Mrs Gates has been sold a portfolio of with-profits bonds worth around £100,000. She has asked for a review of the holdings as she is concerned about press reports that her money may not be earning the profits she expected. What should she be told?
Mrs Gates is right to be concerned as her portfolio contains some arrangements with life offices that are currently not applying bonuses to the funds. She is therefore in a dilemma.
Historically, the concept of bonuses higher than conventional building society rates, tax-free withdrawals, potential terminal bonuses and guaranteed year-one enhancements made with-profits bonds attractive. However, the decline in stockmarkets and the effect on life company reserves has had serious repercussions for investors.
Mrs Gates could encash the bonds and suffer market value reductions but this could result in penalties as high as 30 per cent of the value. Alternatively, she could keep the bonds to see if the companies' financial strength improves but this is unlikely in the short term.
It is a difficult decision and her choice will depend on her personal circumstances. Top priority is to establish whether or not income is required. Let us initially look at the concept that income is not required and consider material facts:
If the assets reflect a current value of £100,000, she will receive around £75,000 if the bonds are surrendered. To recover the position, growth of around 7 per cent will be needed in the coming four years. The client needs to be aware that this is unlikely to occur unless she adopts a risk profile with which she may be uncomfortable, bearing in mind the choice to invest in with-profits in the first place.
She needs to seek clarification from the life offices regarding whether or not the MVR will actually apply. In many cases, it depends on the date of investment and reduces on a sliding scale. She may be pleasantly surprised.
Reinvestment in hybrid arrangements is an option and several providers have designed arrangements to recoup some if not all of any penalty incurred. The net £75,000 can be enhanced by up to 122 per cent to provide a day-one value of £91,500.
Use may be made of 5 per cent tax-free withdrawals to release some capital free of penalty. Even if the income is not required, at least the money escapes without penalty. Caution is needed when using these rules, however. The 5 per cent allowance is cumulative, meaning that if an investment has been held for five years and the allowance has not been taken, 25 per cent could be extracted. But life companies have become wise to this and the MVR will be applied on any withdrawals above 5 per cent a year.
Mrs Gates could also hedge her bets by incurring the MVR on a partial surrender combined with the use of the withdrawal facility, leaving some of the money in case of recovery.
As with many investment portfolios these days, Mrs Gates should assess whether or not inheritance tax is an issue. If it is and income is not required, then assignment of the bond to grandchildren, for example, could be considered.
If the with-profits bond investment would comprise part of an estate over the inheritance tax threshold of £263,000, she may be best to suffer the penalty to make use of discounted gift or gift and loan schemes, anyway. Even a 30 per cent penalty is more attractive than 40 per cent tax.
The concept that 5 per cent income is needed throws a completely different light on matters and Mrs Gates needs to be made well aware that continuing to take – and spend – the income is likely to reduce her capital if the MVR factor does not improve.
If we take a simple mathematical calculation and assume that for five years withdrawals of 5 per cent are required, if the MVRs remain unchanged, the current £100,000 will only have a net value of around £52,000 at that point in time.
Reinvestment into conventional arrangements would mean that a return of 6.66 per cent would be required in order to preserve capital.
Reinvestment into hybrid plans is perhaps the most attractive alternative but in many cases the fund choice is limited and some exposure to equity-backed investment may have to be made. Additionally, the charging structure is higher than standard arrangements. All these factors may make this less than appealing to the client.
Action is needed to improve Mrs Gates' position and thoughtful planning is required to ensure that she gets back on track with her financial strategy. But all is not lost if remedial work is undertaken.