Life Assurance Bonds

The technical title for life assurance bonds is single premium whole of life assurance policies. They are lump sum investment vehicles. The life assurance element is minimal (101% of the unit value or less i.e. a return of the value of the policy plus up to 1% extra), but it does give the policies the right to benefit from life assurance policy taxation. These policies cannot benefit from the additional tax benefits of a qualifying life assurance policy as they are set up on a single premium basis and do not qualify. Nonetheless, they benefit from an advantageous tax regime, and one that was recently under consideration for removal on the grounds that it is too good.

As a life assurance investment, corporation tax at the life assurance company's rate of up to 20% will have been paid from within the life office's funds. Basic rate taxpayers have no further tax to pay and, even where there is a tax charge for higher rate tax payers, it will only be at a maximum of the difference between 20% and higher rates of tax (40% – 20% = 20%).

Investors are allowed to encash as much as they want on a one-off or regular basis providing this is allowed for by the rules of the rules of the plan. Withdrawals of less than 5% overall for each year the policy has been held may be withdrawn without immediate tax consequences, but the withdrawals are taken into account on final encashment (tax deferred). The allowance is cumulative and any unused allowance can he carried forward. As such, the allowance is often described as the '5% tax deferred cumulative allowance'.

Chargeable events
There are a number of circumstances that could give rise to a tax charge. These are called chargeable events and include:

• Death, resulting in the policy paying out benefits. Assignment for money or money's worth*.
• Maturity (some bonds are time limited).
• Partial surrender above the 5% cumulative allowance.
• Surrender.

*Assignment between two individuals that is not for money or money's worth is not a chargeable event.
Where a chargeable event occurs it is necessary to calculate the chargeable gain and, if there is one, to then calculate whether a tax charge will apply. Any gain is subject to income tax at the higher rate less 20%, but only if the policyholder is already a higher rate taxpayer or the gain takes them into the higher rate tax bracket.

Types of life assurance bond
We have briefly examined the tax treatment of life assurance bonds. This tax treatment applies to a number of variations of this type of investment, including the following:

• Guaranteed income bonds.
• Guaranteed growth bonds.
• Distribution bonds.
• Stock market linked income and growth bonds.

Let us now consider these types.

Guaranteed income and growth bonds
These can only be issued by life assurance companies and may take the form of a single premium endowment. The tax treatment is the same as for non-qualifying life assurance policies.

Guaranteed income bonds
These are single premium non-qualifying policies providing a guaranteed 'income' each year for a specified term arid then on maturity returning the original capital invested. Some companies may offer the facility to roll the investments into an additional term at maturity.

Guaranteed growth bonds
These bonds are similar to guaranteed income bonds:

• However, there is no 'income' and all interest payments are rolled up to increase the capital returned at the end of the term.
• The bonds grow at a fixed rate of interest determined at the outset.
• Bonds are issued for fixed terms, such as three or five years (some may allow investors to roll the investments into an additional term at maturity).
• The growth rate depends on prevailing interest rates at the time of issue.
• The investor receives a guaranteed return, which is free from basic rate income tax and Capital Gains Tax (CGT).

The actual underlying structures of both types of plan can be complex and may include annuities and offshore products. These products are treated the same way as life assurance bonds and as such share the same tax treatment and system of investor compensation.
As structured products, it is not possible to simply encash them at any time and get the full value of the capital. The schemes are designed to run for the full original term of investment, but most policies will give an encashment value part way through the term of the policy if required. There will be penalties and in some cases these can be quite significant. The 'small print' of the product should in each case detail the level of penalty on early encashment and it is important to read this and make the client aware of the potential costs of stopping a scheme of this type before the normal maturity date.

Distribution bonds
Life assurance bonds do not produce income in the true sense of the word. It is possible to provide a steady stream of capital by regular encashments which may seem like income, but is not and there are dangers in treating it as such.
Withdrawals of 5% per annum from a life assurance bond that is riot growing at 5% per annum in terms of income and growth combined will lead to erosion of capital. Once this starts, it can gather pace as the 5% withdrawals are couched in original investment terms and once the capital value is less than the money invested, the withdrawals will amount to more than 5% of the capital remaining.
The problem is that the unit-linked structure of a life assurance bond does not lend itself to the production of a 'natural' income. The distribution bond was created as a product by life assurance companies to get around this.
The distribution bond typically contains two different types of unit, the normal investment-based type and a separate type with an underlying cash investment strategy:

• Income is received from the underlying investments of the normal units in the form of:

1. dividends;
2. interest (savings income);
3. rent.

• This money is placed into the cash units.
• These units are encashed periodically, usually half-yearly (hut some monthly) to provide natural 'income' for the investor.
• Unlike the regular capital withdrawal method, the underlying investment remains undisturbed and is not eroded by 'income' payments.
• Please note that, as the underlying value of the investment can fluctuate it is possible, even with a distribution bond, for the value of the investment to fall.

In order to maintain capital values and provide a steady stream of 'income', distribution bonds often take a lower risk approach to investment, investing in gilts, corporate bonds and high income shares.
Care must be taken as distributions in excess of the 5% cumulative allowance will create a chargeable event.

Stock market linked income and growth bonds
These are commonly called guaranteed equity bonds:

• They aim to provide capital growth linked to a stock exchange index with a minimum return of the original capital invested.
• In essence, a proportion (say 95%) of the investment is used to provide the guarantee and is invested in low risk assets.
• The remainder is invested in derivatives, such as options and futures.
• The return on the investment is dependent on the success of the derivatives.
• Care is necessary when reading the small print as the terms of the guarantee may be complex.

The investments may or may not provide a level of income payable on a regular basis. Where income is paid, this is generally removed from the repayment of the original capital that is paid out on the maturity of the bond.

For more information, please contact us.