Why are Investment Bonds less popular?

Arthur Childs
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Why are Investment Bonds less popular than they were twenty to thirty years ago? Twenty years or more ago investment bonds were one of the main investment products recommended by independent financial advisers. 

In particular, With Profit Bonds and then Distribution Bonds were seen to provide many benefits to the more cautious investor.

 

Whilst many of these bonds are still in existence and have generally performed well, the advent of other products, particularly ISAs and the widespread use of online investment platforms has removed most of the perceived  advantages of investment bonds. They still have their uses but in more specific circumstances rather than a product that nearly every investor should have.

Table of contents

Income Tax

  • Income Tax – a major reason for using bonds was the ability to take monthly withdrawals of up to 5% pa which are not taxable in the hands of the bondholder.  This is because tax is deferred on the withdrawals until the bond is finally surrendered.  Investing instead in a collective investment such as a unit trust, or OEIC resulted in tax being paid on interest and dividend income.

 

  • However … the withdrawals from a bond have already suffered a tax charge within the fund and are effectively paid net of tax which HMRC deems to be equivalent to basic-rate tax.  Non-tax payers cannot reclaim this back.  The 5% withdrawals therefore only offer a tax benefit to higher-rate tax payers and only on a tax-deferred basis.

 

  • The widespread use of online wrap platforms has changed the argument in favour of using unit trusts etc.  Using an investment portfolio via a wrap platform makes it a simple matter to transfer money into a stocks and shares ISA account each year.  At the same time the annual ISA allowance is now much higher at £20,000.  This can create an increasing fund where the interest or dividend income does not need to be reported to HMRC and where there is therefore no requirement, even for higher rate tax payers, to pay tax on the income which they receive.

 

Withdrawing an ‘income’

  • Withdrawing an ‘income’ – An important aspect of the regular withdrawals from a bond has been the ability to set these at a level required by the bondholder.  Many investors like the idea of having a regular known ‘income’ especially one on which there was no obvious tax charge.  This feature has been a differentiator between bonds and many other investments.

 

  • However … the advent of wrap services enables investors to take ‘income’ by setting up regular withdrawals from the portfolio in a similar way to those taken from a bond.  Whereas the withdrawals from a bond are on a ‘tax deferred’ basis, those from an investment portfolio could be tax-free if below the annual CGT exemption currently £12,300 (2020-2021), or from an ISA.
  • Age-Related Allowance – those aged 65 or over had historically received an additional personal allowance referred to as an ‘age allowance’ which could be lost if the investor’s total income exceeded a certain level.  Withdrawals of no more than 5% a year from a bond did not count as ‘income’ for this purpose and so were beneficial for many retired clients.

 

  • However … The Government initially froze age-related allowances until there is now no additional allowance for those 65 and over, thus removing any benefit from holding a bond to avoid the loss of age allowance.   

Capital Gains Tax

  • Capital Gains Tax – funds held within a bond issued by a UK life assurance company pay the equivalent of 20% after indexation relief on capital gains.  There is no further tax to be paid unless the bondholder is, or becomes, a higher rate tax payer upon receipt of the bond proceeds.

 

  • However … investors in an investment portfolio now only pay 10% capital gains tax (20% if higher-rate tax payers), but this is only on gains over the annual CGT exempt amount, currently £12,300 (2022/23).

 

  • If we assume an average investment return of 4% a year net of charges, together with annual ‘washing-out’ of gains, an investor could have £300,000 invested in a portfolio before he or she would start to pay any capital gains tax.  This is preferable to tax being deducted at source on the whole amount under a bond.

Investment simplicity

  • Investment simplicity – many investors appreciated the simplicity of investing in a range of funds via a single bond rather than holding individual unit trusts, each with their own paperwork.

 

  • However … the last two decades has seen a huge shift in the investment advice propositions of financial planners towards the use of online wrap services.  Instead, therefore, of being restricted to the limited range of funds on offer from a typical life assurance company, moving to a wrap offers a far wider range of funds from an unrestricted number of investment houses yet at the same time keeps the paperwork to a minimum.

 

  • Wraps also allow the use of risk-rated, discretionary investment portfolios  which can be regularly rebalanced to stop the portfolio from moving away from the required level of risk.

Free fund switches

  • Free Fund Switches – many bond providers allow free fund switches, which was an advantage over many other investment forms at the time when every switch of a unit trust would involve a selling and buying cost.  Furthermore, such switches did not generate an additional tax liability.

 

  • However … through the use of online platforms, switches between funds can now be carried out easily and without selling and buying costs. 

 

  • Although switches within an investment portfolio can involve a capital gains tax liability, by automatically rebalancing the portfolio at regular intervals small capital gains are regularly removed from the portfolio within the annual CGT exempt amount.

Death of the bondholder

  • Death of the bondholder – bonds include a death benefit that is typically 1% on top of the surrender value of the bond at the date of death.  The death benefit is paid out on the death of the life assured, which may not be the bondholder.

 

  • However … the death benefit is not significant.  Furthermore, on the death of an investor with an investment portfolio, the capital gains that have arisen to that date disappear as CGT is not chargeable on death.  The investor’s beneficiaries will inherit the investment portfolio with a new base cost equal to the market value of the portfolio at the date of death.

With Profit Bonds

  • With Profit Bonds – were an extremely useful investment tool for investors wanting a lower risk investment as they were designed to ‘smooth out’ volatility of stockmarket linked returns by a process of annual bonuses.  On surrender the bondholder could also expect to receive a terminal bonus to reflect investment returns over the period the bond had been held which were in excess of the annual bonuses actually paid.

 

  • However … investors in With Profit Bonds over the last two decades will generally have been disappointed with returns.  Even where returns have been more acceptable, there has been a move to increase terminal bonuses at the expense of guaranteed (once added to the bond) annual bonuses.  Terminal bonuses can be removed without notice and this move has increased the risk of this type of investment.  Bondholders also suffered many years of market value reductions (MVR) being applied.

 

 

 

 

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.