Back in the 1980s, if a retail investor wanted access to the universe of funds available, they could have found themselves forced into a unit trust wrapper.
The fund range that was accessible through a bond issued by a life company during the times that Margaret Thatcher presided over the country was generally very restrictive.
Investors would have had a with-profits fund, a managed fund, a gilt fixed-interest fund, a European or UK equity fund, a property fund and little else, if anything.
Investors wanting a wider array of assets and fund choice, would have looked to unit trusts as the best option.
Fast-forward 10 years to the early 1990s with John Major as Prime Minister and investors were starting to sit up and take notice of multi-manager funds which were becoming available through investment bonds.
Life companies rose to the challenge to provide investors with more choice and bonds started to offer a wider range of insurers’ internal funds – from typically around four funds to choose from, retail investors suddenly had 20 to consider.
Bring forward the clock to today and multi-manager propositions are everywhere.
The lack of fund choice accepted by investors in the 1980s is no longer acceptable at a time when Tony Blair has bowed out and Gordon Brown has stepped into power.
As a result, although mutual fund platforms offer more funds, the fact is that the top 100 or so retail funds take the lion’s share of the new business because they meet the needs of the vast majority of customers. Many life companies now provide these top 100 or so, and some offer many more than that.
Product choice is no longer driven by specific fund availability.
Sterling’s bond offers access to more than 170 funds from over 30 fund management groups – retail investors can now select multi-asset class offerings, CPPI, or even derivative-backed funds through the vehicle.
As well as offering a choice of funds, allowing advisers to create bespoke portfolios, free switching is offered by the leading providers to keep these portfolios fresh and to deal with changing attitudes to risk over time.
Conversely, switches in a unit trust or Oeic normally carry cost and, in any event, are a disposal for capital gains tax.
So, in terms of fund choice, unit trusts and Oeics no longer have this edge over bonds. As it is a level playing field when it comes to fund choice, the clear differentiator between unit trusts and bonds is the way that they are taxed.
As a result, while advisers must never allow the tax tail to wag the investment dog, they must think very carefully about the impact of the wrapper choice on a client’s tax position.
As unit-linked investment bonds are offered by life insurance companies, they are classed by the Inland Revenue as nonqualifying life insurance policies. This classification brings with it a wealth of product flexibility.
One of the more obvious features is a requirement to add a standard death benefit to the product at no charge to the customer. This tends to be in the range of 100.1 per cent to 101 per cent of the value of the investment but some companies go further and also offer a return of the client’s initial investment, if greater.
This provides additional security for would-be beneficiaries, especially in the short term if market values have fallen.
A couple of providers also offer an accidental death benefit guarantee as standard which pays 110 per cent of the fund value. Enhanced death benefit options are sometimes available in addition to the free, standard ones.
By far one of the most interesting features of an investment bond is how it is taxed. The Inland Revenue allows the investor to withdraw up to 5 per cent of the original investment annually, with no immediate liability to income tax.
This rule is cumulative for up to 20 years. In other words, a client who invests £100,000 and takes no withdrawals for 20 years can, at that point, withdraw £100,000 from the bond with no immediate assessment to income tax.
This 5 per cent facility is particularly useful for higher-rate taxpayers and investors over the age of 65. Higher-rate taxpayers can make use of the 5 per cent withdrawal with no immediate liability to additional income tax.
Individuals over the age of 65 in receipt of additional age-related relief against their income tax can take the same 5 per cent withdrawals without being caught up in the age allowance trap.
This trap is where traditional forms of income, for example from unit trusts and Oeics, erodes their additional income tax allowances, reducing the additional allowance by £1 for every £2 of income, giving a marginal effective rate of 33 per cent income tax for those affected. Income from unit trusts and Oeics have a similar impact on a customer’s tax.
Many investors are attracted by this 5 per cent rule, which is not available when investing in unit trusts and Oeics. Apart from the 5 per cent rule, investment bonds are, from a tax perspective, non-income producing assets. They can therefore be of particular interest to trustees looking to accumulate without generating income that would otherwise be taxed at trustee rates, up to 40 per cent.
Research by IFA Promotion shows that the overall amount of inheritance tax payments totalled £3.5bn last year, including £1.5bn in avoidable payments.
In an age where a mounting number of people are paying inheritance tax, bonds have the edge over unit trusts as an estate planning tool as they are more simple for trustees to administer. Most life offices offer a full trust range without charge to the customer.
When investment bonds are encashed, the investor’s profits are taxed as income, rather than capital gains.
HM Revenue & Customs deems the investment to have paid 20 per cent tax at source to reflect tax paid by the life fund. This means that investors who are still basic-rate taxpayers after cashing in their investment have no further tax to pay.
However, like equity-based unit trusts and Oeics, those who do not pay tax are unable to reclaim tax paid at source.
Although life funds still benefit from indexation on gains, capital gains tax is also paid within the life fund and cannot be reclaimed by the investor.
But this is not to say that investment bonds enjoy better tax breaks than unit trusts and Oeics. The tax breaks are simply different and, in some cases, may make bonds less suitable for certain investors.
For example, bonds issue accumulation units, which are priced to include any income and capital gains received by the fund.
Some investors prefer to see, and in some cases receive, the actual income being generated on their investment and might therefore want to lean towards unit trusts or Oeics, as these distribute their natural income.
However, these investors could consider unit-linked bonds that offer distribution funds. These identify the natural income received on the fund’s underlying assets and have the ability to pay this as an income to the investor.
These types of funds therefore have many of the characteristics of a unit trust or Oeic but with the tax structure of a life insurance bond.
Bonds have evolved considerably over the course of the last two decades to the point that similarities with unit trusts and Oeics are less important than the tax differences, and this is where the adviser should focus.
What can investors and advisers expect for the future?
Manufacturers will become even easier to do business with as a result of the trend towards greater e-capability. E-enabled products can be placed on independent platforms, providing intermediaries and clients easy access to products from the whole of market.
Rather than changes to the shape of bonds, what advisers are more likely to see in the next few years is a move towards customer-agreed remu-neration as highlighted in the FSA’s review of retail distribution.
The regulator is looking to disaggregate charges for products from payment for advice and charges made by funds.
We welcome diversity of remuneration. The FSA’s RDR discussion paper highlights factory gate pricing and we will be launching such a structure at the end of July.
It is likely that more advisers will move towards a trail commission business model and will look to insurers to provide commission and charging structures that can make this journey easier.
Product providers will increasingly need to offer factory gate pricing with flexibility for IFAs to choose their remuneration method while giving customers a choice of how to pay for the advice that they receive.
We can expect the bond market to continue to flourish and change. Evolution will include further fund innovation, e-enablement and a rapid move to customer-agreed remuneration in some segments of the adviser marketplace.