payer).

 

Keeping the Age-Related Allowance

We have mentioned that insurance/investment bonds are insurance policies and withdrawals from them are taxed as income but they are not really considered to be income.

Currently, this gives us a neat opportunity to do planning for our older customers who rely on high levels of bank interest to boost their retirement income.  Older people get an age-related personal allowance.  They can earn £2,395 per year more than under 65’s without paying income tax but that higher personal allowance gets scaled back when their income exceeds £25,400 in 2012/13 tax year.

However, the withdrawals from an investment bond don’t count towards that income provided they stay below the 1/20th limit, so people can keep more of their money and pay less income tax.  Our clients seem to like that.

 

Means Testing for Nursing Home Costs

Insurance/investment bonds also are currently excluded from the assets taken into account for calculating how much people should contribute to the costs of nursing home care/residential care. This was a recommendation of the CRAG report.

I consider this to be a welcome benefit available from a product that is already useful and would not recommend taking out an insurance bond purely for this purpose.

 

Should I have a single premium investment bond?

A Single Premium Investment Bond might suit you…

  • If you have used up the tax breaks provided by ISAs and Pensions.
  • If you have a lump sum to invest.
  • If you are retirement income makes you a basic rate tax-payer.
  • If you are looking for a growth vehicle which allows you to defer the tax payable.

You should be aware that the value of an investment can fall as well as rise and that investors may not get back the amount they invested