Investment principles and risk

Our audiovisual presentation provides an introduction to deri...

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...nvestment products, including life insurance based investments.

Life assurance investment products

Life assurance products mainly fall into two categories - those which only have a protection element such as a term assurance and those which have both a protection and an investment element such as a whole of life policy or an endowment.

Certain pro...

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...aps 101% of the premiums paid, carry little risk in the event of death. Therefore, either the premiums will be lower or more of the policy premiums will be applied for investment purposes.

Into which two broad categories can life assurance products be divided?

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Life assurance investment bonds – Part 1

Insurance bonds are a type of collective investment scheme that are categorised as single premium, non-qualifying life assurance policies. The term 'insurance bond' is not really indicative of their use, however, as they are primarily investment vehicles.

The is a wide variety of bonds available on the market nowadays, each attempting to serve a slightly different purpose in terms of capital and income needs whilst accommodating the investor’s views on risk, tax status and desire to access funds.

If the bond has no specific term, it should usually be viewed as a medium to longer term investment of at lea...

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...ity of a fund value will also be affected by any charges that may apply to the fund on encashment (and for structured bonds that provide an underlying guarantee if the investment is held over a period of time). For certain types of fund such as with-profits or property, these penalties may be considerable and leave the investor with less than they originally paid into the plan.

Access

Accessibility to funds will not usually be a problem but withdrawals could result in an early surrender penalty being applied if the investment has only been held for a short term.

What is the definition of a life assurance investment bond?

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Life assurance investment bonds – Part 2

Taxation of life assurance funds

The taxation of life assurance companies is extremely complicated, but the basic principles are relatively simple in relation to policyholders’ funds:

Savings income (e.g. interest from gilts, cash, bonds) is taxed at 20%

Dividends are exempt from tax whether from UK or overseas companies

Non savings income such as rent is taxed at 20%

Any capital gains on gilts and corporate bonds are free of CGT

Capital gains on other assets are subject to tax at 20%. The life fund does not have an annual exempt amount, but can use indexation (although this is capped to 31 December 2017) to reduce the capital gain

The expenses of an insurance company can be offset against its unfranked investment income.

Taxation of the investor

There are a number of circumstances where a tax charge could arise as a result of a “chargeable event” taking place. These are:

Death resulting in payment of policy proceeds

Assignment for money or money’s worth

Maturity (if a fixed term)

Partial surrender above the 5% cumulative allowance

Full surrender

Where such an event takes place, any resulting gain must be c...

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...o the top-slice. 

NB

An individual’s personal allowance (but no other relief or allowance such as the PSA) is to be calculated as though the gain from the chargeable event is limited to the top-slice in tax year 2019/20 and later years (not on gains that occurred before 11 March 2020). 

By cashing a bond when other income is low (e.g. after retirement) it might be possible to reduce or eliminate the  tax liability. In addition if the bond is issued as a series of clusters, full policies can be cashed in separate tax years, which should further reduce the chance of a tax liability.

Many investors hold on to these bonds until death. The tax liability may then be reduced because total income in the year of death will be less than usual. This is especially true if the investor dies early in the tax year.

With jointly owned bonds, the gain is split in the same proportion as ownership, regardless of who the money is paid to, so that each owner is taxable on their share of the gain. If the joint owners are married, or in a civil partnership, HMRC considers each should be taxed on 50% of the gain.

What relief is available to taxpayers on a chargeable gain?

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Life assurance investment bonds – Part 3

Independent taxation

There are a number of ways in which independent taxation can be used to reduce the tax liability on gains on bonds:

If an investor is a higher rate or additional rate taxpayer but the spouse is not, the bond could be assigned to the spouse before a surrender is made

The assignment is not a chargeable event and is free of CGT and IHT (assuming the spouse is UK domiciled)

A tax saving of 20% or 25% of the gain can therefore be made.

Married Couple’s Allowance (MCA)

This can be claimed by a couple if at least one of them was born before 6 April 1935. When a chargeable gain is added to their income they may find that they lose some of the allowance. The total gain on a final encashment is treated as income and they will not be able to use top-slicing. This means that the MCA will be restricted, but not below the minimum level (£4,010 in 2023/24).

Universal Credit/Child Tax Credit and Child Benefit

Child Tax Credit (CTC) is a State benefit paid directly to the main carer, but is reduced according to the joint income of the claimants.  For most people this has been replaced by Universal Credit. 

In addition, if someone has adjusted net income of more than £50,000 and claims Child Benefit, a tax charge will be levied. 

When determining adjusted net income for Universal Credit  and Child Benefit purposes, a chargeable gain is included in the taxpayer’s income without top-slicing, so that:

Any withdrawals in excess of the 5% cumulative allowance is treated as income

The total ga...

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...drawals

2,400

12,800

Less original investment plus previous chargeable gains

10.400

Chargeable gain

2,400

On final encashment, the chargeable gain using segmented surrender is higher but the total gains are the same for each method (£2,800). Deferring gains to final encashment this way can be beneficial for a higher rate taxpayer especially where they can encash the investment at a time when they are a basic rate taxpayer.

The example above compares a single bond with a segmented policy. The total gains over the lifetime of the policy are the same, however, segmentation is preferable for the following reasons:

Most investors prefer gains to occur later rather than sooner, e.g. final encashment after retirement when the tax rate may be lower. Segmentation will always effectively defer gains

There is a cash-flow effect of deferring gains, and therefore tax, for as long as possible – tax deferred is tax saved

Although total gains are the same in each case, the greater top-slicing relief given by segmentation can lead to less tax being paid if the investor is on the borders of higher rate tax. This will be especially true if frequent withdrawals are taken

If the bond is held until death, the deferring of much of the gain until then will be beneficial in that the investor’s tax rate in the year of death is often lower than normal, especially on death early in the tax year. Also, any income tax liability reduces the estate for inheritance tax purposes

At what rate is additional tax payable on a chargeable gain for a higher rate taxpayer?

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Life assurance investment bonds - Part 4

Types of investment bonds

Investment bonds are frequently used for lump sum investments.

An investment bond is a single premium life assurance policy

Most bonds are written as whole of life policies, with no specific maturity date and no obligation to pay any more contributions for the duration of the plan

Investment bonds are structured primarily as investments and provide only nominal life cover, which is typically just in excess of the value of the fund on death (i.e. 101% of the value of the units)

They can be written on a single life or joint life basis, and it may be possible for trustees to effect a policy on the lives of beneficiaries

When an investment is made, the premium is used to purchase units in funds of the investor’s choice at the offer price. When an investor wishes to cash in a bond, or make withdrawals from it, the units are surrendered at their bid price. The price of the units therefore has to rise above the initial bid-offer spread before any gain is made, although the unit price will vary according to the market value of the underlying investments. The bid-offer spread is usually around 5% of the offer price

In addition to the initial bid-offer spread, the fund is subject to an annual management charge, which is typically 1% of the value of the units, and this is allowed for in the published unit price of the units

Some investment bonds have a single pricing system with the same price applying to both purchases and sales. This means that there is no explicit initial charge, and the manager can only extract their costs through the annual management charge. In this situation an exit charge is likely to be applied on surrenders within the first five years

The main types of lump sum life assurance bonds are:

Guaranteed income bonds

High income bonds

Guaranteed growth bonds

Unit-linked bonds

Guaranteed/protected equity funds

With-profit bonds

Distribution bonds

Guaranteed income bonds

These bonds produce a specified guaranteed income each year for a specified term. The income is usually paid annually in arrears and terms typically run from two to five years. At maturit...

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...arantee is usually achieved by a fixed term deposit or zero coupon bond, with the exposure to the growth in the stock market index being provided by some form of option (often an OTC option) purchased by the life office.

Protected equity bonds

Protected equity bonds allow investors to select a quarterly guaranteed level of protection. This is typically between 95% and 100% of the capital at the start of the quarter, though the actual level of protection varies between providers. The bond will be protected against falls in excess of this selected level of guarantee, regardless of the performance of the index to which it is linked.

The greater the level of protection, the slower the bond’s value will rise if the underlying index rises.

These investments are worthwhile for those who like the idea of an equity-linked product but do not want to risk losing money.

If only the original capital is returned, the investment will be subject to inflation risk

Guaranteed equity bonds need to be held for their full term to benefit from the guarantee of capital protection and are not suitable as short-term investments

Protected equity bonds with a 95% quarterly rolling guarantee can still produce a loss of nearly 20% over a one-year period, ignoring any initial bid-offer spread (5% each quarter x 4)

The indices chosen follow the price of leading shares. They usually make no allowance for dividend income, which can be an appreciable part of normal unit-linked fund growth

All guarantees involve costs. In general terms, the better the guarantee, the lower the ultimate return will be when compared with a non-guaranteed equity bond (particularly if stock market performance over the period is good)

Assuming that they are held to maturity, they are relatively low risk but if surrendered early, the investor may receive a value below their investment due to the fact that the underlying structure of investments may be complex and difficult to liquidate.

A bond provides a fixed income of 4.5% per annum for five years and a full capital return at maturity at the end of five years. What type of investment bond is this likely to be?

Answer : Purchase course for answer

Life assurance investment bonds – Part 5

Personal portfolio bonds

On a normal unit-linked bond, investors pay cash to the life office that is then invested in the selected funds. Alternatively, they may have used a share exchange scheme to sell the shares and purchase a bond with the proceeds.

Some investors may have a portfolio of shares that they would like to keep and manage themselves, or they might prefer the stocks to be managed by their existing stockbroker rather than the life office. Historically, a few UK offices allowed this to be done by creating a personal bond, which in reality is the investor’s own portfolio wrapped up within a bond. Nowadays only offshore offices provide this facility to non-residents, as it is hopelessly tax-inefficient for UK residents.

HMRC had long disliked personalised bonds and acted against them in the Finance Act 1998 by imposing a penal tax on a deemed gain.

The deemed gain is 15% of the total premiums paid at the end of a policy year plus the total deemed gains from previous years (minus any chargeable withdrawals). The effect of this is to tax the policyholder as if the investment was yielding 15%, regardless of any actual growth

In addition, the deemed gain is on top of the normal ...

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...xtend the term.

The 25% tax charge referred to above can be avoided if the beneficiaries are non-taxpayers or basic rate taxpayers. This can be done by arranging for the trustees to retire and be replaced by foreign trustees (e.g. in the Channel Islands or Isle of Man) before the chargeable event. The beneficiaries would then be liable at their personal rates and there would be no tax if their incomes were low enough to avoid the chargeable gain putting them in the higher rate tax band. However, top-slicing cannot be used for this purpose.

Alternatively, the trustees could assign the policy to a beneficiary, free of the trust, before a chargeable event occurred. The policy could then be cashed in by the ex-beneficiary (now the full owner) and tax would be chargeable on them, rather than on the settlor or the trustees. If the beneficiary was well below the higher rate tax threshold, this could eliminate any tax liability on a UK policy. They would also benefit from full top-slicing relief, which would not be allowed if the policy was in trust and the gain was made by foreign trustees but taxable on the beneficiary under the above rules.

Why can investment bonds be attractive investments for trustees?

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Offshore bonds are generally issued by subsidiaries of well-known UK life offices in jurisdictions such as Luxembourg, the Channel Islands or the Isle of Man. Although onshore and offshore bonds are structured in similar ways, the tax treatment of the two types of bond is different.

The perceived advantage of these bonds is that the country concerned imposes little or no tax on the income and gains of the underlying life fund, thus allowing what is often called a gross roll-up, which is valuable (particularly to a higher rate taxpayer). This contrasts with an onshore bond, where the fund suffers tax at up to 20% on income and on gains (although indexation allowance still applies up until December 2017). However, the effect of gross roll-up can be reduced by the fact that charges are often higher for offshore bonds than for their onshore competitors and some investment income may be received after the deduction of non-reclaimable withholding tax.

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...eived after deduction of non-reclaimable withholding tax which reduces the effect of gross roll-up. In addition, there is no credit for this in the chargeable gain, leading to possible double taxation

Charges on offshore bonds are generally higher than onshore bonds, which reduces the final net return

In an onshore fund, management expenses can be deducted from fund income for tax purposes. An offshore fund has no tax from which  management expenses can be deducted, again  reducing the effect of  gross roll-up

In theory, over the long term, the compounding effect of gross roll-up could make a difference to the eventual return, despite the higher tax on final encashment. However, this is generally only gained over the long term or where the fund is invested in interest-bearing assets.

What is the main difference between how top-slicing relief is applied to offshore bonds compared with their onshore counterparts?

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Life assurance bond investment options

The basic structure of these types of investment bond has already been discussed on the previous pages. We will therefore concentrate on the types of available investment funds that investors can select:

Managed funds - is a popular default fund for investors who do not necessarily wish to concentrate on any specific investment area due to perhaps a lack of investment expertise. It will typically combine investment in UK equities, fixed interest funds, cash and property. Managers will hold and alter specific weightings of each asset type to create the most favourable returns. The balance of investments held in these fund types would provide some exposure to capital risk but would (through appropriate diversification of assets) attempt not to expose the investor to any very high risk investments. This will usually be at the expense of unspectacular returns. The managed fund sector is sub-divided into four  sub-sectors with varying equity content:

Mixed Investment 0 – 35% Shares

Mixed Investment 20 – 60% Shares

Mixed Investment 40 – 85% Shares

Flexible Investment – up to 100% in shares if required

Cash funds - investing in money market cash-based securities. It will normally be used as a “safe h...

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... relatively low equity requirements mean that some high yield equity funds are not classed as distribution funds.

The money is invested in a special distribution fund which pays out the natural accrued income of the fund, i.e. dividends, interest or rental income, usually two or four times a year (though some offices can pay monthly)

Investors can take these payments as income, but there are no unit encashments and the number of units in the bond remains constant – although the payments look like income, they are legally capital

The unit price will fall in line with the pay out on each distribution date

The investment managers of the fund have to bear in mind the requirement for income in the way they manage the fund’s assets, which tend to be well spread with a high proportion of gilts and fixed interest securities to lessen the risk

These bonds should be regarded as a medium to long-term investment because many offices have early surrender penalties 

The taxation of distribution bonds is the same as for ordinary unit-linked bonds, i.e. the 5% cumulative allowance rules apply to the income distributions

How much can a fund that sits in the Managed Fund sector and Flexible Investment category invest in shares?

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In the past, with-profit policies have been the main investment products offered by insurance companies. They are available in both regular and single premium contracts, although in recent years the bulk of new investment has been in single premium bonds. Virtually all with-profit policies currently available are written on a unitised basis. The traditional with-profit contract, while still an important part of the traded endowment policy market, has all but disappeared in terms of new business.

With-profit funds

These funds can either be unitised and divided into a number of segments, or can be a single contract. In the latter case there may be less flexibility to make changes to the investment and fund switches may be restricted.

Instead of variations to the value of the fund (as would be the case with the unit linked funds already mentioned, to a greater or lesser extent), the capital invested in a number of units would receive a bonus when declared by the insurance company.

Bonuses, if declared, are added to the value of the policy annually. The bonuses are based on the company’s profits from its investments. In recent years bonus rates have been cut severely, sometimes to zero

The largest single investment area of with-profit funds used to be equities but in recent years there has been a move away from these for solvency reasons. Some closed funds are now almost entirely invested in fixed interest securities, property and cash, while open funds typically have less than half of the fund invested in equities

In the case of some companies, notably the handful of remaining mutuals where the owners of the company are the with-profit policyholders, the returns are also affected by the company’s profits from other insurance activities. These may include the issue of non-profit and unit-linked policies

The annual bonuses are generally set at a rate that the insurance company’s actuary believes represents the long-term returns from the funds. On the whole they reflect the income yields on investments in a smoothed, long-term fashion. However, financial pressures have limited the scope for companies to take a long-term view

Terminal bonuses are pa...

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...t securities with only a small proportion invested in equities, although the allocation to equities is primarily dependent on the financial strength of the insurer. This has the following consequences:

Funds with a relatively high weighting in fixed interest securities are not as likely to perform as well over the longer term as funds with a higher equity content

This will restrict the fund’s ability to pay future bonuses

Where a fund is paying no annual bonus the charges of the fund will eat into the policyholder’s investment

The position of policyholders in these funds is complicated and it is extremely difficult to generalise about what they should do. Each client’s circumstances are different and any decision needs to be made on an individual basis. Policyholders should consider the:

Financial strength of the insurer

Current asset allocation of the fund

Current bonus rate

Long-term performance of the fund

Current surrender value of the policy

Penalties for exiting the fund (if any) i.e. an MVR

Length of time until the end of the policy or an MVR-free encashment date

The problem for policyholders remaining in a closed with-profit fund is that those policyholders who leave in the next few years, on policy anniversaries when they will incur no exit penalties (i.e. MVR-free dates) will be taking more than their fair share of the fund and this will lead to the fund becoming considerably weaker.

Where exit penalties are at the less punitive end of the scale, policyholders have to weigh this up against the option of exiting the fund and reinvesting the money to get a better return.

With-profit bonds

These are single premium, non-qualifying life assurance contracts that operate in a similar fashion to the bonds already described. They are subject to the same taxation treatment on withdrawals as previously described.

Some with-profit bonds only offer one type of investment fund, whereas others will offer a choice of funds to allow the investor to switch as and when required (subject to an MVR).

When are the bonus rates for unitised with-profit plans usually declared?

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Life assurance savings plans

These policies are defined as regular premium life assurance policies effected for a fixed term. They pay out on either maturity of the term or on death whichever is sooner.

Amongst other requirements, an endowment assurance must provide a minimum level of life cover of 75% of the premiums payable over the term (which can be reduced proportionately for over 55 year olds) and must be for a minimum term of 10 years in order to be classed as “qualifying” under life assurance policy rules.

If the policy satisfies qualifying criteria no chargeable event gain will arise on any policy proceeds on death or maturity. This will effectively mean that there will be no liability to higher rate tax on policy gains.

Some arrangements have been available which run for shorter terms than 10 years; these are classed as non-qualifying and the same tax implications arise as those for investment bonds.

Life assurance savings plans can be classed as either Qualifying or Non Qualifying. The investor will only suffer tax on policy proceeds if the life policy is already non-qualifying or has become non-qualifying as a result of an encashment. Even in these circumstances, tax will only be payable if the policy holder becomes a higher rate taxpayer as a result of the chargeable gain being added to other income.

Qualifying policies

Most regular premium life assurance policies taken out for investment purposes (as opposed to protection) are likely to be endowments. An endowment policy must pass various tests in order to be qualifying:

The term of the policy must be at least 10 years

Premiums must be payable annually or more frequently for at least 10 years (or until death or disability)

The minimum level of life assurance cover is 75% ...

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... will be no chargeable event and no resulting income tax liability. If, however, the policy they hold is non- qualifying, a chargeable event will arise on death. maturity or surrender and the buyer will be subject to income tax on the difference between the maturity (or surrender) value and the total premiums paid by the buyer and seller combined.

The buyer may also be subject to CGT as the claim is considered a chargeable disposal of a capital asset. Any taxable gain that arises on the difference between final value and total payments made for the policy (both original purchase price and subsequent premiums) can be reduced by the amount that has been subject to income tax under the chargeable event rules.

FCA requirements on policy surrenders

FCA rules state that:

When an independent adviser is asked to arrange the surrender of a with-profit endowment policy, the adviser should tell the client, where appropriate, that it may be possible to obtain a higher cash value through the second-hand policy market

Similarly, life offices are required to inform policyholders considering surrender about the second-hand market if the policy is marketable

A financial adviser advising buyers must give the buyer a quotation of the life office’s surrender value

The financial adviser must also explain the arrangements for assignment, including notice to the life office and for keeping the deed and copy notice with the policy

The financial adviser should explain the claims procedures and the arrangements for checking whether the life assured has died

The financial adviser must also ensure the buyer understands the tax position

What is the maximum annual amount that a parent can contribute to a Friendly Society investment for a child under 18?

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These are index tracking funds that are listed and traded on major stock markets in the same way as publicly quoted shares. They are similar to an index-tracking pooled fund, as they reflect the diversification and performance of a chosen index. They are, however, traded like a single share through stockbrokers and their prices are updated in real time.

The first ETF tracked the FTSE 100, but the range rapidly expanded to cover equity, fixed interest and property indices in the UK and around the world, providing investors with ways of achieving exposure to entire asset cl...

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...d bond issued by a bank that is traded on the stock exchange throughout the day. In the same way as other types of debt, ETNs have a maturity date, but they do not pay any interest. The returns are instead linked to the performance of a market index, minus the management fees.

ETNs are a riskier investment that ETFs, as their value can be affected by the credit rating of the issuing bank.  Also, their repayment is wholly dependent on the issuing bank being able to meet its commitments.

What type of investments are ETCs?

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As an alternative to direct property investment, it is possible to invest indirectly through:

Shares in listed property companies

Property unit trusts and investment trusts

Insurance company property funds

Real Estate Investment Trusts (REITs)

Each of these has different investment characteristics from direct property investment.

Shares in listed property companies

A much more liquid way to invest in property than a direct investment is to own shares in one of the property companies listed on the London Stock Exchange.

Such an investment differs from a direct investment in the following ways:

The investment is diversified over a number of different properties

Share prices are affected by the quality of the management and the level of gearing, as well as the underlying asset value of the property portfolio

Property shares can be highly geared as the companies usually borrow to purchase more property, making the shares more volatile

The share prices will rise and fall independently of the underlying asset values, depending on the forces of supply and demand

They will also be affected by the risks that affect the stock market as a whole, such as general economic conditions, as well as those that are specific to the company

The company will be liable to corporation tax on capital gains and rental income

There is a range of different property companies, specialising in different areas and with different investment objectives:

Some hold property as an investment – they are property companies that act like professional landlords

Others undertake developments – they are property development companies that are more like construction companies and

Many do both

Property unit trusts and investment trusts

A convenient way for an investor with limited funds to invest in the property market,&...

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...iod, the value of the assets in the tax-exempt business must be at least 75% of the total value of the assets (ignoring secured loans) held by the company

REITs cannot have an excessive amount of debt financing. Interest on borrowings has to be at least 125%, covered by rental profits (before deducting interest costs). If the cover falls below this level the company will be taxed on the excess interest

Taxation within the REIT

At least 90% of the profits of the tax-exempt business arising in an accounting period must be distributed as a dividend within 12 months of the end of the accounting period. Stock dividends can be issued in lieu of cash dividends for the purpose of the distribution requirements.

Property can be developed within the ring-fenced tax-exempt business, providing it is for the purpose of generating future rental income (i.e. it is added to the property portfolio).

If a property is developed to be sold for a profit, the disposal would not be tax-exempt and corporation tax would be payable. However, where a property is developed for investment purposes but later sold, providing a period of three years has elapsed, the sale will be treated as tax-exempt.

Taxation on investors

Distributions from REITs can comprise:

A payment from the tax-exempt element. For individual investors this is treated as UK property income and will be paid net of basic rate tax (20%). Non-taxpayers can reclaim the tax deducted. ISA and SIPP investors receive payments gross

A dividend payment from the non-exempt element. This will be treated in the same way as any other UK dividend i.e. it is paid gross

Gains on REIT shares are subject to CGT in the usual way

To qualify as a REIT, what percentage of the company’s gross profits must come from the tax-exempt ring-fenced business?

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These are highly specialised investment products which encourage the development of small and new business ventures by offering investors tax incentives.

Enterprise Investment Schemes (EIS)

The EIS was set up to help certain types of small, higher risk, unquoted trading companies raise capital by providing a range of tax reliefs for investors.

There are generous tax reliefs for placing funds into an EIS but these are subject to certain conditions:

Income tax relief is given at 30%

The annual investment limit is £2m although above £1m must be in knowledge intensive companies

The relief is given as a reduction on the investor’s overall income tax liability

The current tax regime is as follows:

Investors can carry back income tax relief to the previous tax year by claiming that the qualifying shares are treated as having been issued in the previous year, provided that the annual limit for the purposes of calculating income tax relief  in any tax year is not exceeded

Relief is withdrawn where the shares are disposed of within three years, unless the disposal is to a spouse or is due to the death of the investor

Capital gains can be deferred from elsewhere without limit by reinvestment into an EIS company, as long as the reinvestment is made one year before or three years after the disposal which gave rise to the gain

Only the amount of the gain needs to be invested in the EIS rather than the full value of the disposal

The deferred gain will become chargeable on disposal of the EIS shares unless another qualifying re-investment is made. The rate that would apply to the deferred gain is that ...

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... example, EISs and VCTs are not allowed to invest in companies seven years or older after their first commercial sale took place and 10 years or older for knowledge intensive companies (those that revolve around intellectual or analytical tasks).  (However, this does not apply if the investment is more than 50% of turnover averaged over the previous five years).

Seed Enterprise Investment Schemes (SEISs)

This scheme is designed to assist small start-up companies and runs alongside the EIS.

Income tax relief is given at 50% of the cost of shares on a maximum investment of £200,000. 

Reinvestment relief allows an investor to treat 50% of a gain as exempt from CGT if SEIS shares are bought. However you cannot get reinvestment relief unless you also get income tax relief.

The shares must be held for a period of three years for the relief to be retained. A ‘carry back’ facility for both income tax and capital gains tax allows the costs of investments to be carried back to the previous year to also gain tax relief in that year.

Provided the shares are held for three years, any gain on disposal is free from liability to capital gains tax. 100% inheritance tax relief is also available after a period of two years.

The main conditions for the company are it must:

be unquoted at the time the shares are issued

employ a maximum of 25 people

be no more than two years old

have less than £350,000 in gross assets

raise no more than £250,000 through the scheme

meet the qualifying trade rules

What is the rate of income tax relief available for EISs in the current tax year?

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Individual Savings Accounts (ISAs)

ISAs are not investments themselves but flexible, tax-efficient savings wrappers within which a wide range of savings and investment products can be held virtually tax-free. There are many ISA providers offering tax-efficient savings through a wide range of investments products.

Investors can subscribe to a:

Stocks ...

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... is £20,000 in the 2023/24 tax year. This can be spread amongst the available ISAs.

If the ISA provider has adopted the ISA flexibility rules cash can be taken out and replaced in the same tax year without it counting towards the ISA subscription. |It is up to the provider to decide whether or not to offer this flexibility and if so on what terms.

ISA investments are free of UK income and capital gains taxes.

Tax treatment of the investor

Interest, dividends and property income distributions from ISA investments are exempt from income tax

All interest earned within a cash ISA is credited gross

Withdrawals can be made at any time without loss of tax relief

Any capital gains on encashment are t...

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...n ISA holds life assurance, the policy must end if the subscription is invalid. The policy may give rise to a taxable gain if the proceeds are greater than the premiums paid

The ISA manager will repay any tax due to HMRC at the basic rate, but the investor must report the gain to their tax office and may have to pay more tax if they are a higher rate taxpayer

There are strict rules in relation to the types of investments that can be held within an ISA. The following are eligible:

Shares that are officially listed on a recognised stock exchange anywhere in the world (including AIM, but not including unquoted companies)

Small and medium sized enterprise securities (not just equities) admitted to trading on a recognised stock exchange

Corporate bonds that are of...

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...dditional amounts) and may not be used as collateral for a loan or placed in trust

* Recognised UCITSs in an EEA state other than the UK held by an investor in a stocks and shares ISA at the end of the transition period on 31/12/20 following the UK leaving the EU are treated as qualifying investments for a stocks and shares component for as long as they are held in an ISA.

Stakeholder standards apply to a wider range of products than just ISAs. To be able to claim the name ‘stakeholder’ the products have to meet certain conditions designed to ensure that they are good value and straightforward.

Stakeholder deposit account (Cash ISA)

There are no c...

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...capital, policyholders can be charged extra

Managers must make available information about their policies on smoothing and charging

The whole of the with-profits fund and the whole of the smoothing account, apart from specific deductions allowed by law, are for the benefit of the policyholders

The main types of ISA now available are:

Unit trust and OEIC ISA s - these are the most popular ISAs. They provide a broad spread of holdings for relatively small investments. ISAs may be linked to one or more funds and many managers offer an extensive choice of funds. Corporate bond ISAs based on unit trusts and OEICs have also proved to be very popular. High yield bond funds investing in sub-investment grade bonds have, in particular, attracted many income seekers. The ISA’s tax structure favours the holding of bonds, as the account manager can receive the interest without any tax being deducted. ISAs may also be invested in UKUCITS and FCA recognised UCITS

Investment trust ISAs - investment trust ISAs are similar to their unit trust and OEIC counterparts, but usually carry explicit additional charges to those levied within the investment trust. The choice of investment trusts is smaller than for unit trusts and OEICs

Investment trust ISA s - investment trust ISAs are similar to their unit trust and OEIC counterparts, but usually carry explicit ...

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...alties – some providers may incur exit charges in the first three to five years of any investment. This may be expressed as a percentage of the original investment or the current value. Some ISA managers also apply a termination fee when the plan is cashed in or transferred

Commission – the purchase and sale of investment trusts and shares will usually involve stockbroking commission. This may be a flat rate charge, at the full rate or may be at a specially discounted bulk rate of 0.2% to 0.5%

Dividend collection fee – self-select ISA managers may charge a fee for each dividend collected rather than an annual charge. This is VAT free and usually between £4 and £7.50 which favours larger shareholdings

Report fees – self select ISAs will often levy a substantial fee, e.g. £50 plus VAT, for investors who wish to receive annual reports and/or attend shareholder meetings. The size of the fee is designed to be a deterrent as, in practice, annual reports are easily available from other sources

It is possible to transfer some or all of an investor’s funds saved in a previous tax year into another ISA without affecting ISA subscription limits for the tax year. In fact, the regulations stipulate that an ISA manager must grant a transfer on request, but they are not obliged to accept one.

If an investor wishes to transfer the current year’s ISA subscription, all of the current year’s subscription must b...

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...ia an extra ISA allowance, the Additional Permitted Subscription (APS). The survivor can invest as much into their own ISA as the spouse/partner held at the date of death, as well as their own annual ISA limit.  This new rule does not save inheritance tax but transfers of assets between spouses are IHT free. If there is no surviving spouse/civil partner the plan will form part of the deceased’s estate in the normal way.

The Child Trust Fund is a long-term savings account for children. All monies within the fund belong to the child and ca...

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...account types:

Stakeholder account

Savings account

Share account

CTFs were replaced by Junior ISAs in 2011.

The Government created Junior ISAs to replace the Child Trust Fund offering parents a simple and tax-free way to save for their child’s future. The key features are below:

Eligibility

All UK resident children (aged under 18) who do not have a CTF are eligible.

Types of Account

Both cash and stocks and shares Junior ISAs are available. The qualifying investments for each o...

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...als are not permitted until the child reaches 18, except in cases of terminal illness or death.

Transfers

It is possible to transfer accounts between providers, but it is not possible to hold more than one cash or stocks and shares Junior ISA at any time.

Maturity

At the age of 18, the Junior ISA becomes a normal adult ISA by default. The funds are then accessible to the child.

The range of products available (and their particular features) has been extensively covered in Chapter 1 of this course. Up-to-date information regarding NS&I products can be found at www.nsandi.com .

Which NS&I products are tax-free?

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Purchased life annuities are bought from life assurance companies and the annuity is split into two parts:

Income element ...

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... 

The taxation of a PLA can be compared favourably with a pension annuity which is taxed in full as earned income.

A derivative is a financial instrument where its value depends on the value of one or more underlying assets. The derivative itself is a contract between two or more parties and the value is determined by the fluctuations in the value of the underlying asset.

Originally the underlying assets were basic commodities such as cocoa, sugar, coffee and wheat. In recent years their use has expanded to include bonds, currencies, short-term interest rates, individual shares or stock market indices such as the FTSE 100.

Using derivatives provides exposure to the underlying asset without having to actually own the asset. It allows investors to make profits on the upwards or downwards movements in the underlying assets.

In the last 25 years, international markets in derivatives have grown exponentially and in some cases the derivative market is larger than the turnover of the underlying assets themselves. They now form a major part of the world’s financial structure.

Derivatives can be used for many purposes. Most often they are used to control or reduce risk and they can equally be used for speculation, which could increase risk. They have been blamed for increased volatility in the market but they also provide stability in many situations.

They are the domain of institutional investors, with few private investors having the requisite financial resources or skill to access derivatives directly. It is more likely that individual private investors will be exposed to derivatives via collective investments.

Derivatives can be either bought or sold on a recognised exchange (exchange traded) or can be created and sold directly to customers by banks and other financial institutions (over the counter – OTC). There are broadly two types of derivatives that are traded on exchanges, futures and options. Exchange traded contracts have standardised terms and this makes them cheaper to enter into and to trade than OTC instruments, which are tailored to meet the needs of a particular client.

OTC contracts are negotiated between two parties and tailored to a client’s particular needs. An example would be where a utility supplier needs to fix the price of buying raw materials such as gas at a predetermined price in the future.

They are traded on specialist exchanges such as the London International Financial Futures and Options Exchange (NYSE LIFFE).

Futures

A future is an exchanged traded forward contract and a legally binding agreement to buy or sell a certain amount of a particular asset at a specified date in the future at a specified price. The contract imposes an open-ended obligation on both parties until expiry or closing out. The exchange standardises the contract specification in terms of quality, quantity, delivery date and delivery price for each commodity and financial asset.

Each futures contract must have a buyer and a seller:

Buyers are said to have a long position. They have the obligation to buy the underlying asset sometime in the future for a price agreed when the contract was made. They expect prices to rise

Sellers are said to have a short position. They have an obligation to sell the underlying asset at some time in the future for the price agreed when the contract was made. They expect prices to go down

The parties to the contract are knows as counterparties, and they both have a legal obligation to honour the contract.

Trading financial futures

An initial trade opens a client’s position in the derivatives market. This may be either a purchase or a sale trade. Open positions are those in which rights or obligations to the market ...

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...is greatest if the price of the underlying asset falls to zero

Sellers of options, called writers, face almost unlimited risks in return for the premium they receive, yet for every buyer of an option there has to be a willing seller. Most writers are major investment banks or specialised traders, but there are some circumstances when fund managers can make use of option writing, despite the apparent risks.

Writing a call

A fund manager may increase income to the fund by writing call options and receiving the option premium. In return, the manager has to accept the possibility that the option will be exercised if the share price rises sufficiently and the shares handed over at the agreed strike price.

Provided the fund owns the underlying stock, when the options are referred to as being ‘covered’, the risk is minimal. It may be that the fund manager has identified the exercise price as the level at which the shares would have been sold in any case. Consequently, they have benefited from the premium income in addition to the potential selling price, but at the cost of foregoing any profits on selling at above that price.

The writer of a call option believes that the share price is likely to either stay the same or fall. If that happens, the writer simply pockets the premium received and will not have to deliver the shares.

The largest risks come from writing options over shares (or other assets) that the writer does not own. In these instances, the writer may have to buy the shares in the market if the option is exercised, possibly at a price well above the exercise price. This would lead to a real loss by the writer. This strategy is called writing uncovered calls.

Writing a put

A fund manager who writes a put option receives premium income, but in return enters into an obligation to purchase an asset at a fixed price.

The expectation is that the underlying asset price will not fall significantly. If it does, the writer of the put will be exercised against, and will have to buy the asset at a price above the current market price. The worst case would arise if the price of the asset falls to zero. If this happens, the loss will be the exercise price less the premium received.

The put writer hopes that the put will not be exercised. This will occur if the asset has a price above the exercise price at expiry.

Taxation of derivatives

Profits from both futures and options are usually chargeable to CGT although if someone is a trader their profits will be taxed as income. For individuals, there is no CGT where the underlying assets are gilts or qualifying corporate bonds.

Buying options:

If a call option is exercised, the cost of the option is treated as part of the total cost of purchase

If a put option is exercised, the cost of the option is treated as an allowable deduction from the sale proceeds (the exercise price)

If the option is allowed to expire worthless, this is treated as a disposal for CGT purposes, giving a capital loss on the date of expiry

Futures:

When a futures position is closed, any money received is treated as consideration for the disposal of the futures contract and any money paid is treated as an incidental cost of disposal

If the futures contract is not closed out, each party is treated as having made a disposal of an asset

Any payment made or received is treated as consideration for, or an incidental cost of, the disposal

An investor purchases an option that gives him the right to buy the underlying asset at any time during the period of the option up to expiry. What type of option have they purchased?

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Since their introduction to the general market place, there is now a wide variety of hedge funds offering different investment styles ranging from risk averse to very high risk.

Traditional “absolute return” hedge funds attempt to profit regardless of the general movements in the market. They do this by carefully selecting a range of asset classes (including derivatives) and by holding buy, hold and sell positions.

Recent innovation has resulted in a much wider range of hedge fund strategies some of which place a greater emphasis on producing highly-geared returns than they do controlling market risk. The Hedge Fund Association recognises at least 14 distinct investment strategies adopted by its members, each offering different degrees of r...

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...sks in hedge funds

As hedge fund managers can use various techniques to achieve their objectives it can be difficult to establish the risks.  It is therefore important to be aware of the differences between the different hedge funds, as their investment returns, volatility, and levels of risk can vary depending on the strategy they use.

Hedge funds were traditionally limited to institutional and wealthy investors, but the availability of funds of hedge funds (which spread risk over several funds) has opened the market to retail investors.  

Hedge funds can be suitable for those with high risk profiles and can help diversify a portfolio. They can however lack transparency making it difficult to find out how they operate to fully assess risk.

These aim to achieve a positive return for investors in all market conditions focusing on the value created by the fund manager (the alpha skills of the manager – see chapter 3).  They  measure their return against an absolute retur...

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...t can make money when the markets fall and reduce overall volatility. However, the success of the strategy is heavily dependent on the skill of the fund manager.

What is the aim of an absolute return fund?

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...

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...

Structured products are designed to offer a tailored combination of risk and return. Many offer capital guarantees for those investors wanting a degree of protection, with others offering absolute return profiles or geared growth with similar risks as an active fund.

Characteristics of structured products

The term ‘structured product’ is a generic one used to describe a range of products marketed under names such as ‘guaranteed growth bonds’, ‘structured funds’ and ‘investment notes’.

They have their roots in the guaranteed life bonds offered by life offices from the 1970s onwards. The development of the traded options market (an exchange where futures and options are traded) allowed more sophisticated products to be developed over time and has led to the development of some that can be traded on the London Stock Exchange.

A structured product is not actually a product but a wrapper designed to achieve a specific set of investment objectives with a specific risk/reward profile. It does this by offering returns from a higher-performing, but riskier, underlying asset, combined with capital protection.

The ‘structuring’ could include offering participation in the return from a underlying index or fund, such as the FTSE 100, S&P 500, Nikkei or Eurostoxx, which is then combined with derivatives or other instruments to provide the capital protection.

As a result, there is a wide variety in the types and features of structured products currently available and sold in recent years. To understand how they are structured, we will look at a simple example.

Example

A typical structured product might offer a 5-year term, 100% capital guarantee and participation in the growth of the S&P 500 index up to a specified limit. The way this works is to combine two instruments within the wrapper of the structured product:

A zero coupon bond

A call option

A zero coupon bond is a fixed interest security that pays no coupon but is instead sold at a discount to its par value and so can provide a known amount at its maturity. As an ...

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...up the dividend flow so that the cost of the protection can be judged

Risk profile

Assets forming the structure of the product

Risks to the principal amount invested

The extent of any capital guarantees

Provisions relating to limited protection guarantees

Costs

Costs and fees associated with buying, holding and selling the structured product

Tax implications for the investor

Encashment

Any early encashment penalties

The transparency of pricing if the product can be sold on the stock market

Liquidity in the secondary market

Costs associated with any stock market sale

Credit risk

The creditworthiness of the issuer

The creditworthiness of any counterparties involved in the underlying derivatives

The credit rating of any zero coupon bond or other instrument

Clearly, it is vital that a realistic assessment is made of the risks associated with any structured products. Advisers need to have a full understanding of these so they can ensure the client has a clear understanding of the potential risks and rewards.

You should note that the FCA has banned the promotion of speculative mini-bonds to retail customers.

Summary

Structured products can have a valuable role to play in financial planning. Investors whose priority is capital preservation can find solutions from amongst the wide range of products on offer.

Investors who are cautious about stock market investments but who want to share in the potential upside that exposure to markets can offer, can consider products that offer combinations of market participation and capital protection.

For the more adventurous, there are products that offer exposure to commodities, hedge funds and foreign exchange markets as their underlying assets and others that offer a mix of different asset classes, indices or baskets of individual equities. Structured products can offer access to asset classes that would not usually be available through traditional investment funds and offer the potential for diversification within an overall investment strategy.

What are structured products?

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Direct versus indirect investment

Finally, we will consider the advantages and disadvantages of direct investment in securities and assets compared to indirect investment through collectives and other products.

Advantages of direct investment

The main advantages of holding equities and fixed interest securities direct, rather than through a collective investment like a unit trust or life assurance policy, are that:

Many clients are interested in having direct holdings in specific companies, whose fortunes they enjoy following

Optimal portfolio diversification is, in theory, only achieved after adding the 20th stock. In Edwin J Elton and Martin J Gruber's book 'Modern Portfolio Theory and Investment Analysis', they conclude that the average standard deviation (risk) of a portfolio of one stock was 49.2%, while increasing the number of stocks in the average well-balanced portfolio could reduce the portfolio’s standard deviation to a maximum of 19.2% (this number represents market risk). However, they also found that with a portfolio of 20 stocks the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio’s risk by about 0.8%, while the first 20 stocks reduced the portfolio’s risk by 29.2% (49.2% to 20%)

They are likely to interest investors who are reasonably accepting of risk, because unless the portfolio is large, it is likely to have more volatile performance

There are very low costs on switching investment managers, because a ...

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...ssures may produce an improvement in performance or even a change of manager. Investors in unit trusts and OEICs have no power to bring such changes about

Investment trusts can borrow to invest. Unit trusts and OEICs have much tighter restrictions on their borrowing powers. In some cases, borrowing can increase the volatility and risk profile of an investment trust. At other times it can reduce the risk if the managers use borrowings to finance the hedging of their positions, either in the market generally, in particular securities or in currencies

Investment trusts can provide higher levels of income than the equivalent unit trust or OEIC if there is a discount to net asset value. The same amount of money buys exposure to more securities within an investment trust with a discount to net asset value, and, as a consequence, a greater annual income

There are several different types of investment trust securities that have specialist uses, such as shares in split capital trusts and warrants:

Split capital shares divide out the investment returns from the trust to different classes of shareholders. The shares also involve different degrees of risk, from lower risk zeros to higher risk capital shares

All investors in a unit trust or OEIC, on the other hand, have an equal entitlement to any income and capital gains, and bear the same amount of risk

There are some types of unit trusts and OEICs that do not exist in investment trust form

Investment trusts are closed-ended PLCs and unit trusts and OEICs are open-ended funds

Your results and the estimated ...

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...te.

Estimated study time 11.4 hours