Funds to tempt the cautious

By DAILY MAIL REPORTER
Updated:

 

WITH-PROFITS funds are losing their shine as insurers have slashed this year's annual bonuses and the City watchdog, the Financial Services Authority, is investigating how they are run.

The funds are supposedly low-risk because they hold back some profits made in periods of prosperity so they can be doled out in harder times, a process called 'smoothing'. But it doesn't seem to have been so successful in today's stock market slump. This year, for example, Royal & SunAlliance with-profits policyholders received only half of last year's bonus.

So are there any alternatives for the cautious investor? One option is distribution funds, so called because they aim to provide a growing income over time and some capital growth. Like withprofits funds, they invest in shares and bonds - an IOU issued by governments or firms that pay an annual income - and sometimes property.

But their value fluctuates daily in line with market conditions, so investors see exactly the ups and downs in the value of their investment at any one time.

In contrast, with-profits funds invest more in shares because they don't have to provide a large income.

Smoothing is supposed to ensure an investment always goes up and never falls in value, so long as it is not encashed early. However, because insurers can be secretive about how it is done, it's hard to work out the actual worth of your money.

There are two ways to hold a distribution fund, either within an insurance policy (usually called an insurance bond) or as a unit trust (a pooled investment fund). The latter can be held in a tax-free Individual Savings Account (Isa).

The return from the insurance bond is paid net of basic-rate tax, so it's advantageous for higher-rate taxpayers who have to pay only 18% on top instead of 40% normally.

But you can't reclaim the basic-rate tax, so insurance bonds are unsuitable for nil or 10pc-rate taxpayers. You can also take 5% of your original investment in the bond every year tax-free or roll up this allowance and use it when you surrender the bond.

After that is depleted, further gains are subject to income tax only, so higher-rate taxpayers can essentially defer paying tax until they are retired and possibly basic-rate taxpayers.

Distribution bonds favoured by Patrick Connolly, of independent financial adviser Chartwell, are from Axa Sun Life and Clerical Medical. Both have unit trust alternatives, while Jupiter has just launched a distribution fund. This has 65% invested in bonds and 35% in shares and pays 5% gross annually.

At IFA Hargreaves Lansdown, Gordon Richardson includes Liverpool Victoria on the with-profits list and recommends only the Axa distribution fund.

Performance varies between companies, but whether the investment is an insurance bond or unit trust seems to make little difference over the longer term.

Figures from Standard & Poor's show that over the past five years, the average distribution unit trust has turned every £1,000 saved into £1,279 while the average distribution bond made £1,280.

Returns from distribution funds are always broadly similar to with profits, says Mr Connolly. But distribution funds have recently held up better than pure shares funds and are therefore coming back into favour with investors, he says.

• MICHAEL McMINN, 66, pictured with wife Christine, 58, and their dog Purdey, invested several thousand pounds in the Axa Sun Life Distribution bond in January 1993.

Since then he has seen 40% growth in the original value, as well as an average 5% a year income, he says.

As a former bank manager (and higher-rate taxpayer), it made sense for Michael to hold his investment as an insurance bond because of the tax advantages.

Michael, who lives near Durham, says:'Cash deposits are becoming almost worthless and everything else seems to be falling in value. I am really impressed to get this kind of return.'

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