Bob Fraser

Introduction

My aim in writing this article is to raise awareness of a significant issue that investors need to taken into account when selecting their investment strategies, or when considering recommendations made to them.

All too often, I find that clients hold the great majority of their investments in the form of  onshore investment bonds. These tend to be in with profits, distribution, or managed funds or, in more recent cases, in a range of external unit trusts.

Reasons to hold Investment Bonds

It is true that investment bonds have attractive features for some investors and can be a useful addition to an overall portfolio for the following reasons:

• If the policy is an offshore investment bond, then it is possible to control when the tax liability arises since:

> there will be no tax charge unless and until a chargeable event occurs;

> by writing the bond on a joint or plural life basis, or under a capital redemption bond structure, there will be no automatic chargeable event on death;

> the bond can be assigned as a gift, which  is not a chargeable event; and

> the income is not immediately charged to tax.

• Again, if the policy is an offshore investment bond then any internal switch between asset classes or funds is not a disposal for capital gains tax purposes. This permits the underlying investments to be managed without immediate tax implications.
• 5% of the initial investment can be withdrawn annually (or this can be accumulated for later withdrawal) without an immediate tax liability.
• The fact that the policies are comprised of numerous segments means that partial encashments can be made at tax advantageous times, such as when the policy holder is a non-taxpayer or while non-resident for income tax purposes.
• The policy may be suitable as a trust investment for administrative ease as, generally, trust accounts will not be necessary.
• As life insurance policies are disregarded by local authorities for means testing, this may help shelter assets.

Tax Disadvantages with Investment Bonds

However, notwithstanding the above, investment bonds are generally not suitable, from a tax point of view, for most investors for the following reasons:

• The owner has little or no control over the asset allocation, meaning these policies cannot be properly integrated with an overall investment strategy. Many individuals are also unaware of the actual investment risk of the funds in which they are invested. Few people realise, for example, that a “cautious managed” fund can hold 60% in equities, while a “balanced managed” fund can hold 80% in equities. For many individuals, this level of equity exposure is excessive for their stated attitude to risk.
• The fund manager is obliged to set aside sums for the payment of capital gains tax (CGT) within the fund.  This is deducted from the returns whether or not the owner is personally liable to CGT, and is consequently a drag on the return. For onshore bonds, this deduction satisfies the requirement for basic rate of tax on any chargeable gains. However, this relates to income tax. As is discussed below, most individuals in the UK do not exploit their capital gains tax allowance (in fact many are unaware that this allowance even exists).
• Higher rate taxpayers are liable to an additional 20% income tax on onshore investment bonds on any chargeable gains after top-slicing.
• The underlying funds in offshore bonds are not subject to UK tax, and the policyholder will not, therefore, receive a credit for basic rate tax. Any gain arising from a chargeable event is thus taxable in full at the owner’s marginal rate, though subject to top-slicing.
• Higher rate taxpayers need to consider:

o If they are likely to be a higher rate tax payer for the rest of their life, the tax liability on their bonds will always exist. This will also apply on their death, unless this occurs so soon in the tax year that the amount that has been earned, together with the top sliced gain, is less than the higher rate band.

o The tax liability will increase year by year if the funds show positive growth in excess of the increase in the higher rate tax band.

o If the investment bonds are written on the life of the owner, they will automatically pay out on death. There are other arrangements that can be made to allow the bonds to be assigned to another on death, which may avoid the tax charge.

o Since income tax is still payable on death unlike capital gains tax, there could be a double taxation liability on the estate when inheritance tax is also considered.

• The initial commission charged on investment bonds can be as high as 8%.

Investment Disadvantages with Investment Bonds

Many investment bonds tend to have “managed” funds as their underlying investment. This is generally not true of unit trusts, where the individual or adviser tends to select a range of funds. However, all too often these funds are selected purely on the basis of past performance, with insufficient account of the basic investment principles of asset allocation, diversification, constant review, and annual re-balancing. Individuals who are committing sizeable sums to unit trusts really should consider making use of the skills of an expert investment manager to structure, and then maintain, a balanced portfolio based around an agreed attitude to risk. It should also go without saying that this should be on a fee basis, rather than commission.

Tax Advantages of Unit Trusts

For almost all individuals, including higher rate tax payers, the starting point for any investment is to consider a portfolio of unit trusts (or open-ended investment companies – OEICs – which are effectively the same thing). The reason is that these investments are chargeable to capital gains tax, not income tax. Very few individuals are aware that each person has an annual personal capital gains tax allowance of – currently - £9,200pa, and even fewer actually make use of this facility. In fact, this allowance is greater than the personal income tax allowance. Furthermore, taper relief applies to capital gains until April 2008, and this is in addition to the annual allowance. If the unit trust was held prior to April 1998, then indexation relief also applies. Assuming an annual growth rate of 8% pa, an investment of £115,000 would be needed to provide a capital gain of £9,200. This annual allowance can be used in one of 4 ways:

1. To skim off an amount of £7,000 to feed into a Maxi ISA, which is exempt from capital gains tax.

2. To provide a regular tax free income.

3. To allow the portfolio to be re-balanced back to the correct asset allocation.

4. To manage the portfolio by adjusting funds as required.

From April 2008, capital gains tax for individuals and trusts will be charged at a flat rate of 18%. This will make unit trusts a far more appropriate investment for higher rate tax payers than investment bonds. Although there may, just, be an argument in favour of investment bonds for basic rate tax payers on the grounds that their convenience and simplicity outweighs the 2% tax advantage (see above), I believe that this will only apply for clients who are already fully using their annual capital gains tax allowance. I would consider this to be a rare occurrence. It would also be essential to consider the question of charges. In my opinion, the additional charges associated with investment bonds would outweigh any argument in favour of simplicity, as shown by the analysis at the end of this article. There may, however, be a justification on the grounds of avoiding means testing of long term care costs, but there is then the risk of a challenge on the grounds of “intentional deprivation of assets”.

It should also be noted that trusts will also benefit from the reduced 18% rate on capital gains. Trustees should therefore bear in mind the same considerations for the most appropriate investments as discussed above for individuals. There are, however, some additional points to consider:

• The cost of administering a trust is usually cheaper where an investment bond is used to hold the investment since the need for annual tax returns and trust accounts may be avoided altogether. This may be an important point for low value trusts. 
• For interest in possession trusts, or where means tested benefits may be reduced if an entitlement to income arises, there may be advantages in the fact that an investment bond is a non-income-producing asset.
• If the trust includes the settlor’s spouse or civil partner as a potential beneficiary, there may be complications if the investments produce income, as would be the case with unit trusts. The reason is that the trust income (including reinvested income) and gains would be attributed to the settlor and, in the case of income, taxed at the settlor’s highest rate. Whilst this could be advantageous if the settlor’s personal allowance and annual exempt amount were otherwise unused, this may be unlikely. Under these circumstances, an investment bond might be a more suitable asset to hold in the trust.

Analysis: Portfolio Management – Unit Trust v Investment Bonds

As a synopsis of the analysis, the main points are:

• Using unit trust investments in investment bonds is much more expensive than using internal managed or distribution funds.
• The use of retail pricing because of commission charges adds to these charges.
• Directly held unit trusts are a more tax efficient and lower cost solution, particularly from April 08.

There are 4 scenarios that need to be considered: Unit Trusts, Investment Bonds, Unit Trusts held in On-Shore Investment Bonds, and Unit Trusts held in Off-Shore Bonds. These scenarios look at the charging structure for plans sold under the commission-based model since these are what are normally sold.

In examining these scenarios, the first key determinant is the differing Capital Gains Tax treatment of assets underlying bonds, unit trusts and unit trusts within investment bonds. For this purpose, I am going to consider four scenarios: "Distribution Funds", Equity Income Funds, Equity Growth Funds and Equity High Growth Funds that deliver a high level of growth. In addition, one needs to be aware that there are special anti-tax avoidance rules in respect of unit trusts held by insurance companies as they are obliged to "mark to market" these at least once a year to calculate and apply the Capital Gains Tax liability arising (subject to indexation for inflation relief and being able to spread the actual tax charge over 7 years but the latter point has limited benefit as it depends upon the attitude of the provider and because of low current interest rates). Furthermore, this "mark to market" approach causes additional complexity for fixed interest funds; qualifying fixed interest securities held directly by insurance companies are not liable to Capital Gains Tax but unit trusts investing in fixed interest securities could be, depending upon how capital values move as interest rates fluctuate but the actual impact of this is extremely complicated and depends upon the unit pricing and tax reserving strategy of the insurer and whether the benefits of "mark to market" losses and indexation are passed back to the specific policy holder or benefit the whole fund. As this is so complicated, and overall it will not have a large impact on the scenarios above, I have not considered it further.

The long-term middle return scenario from equity income fund, before charges, would be approximately 8.5% per annum, based upon a current yield of about 3.5% per annum net of basic rate tax, long-term inflation expectations of 2.5% per annum and expectation of dividend and Gross Domestic Product (GDP) growth of 2.5% per annum. If these assets are held directly by an insurance company, an insurer would be liable for 20% Capital Gains Tax on policyholder funds on the growth above indexation, i.e. 20% of 2.5% per annum, i.e., 0.5% per annum. As this is not immediately payable, for directly held, equity income investments, insurers may make a reserve, possibly at 18% slightly reducing the impact. For simplicity, I have assumed the full charge. If the equity income asset is held through a unit trust or mutual fund because of the "mark to market" approach, insurers would normally immediately apply the full 0.5% per annum charge.
If however, instead of investing in equity income funds, assets with a very low yield were used instead but with the same expected return, that is 8.5% per annum, then the post-indexation capital return would be 6% per annum and this would result in Capital Gains Tax charge of 1.2% per annum. In the event that assets were chosen for potentially higher risk but for higher returns, and say, 12.5% per annum was achieved and after indexation of 2.5% per annum, Capital Gains Tax of 2% per annum would be incurred.

"Distribution Funds" Assets

A distribution type fund traditionally would hold approximately 50% of the assets in equity income and 50% in fixed interest. If these assets were held directly by an insurance company for their distribution bond, the reduction in yield over 10 years would be between 1.1% and 1.3% per annum and the Capital Gains Tax drag on 50% of the assets would therefore work out at 0.25% per annum of the total, giving a total tax drag and charges of between 1.35% and 1.55% per annum.

If instead, two unit trusts were held directly by a client, one a fixed interest fund and one an equity fund, it is likely that the fixed interest fund would have an annual management charge of 1.25% per annum with other expenses of between 0.125% and 0.25% per annum and the equity fund would have an annual management charge of 1.5% per annum and the same additional charges. Thus the average Total Expense Ratio (TER) would be between 1.5% and 1.625% per annum. In addition, for a client of a commission charging adviser, there would be a charge to invest of approximately 4%, though this can be higher. Assuming this lower level, it can be seen that a distribution bond, in total, can be competitive with a unit trust. This does not ignore the potential for putting a unit trust in an ISA but it is assumed this investment has already being made. In addition, the distribution bond would have tax deferral advantages for higher rate income taxpayers on top of its total lower cost.

Continuing this distribution fund scenario, the next possibility is to place these two unit trusts inside an on-shore investment bond. However, in this circumstance, based upon the charges of the Fidelity Standard Life Bond and the Cofunds Legal and General Bond, the combined tax and annual charges will be between 2.55% and 2.7% per annum. That is double the price of an ordinary distribution bond and much more expensive than the directly held unit trust average T.E.R. The unit trust initial charge would be made up in less than five years. The only potential that this structure has of beating a distribution bond is if the equity portion of the fund performs particularly well which in turn would increase CGT as well. However, the same argument could be made for the direct unit trust and most investors wishing to purchase a distribution fund are towards the bottom end of the risk profile and would not want to hold a fund that was trying to aggressively out-perform.

In an off-shore bond, the charges could be expected to be higher than the on-shore bond as there will be no tax relief on expenses for the insurance company and the investor would not receive the credit for the basic rate income tax presume to have being paid on the equity income and would lose the benefit of taper relief and the personal Capital Gains Tax exemption compared to the directly held unit trusts.

Equity Income Assets

Moving on to directly held equity income funds, the annual management charge would be 1.5% per annum plus other expenses would be between 0.125% and 0.25% per annum giving a total expense ratio of between 1.625% and 1.75% per annum. There would be an initial charge of about 4% per annum.

If these pure equity income type assets were held within an insurance bond, there would be a reduction in yield of between 1.1% and 1.3% per annum and Capital Gains Tax drag of 0.5% per annum, giving a total cost charge of between 1.6% and 1.8% per annum. Thus, once more, equity income assets held directly through insurance bonds are competitive with unit trusts. The unit trusts generally still out-perform in the longer term through the better investment skills. However, if the equity income unit trust is held through an investment bond, the total charges and tax drag would be between 2.8% and 2.95% per annum. A classic example of the worst of both worlds. Even allowing for the initial charge on the directly held unit trust, the total of charges levied by the unit trust would be cheaper than the unit trust held through a bond, if it was held for more than 4 years and as these are medium to long-term investments, i.e. assumed to be 7 to 10 years, it is clearly better to invest in the unit trust.

Equity Growth Assets

I am now going to consider the equity growth scenario. Most of the calculations are very similar to the equity income scenario but because there is no income, which is treated similarly within unit trusts and bonds (except for Higher Rate Taxpayers) and the higher amount of capital growth, the CGT drag of the bond becomes much worse, rising from 0.5% to 1.2% per annum.
Thus, a bond holding direct equity growth assets would have a combined charge and tax drag of between 2.3% and 2.5% per annum, while the unit trust would have a total expense ratio of approximately 1.7% per annum and would make up its additional charge of 4% between 6 and 7 years while an investment bond investing into an equity growth unit trust would be looking at a combined charge and tax drag of the order of between 3.4% to 3.55% per annum which would mean a direct held unit trust would be cheaper after being held for less than 3 years.

High Return Growth Equity Assets

Finally, one should consider a high return equity portfolio which I am assuming has a 0% yield and generates 12.5% per annum growth. The CGT drag (after indexation for inflation) on directly held assets within an investment bond will be 2% per annum, and including charges will give a total drag of between 3.1% to 3.5% per annum. Compared to directly held unit trusts with a total expense ratio of 1.7% and an initial cost of 4% (if commission is charged), clients would break even in less than the 3 years and a bond investing in such unit trusts would have a total charge and tax drag of between 4.2% and 4.35% per annum.

Action Points

The changes to capital gains tax will need to be taken into account when existing investments are reviewed (this should be annually). Where these are held within an investment bond wrapper it is very likely that from the point of view of future growth a unit trust investment will be preferable.

However, no immediate action should be contemplated. The Government has not yet published draft legislation and the life insurance industry is lobbying fiercely on the adverse effect of the proposed changes for the life insurance investment market. In the light of this, it is always possible that there may be Government policy changes in the actual budget. Watch this space.

Article Added Thursday, 01 November 2007 | 9281 Hits

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