Aifa and the FSA have both urged caution over taking broad-brush approaches on the suitability of either product.
Many factors will determine what is best for any particular investor, so the role of the adviser will be vital in helping clients understand what the changes might mean for them.
The tax position and investment motives of every client are unique and this makes it difficult to provide any specific guidance in a short article. I have therefore focused purely on the impact of the tax changes and applied these against a number of typical investment scenarios. These serve as a useful backdrop to further, more detailed analysis of the investor’s circumstances.
What will change?
Let us first consider what the actual changes are.
For mutual funds which are potentially subject to CGT on the proceeds of any gains, CGT from April 6 will be charged at a flat rate of 18 per cent, irrespective of the individual’s personal tax position or for how long they have held the asset.
This replaces the old regime of a decreasing rate based on a combination of the client’s personal tax position on exit and how long the asset has been held.
So what has not changed? Essentially everything else. In particular, there has been no change to taxation of income where returns are subject to income tax rates.
What is the tax position on different classes of asset?
The following are guiding principles for the relative tax position of life bonds and mutual funds based on different asset types:
Assets producing primarily income, such as cash and fixed interest will be in a more advantageous tax position within life bonds compared with mutual funds.
For a higher-rate taxpayer income generated in a mutual fund is assessed as annual income declared through tax returns whereas within a life bond there is no such requirement. Not only is this easier for administration but it also allows for growth on the deferred tax until the bond is redeemed.
For higher-rate taxpayers, assets producing primarily growth in a mutual fund are now in a relatively better position.
However, for basic-rate taxpayers, the position will worsen on a relative basis, making life bonds a more sensible choice.
For clients redeeming assets within their annual CGT exemption, the position has not changed.
Growth and income assets
The majority of clients are likely to hold investments that generate both income and capital returns. Unfortunately, this is where the product comparison becomes more complicated.
As previously mentioned, there are many other factors that have an impact on the relative merits of mutual funds compared with life bonds. These include:
The tables published above on the next page show, in high-level terms, the investment vehicle that can potentially provide the higher net of tax return where a variety of asset mixes are held.
The tables use five example portfolios with varying splits between UK equities and fixed interest.
The tables are illustrative only. As mentioned above, the actual outcomes for individual clients will depend on a number of different factors.
For these examples, we have assumed a total gross return of 8.5 per cent for UK equities (3.5 per cent income and 5 per cent capital growth) and 6 per cent for UK fixed interest (1 per cent from capital appreciation).
For either product to be highlighted as more taxefficient, there must be a difference in the reduction in yield due to tax of at least 0.2 per cent a year.
The tables are intended to illustrate that:
What can we conclude?
There are many factors that influence the suitability of different investment products including tax treatment, charges, asset mix, features and flexibility.
The investor’s tax status when they redeem their investment is of particular relevance and while this is difficult to predict, the vast majority of investors over 60 are basic-rate taxpayers.
Based on this analysis, advisers can be confident that most of their clients who have life bonds are as well off as they would be with a mutual fund. Crucially, if a life bond was good advice initially – and the investor’s circumstances have not materially changed since – it is likely to remain so. A justifiable change of products is likely to be the exception rather than the rule.
For some higher-rate taxpayers there may be cause to consider whether a life bond is still the correct choice. Equally, there may be reason to consider whether a mutual fund remains appropriate. There is no one size fits all answer.
Only by considering the combined effect of all of the relevant factors can an appropriate investment solution be identified. In such instances the role of the adviser will be vital.