Attractive option for the cautious

With-profits bonds may not be the most tax-efficient investment available but hidden away in their sometimes complicated rules is a tax break that will appeal to many, particularly higher-rate taxpayers and those looking for income.

With-profits bonds may not be the most tax-efficient investment available but hidden away in their sometimes complicated rules is a tax break that will appeal to many, particularly higher-rate taxpayers and those looking for income.

With-profits bonds are a type of investment bond sold by insurance companies. They allow you to tap into the high returns offered by the stock market while protecting your investment against a sudden slump. Each year a bond will payout an annual bonus, as well as a final, larger terminal bonus.

This makes for an attractive prospect for cautious investors, but only those who pay tax, says Patrick Connolly, director of Chartwell Investment Management. "Proceeds are paid net of basic rate tax at 23 per cent and this cannot be reclaimed. If you don't pay tax, forget about them."

If you are among the majority of us who are under Hector's fiscal thumb, the investment decision is more complex.

The tax advantage they offer comes in the form of an Inland Revenue rule that allows bond holders to take up to five per cent of the value of their investment as income each year for 20 years and pay no immediate tax on the proceeds.

All taxpayers benefit, although higher-rate taxpayers inevitably benefit more. This tax benefit is not as attractive as those offered by other tax-free savings vehicles such as individual savings accounts (ISAs). With-profits bonds cannot be taken as an ISA.

Cautious investors looking to save tax should also consider National Savings Certificates, low risk investments which offer returns free of all income and capital gains tax.

Philippa Gee, an independent financial adviser in Shrewsbury, says less aggressive investors looking for steady growth should definitely consider with-profits bonds. "Combining a with-profits bond with other equity investments should give you a good spread of risk within your portfolio."

She says that when picking an investment you should not make your choice solely on the tax benefits on offer. Many factors come into play, including your age, the length of time you can invest and the level of risk you are willing to accept.

Investors most likely to consider with-profits bonds are either looking for income now, or will need income in the near future. Many transfer the returns from more risky equity investments to with-profits bonds in the run up to retirement. "With-profits bonds have several advantages. They are open ended with no fixed maturity date. You can take an income if you want, or allow it to grow."

A number of insurance companies have just announced their latest annual bonus rates, most of them showing a small fall. Scottish Widows has kept its steady at 5 per cent, but Royal & Sun Alliance has cut its bonus from 5.5 to 5 per cent, Friends Provident from 6 to 5.25 per cent, CGU Life from 6.25 to 5.75 per cent and Norwich Union from 5.5 to 5 per cent.

This continues the trend to falling annual bonus rates seen in recent years, something that has not hit the popularity of with-profits bonds, as rates on other low-risk investments such as building society accounts, guaranteed income bonds and National Savings Certificates have also fallen. In 1997 sales totalled £5.4 billion, which rose to £6.8 billion in 1998. Early estimates put sales at £8.8 billion last year.

As a guide to current terminal bonus levels, the UK's most popular bond, the Prudence Bond, from Prudential, pays 5.25 per cent annually with a 2.75 per cent terminal bonus for the 1999/2000 financial year, giving a total return of 8 per cent.

Some alternative sources of investment income can seem more attractive by comparison. Ms Gee says investors can earn up to 9 per cent through a high yielding corporate bond but adds: "You can get a higher annual income but you are taking a greater risk with your original investment." John Hutton-Attenborough, senior financial planning consultant with Berry, Birch & Noble, favours the Prudence Bond for its consistent track record. Other favourites include Scottish Equitable, Clerical Medical and NPI.

One final thought. With-profits bonds pay advisers high levels of commission, up to 5 per cent. You can reduce this by buying through an 'execution-only' discount broker.