Investment bonds: too many strings attached?

Unscrupulous financial advisers could be pushing unwary people into the wrong type of investment, simply to boost their income ahead of a commission clampdown. Alarm bells have been raised by an independent financial adviser worried that the practice is widespread, despite the financial services industry already suffering a serious image problem from several previous commission scandals.

Philippa Gee, managing director of Philippa Gee Wealth Management, says investment bonds are being pushed on investors because they pay commission to advisers of up to 9 per cent. She says the sky-high payouts encourage advisers to recommend the bonds – which are offered by insurance companies – even though they may not be right for people. She points out that the bonds have exit penalties for cancellation within five or six years, they are not always tax-efficient and they carry risks which an investor may not understand.

"Investment bonds are single premium life insurance contracts but I think the word 'bond' is misleading as it naturally instils a confidence in the product that shouldn't automatically be there," says Gee. "How well the investment bond does depends on how it is invested and what charges are involved.

"The problem with the charges is that they are far from transparent, as the bond may seem to be adding to the investment amount through so-called allocation rates but actually taking away from the policy in terms of commission to the IFA and charges to the insurance company," says Gee. "Clients often end up getting charged 10-12 per cent if they surrender the policy in the early years and don't appreciate how much of their money has actually been paid out to others."

She's not alone in being worried about the mis-selling of the bonds. "I don't see a role for onshore investment bonds other than to pay large commissions as high as 8 per cent to advisers," says Danny Cox of the Bristol-based wealth manager Hargreaves Lansdown.

"Many insurance company bonds are designed to confuse the investor with their charging structures in order to allow these commissions to be paid," he says. "And guaranteed options are only added to make them seemingly more attractive."

Cox's view is that for the vast majority of people, stocks and share ISAs together with a portfolio of funds where they can use their capital gains tax allowance are far more tax efficient and far less complicated.

Nick McBreen, an independent financial adviser with Worldwide Financial Planning in Truro, Cornwall, says the commission clampdown included as part of the Financial Services Authority's Retail Distribution Review has failed to stop the practice. The new rules are due to be introduced in two years' time – from 2012 – which, some critics say, gives plenty of time for commission-hungry advisers to boost their profits before they are forced to comply with the rules.

"The FSA said it would be monitoring levels of commission-based sales in an attempt to prevent a fire sale rush to flog bonds and capture the 7 per cent upfront commissions before the door closed," says Breen. "How they planned to do that alongside all the other work that needed to be done is a mystery to me.

"In my opinion – and experience from listening to clients – the biggest problem lies with high-street bank advisers. The FSA's review will do nothing to address this and I suspect the banks will still be flogging inappropriate bonds to unwitting customers," he claims. "Some individual advisers may make hay while the sun shines and fill their boots now with commission and worry about the consequences later – or not at all," Breen warns. "It's not pretty, but in the harsh economic environment we're experiencing the rising costs of running a business have to be met somehow."

He is not a fan of investment bonds at all, and happily lists all the things he thinks are wrong with them. "Investment bonds offered by life companies are not tax-efficient for UK resident taxpayers; they are inflexible in terms of accessibility; they are expensive in terms of charges; they are very limited in their investment choice; and they are riddled with mirror fund nonsense," says Breen.

"Many of these bonds are with-profits, or – as I refer to them – without-profits," he says. "These bonds benefit only one party: the life company which issues them."

Do investment bonds warrant such scathing comments?

In themselves they appear to be just another investment product. They are sold by life insurance companies including big names such as Prudential and Aviva. They are generally aimed at producing long-term growth for investors' money by investing in a variety of funds managed by professional investment managers. They can also be used to generate an income, which can make them seem attractive to older investors keen to boost their retirement income.

So what are their drawbacks? In one word, it's charges. There's not only the high commission – which is effectively paid out of investors' money – but charges which are not easy to understand. Some bonds, for instance, have an initial charge of something like 5 per cent, and then have an annual management charge of 1 per cent or more on top. Meanwhile other bonds have no initial charge, but a much higher annual charge. It means it's difficult to make comparisons between different bonds.

There are also hefty early withdrawal penalties with most bonds, which means losing a fair chunk of your money if you cash in your bond during the first five years. It means the bonds can be very inflexible.

Why do insurance companies sell them?

"Investment bonds are really just a tax wrapper round an investment," says Richard Kelsall, head of investment marketing at Aviva. "They are typically aimed at risk-adverse customers who are looking for investments that have a guaranteed certain level of protection."

Aviva has around 750,000 people invested in its Portfolio Bond. "We have more than 200 different funds that people can invest in through the bond," explains Kelsall. He says that people can choose the level of risk and return they get by picking different funds and can even move money from fund to fund, although there is an extra charge if you do so.

Kelsall rejects claims that advisers are pushing the bonds on people to earn high commission. "I don't belief there are any financial advisers out there trying to boost their commission by selling what may be the wrong products," he says. "In fact we've cut the commission on our bond from 5-6 per cent a couple of years ago to just 3.5 per cent initial commission and 0.5 per cent annually."

Patrick Connolly of the independent financial adviser AWD Chase de Vere also thinks the mis-selling of investment bonds is disappearing as commission rates fall. "Investment bonds have been oversold in the past," he says. "This was largely because they paid higher levels of commission to financial advisers than they could get from alternative types of investment.

"It has not been unusual for investment bonds to pay an initial commission of 7 per cent, 8 per cent or even up to 9 per cent of the initial investment amount. It meant if somebody invested £100,000 into a bond, their financial adviser could pocket between £5,500 and £9,000 of commission, so you could see the attraction.

"But thankfully those days are largely behind us, and independent financial advisers in particular will rarely take the full initial commission available when selling an investment bond," he claims.

Philippa Gee is not convinced. "I think the FSA's Retail Distribution Review is putting extra pressure on certain financial advisers to get as much income in now ahead of the move to fees," she says. "If this is the case, the new rules are going to be a major shock to certain advisers. Having said that, there are already plenty of independent financial advisers who, though still working on commission, want to do better for their clients and are happy to take a lower level of commission."

Connolly concedes that most people are better off investing in collective investments rather than investment bonds. "That's particularly true if they are using ISA wrappers and then beyond that, their annual capital gains tax allowance of £10,100.

"However there is still a case for using investment bonds in some situations," he says. "For example those who already use their annual capital gains tax allowance, higher rate taxpayers looking to defer income tax, people who have age allowance concerns and in some inheritance tax planning where trusts are used."

James Sumpter, senior financial planner at Bestinvest, is more cautious about the bonds. "If you have used your ISA allowance and annual capital gains tax exemption in full each year, than investment bonds can be a useful planning tool for those investors seeking a regular fixed income from a balanced portfolio," he says. "However, as with any investment, investors should consider the investment choices available within the bond, as many onshore bonds will only allow access to a limited range of funds. Wider choice is normally available in offshore bonds, but these tend to be more expensive."

He warns about bonds which offer a 5 per cent yearly withdrawal for income seekers. "Care needs to be taken as the withdrawal only defers a tax liability – it does not avoid one."

Nick Breen's warning is put in stronger terms. "UK resident taxpayers who want to invest in equity markets need life assurance bonds like they need a hole in the head!" he says. "Collective investments held in a tax-efficient platform and with advice from a fee-based independent financial adviser are the logical place for the first £200,000 or so of someone's investment," he suggests.

"That figure is to make sure that people make the most of their capital gains tax annual allowance, which is currently £10,200 per person or £20,400 for a couple, by withdrawing if required up to 5 per cent a year from their capital," says Breen. "Above that they should be considering offshore portfolio bonds, not life company bonds, and structuring their investments with an eye on inheritance tax mitigation, retirement planning, and future care cost liabilities."

If you have an investment bond or have been recommended one by an adviser, what should you do? "If you are concerned about an arrangement you already have, get a second opinion," advises Philippa Gee. "Have it looked at by a fee-based adviser so you are getting complete impartiality.

"If you are in the process of considering an investment bond, tread extremely carefully," she cautions. "You may have been recommended it for absolutely the right reasons, but to ensure this is the case, ask to work on fees with zero commission (up front or ongoing) so that any bias is removed."

If you are unhappy about the advice you have received from an adviser or think you may have been mis-sold a product, you can take your complaint to the Financial Ombudsman Service by calling 0300 123 9 123 (8am to 6pm, Monday to Friday) or by emailing complaint.info@financial-ombudsman.org.uk.

Adviser's advice

'7% commission? That's really outrageous'

When the independent financial adviser Philippa Gee, right, set up her wealth management business in Church Stretton, Shropshire, last month, she discovered that a large number of investors had been recommended an investment bond by other advisers.

"I couldn't believe it," she says. "I really thought this type of bad advice had gone out with the ark."

The worst example was a woman (who doesn't want to be named in this article) who turned to Gee to find out what she thought of advice given by another adviser.

"She had heard I had just opened up again as a local IFA and wanted a second opinion," Gee explains. "She had £125,000 to invest, was a non-taxpayer and wanted access to all the capital in 10 years' time. She had been recommended to put all the money into one investment bond. That's not good advice, in my opinion. I found out that the adviser was taking 7 per cent commission, which is really outrageous. I'm sure that the adviser wouldn't have recommended all the cash was put into National Savings' Investment Bonds because it pays no commission."

Gee says that for most clients the best option is to have a range of different investments that will suit their risk tolerance and be appropriate for their tax status. A range of mutual funds could be a better option, for instance, she says.

"I also think it's important to let people see clearly what the costs are and what their adviser has been paid for the job. Clarity and transparency are essential, then people can make an informed decision," says Gee.