AFA 1 Investment 2024 Topic 11 PDF

Topic 11 Collective investments – life assurance Learning objectives After studying this topic, you will be able to demonstrate an understanding of the nature and characteristics of life assurance as an investment medium, including: ‹ qualifying and non‑qualifying status; ‹ endowment...

Topic 11 Collective investments – life assurance Learning objectives After studying this topic, you will be able to demonstrate an understanding of the nature and characteristics of life assurance as an investment medium, including: ‹ qualifying and non‑qualifying status; ‹ endowments; ‹ investment bonds; ‹ annuities. 11.1 Introduction Life assurance is usually seen as a way to provide a lump sum on someone’s death. In fact, it has long been a popular way of saving and investing, through endowments and investment bonds. This topic will consider the life assurance investment options available. Life assurance products are broadly categorised as qualifying and non‑qualifying policies. We will start by looking at what these categories mean. Pure protection policies, such as term assurance, which have no investment element or cash‑in value are not qualifying policies as such. They are subject to different rules, which means that they are not usually subject to taxation when benefits are paid. They are not affected by the changes to qualifying rules detailed in this topic. 11.1.1 Qualifying policies A qualifying policy is one that meets the qualifying rules for life assurance policies. Qualifying status means that proceeds on death or policy maturity are free from tax. The qualifying rules for investment‑based life assurance policies are as follows. ‹ Premiums must be paid at least annually. ‹ The policy must have a term of at least ten years. ‹ The policy must provide a death benefit (sum assured) of at least 75 per cent of the premiums payable over the term of the policy. — In the case of a whole‑of‑life policy, the term is deemed to end at age 75. — In the case of endowments, the 75 per cent requirement is reduced by 2 per cent for each year the life assured exceeds age 55. ©LIBF Limited 2024. All rights reserved. 321 11: Collective investments – life assurance ‹ Premiums in any one year cannot be more than twice those in any other year. This means premiums can double from the initial premium. ‹ Premiums in any one year cannot be more than 12.5 per cent (1/8) of the total premiums payable over the term. If a qualifying policy is made paid up or surrendered within 75 per cent of the initial term, maximum 10 years, it will be treated as a non‑qualifying policy. For example, this means that a 10‑year endowment must run for 7.5 years and a 15‑year endowment for 10 years to avoid losing its qualifying status. Qualifying status may also be lost if the sum assured or premiums are increased beyond the limits shown above once the plan has started, although this can be avoided by extending the term by a further ten years when the change is made. The taxation of qualifying policies changed from April 2013: ‹ From 6 April 2013, premiums to qualifying life policies are limited to £3,600 in any 12‑month period per person. A policy that came into force from that date is totally non‑qualifying from the start if it exceeds that amount. ‹ The annual limit applies per person, not per policy. This means that any new policy issued after 6 April 2013 that takes the owner’s total premiums on all policies above £3,600 is fully non‑qualifying. ‹ The limit also applies to premiums payable from 6 April 2013 on all qualifying policies issued on or after 21 March 2012. Policies that came into force between 21 March 2012 and 6 April 2013 (the transitional period) are fully qualifying if the premiums do not exceed £3,600. Specific rules apply to other policies issued in that transitional period: — If the premium on such policies was more than £3,600 from the start, gains attributable to the first 12 months’ premiums and the first £3,600 of future premiums were treated under qualifying policy rules. Gains attributable to the excess premiums after 6 April 2013 are treated as non‑qualifying. These policies are referred to as restricted relief qualifying policies (RRQP). — Where a policy was issued during the transitional period with a premium up to £3,600, but the premium increased above £3,600 after 6 April 2013, it is also treated as an RRQP. Increases as a contractual obligation under the policy do not affect its qualifying status. ‹ Policies in force before 21 March 2012 are not affected unless the premium is increased or the term is extended. If the premium is increased under a contractual term, for example automatic 5 per cent increases, the policy is not affected. If the premium and term remained the same, the policy is ‘protected’ and remains qualifying, regardless of the level of the premium. If the premium is increased, the policy becomes an RRQP, as above. Clearly, if the existing policy has premiums substantially above £3,600 and the policyholder wishes to increase premiums, it is more beneficial to start a new policy rather than increase the existing plan. Although the new policy would be non‑qualifying, the whole gain on the existing policy would be protected. ‹ New policies where premiums are set to vary during the term, such as low‑start endowments, are non‑qualifying from the start if the premiums payable exceed £3,600 in any future 12‑month period. ‹ Where more than one person has a beneficial interest in the policy, the full premium payable counts towards each person’s annual premium limit. 322 ©LIBF Limited 2024. All rights reserved.  11.2 Endowments ‹ If a qualifying policy is assigned to someone else, it becomes a non‑qualifying policy. This does not apply to assignment into trust or assignment as security for a debt, such as a mortgage. ‹ If a policy is assigned into trust, the premiums payable are treated as part of the beneficiary’s annual premium limit. If there is no defined beneficiary (such as a discretionary trust) the premiums are then treated as part of the settlor’s annual premium limit. ‹ Endowment policies taken out on or before 21 March 2012 for the sole purpose of repaying an interest‑only mortgage continue to be qualifying, even if increases are required in order to meet the original maturity target. They are not regarded as RRQPs. One important factor to consider is that with a non‑qualifying policy, the chargeable gain is always calculated as the difference between the cash value of the plan and the total premiums paid at the time of the chargeable event. For example, George took out a non‑qualifying, regular premium, whole‑of‑life plan with a premium of £120 a month and a sum assured of £50,000. On his death after seven years the plan had a surrender (or cash) value of £7,000. Although the plan would pay the £50,000 sum assured, the chargeable gain would be £7,000 cash value minus £10,080 premiums paid, which is nil. The same principle applies to term assurance plans, and the reality is that there will never be a chargeable gain on a term policy because there is no cash or surrender value at any point. For this reason, HMRC considers there will not be a need to write term assurance as qualifying policies. 11.1.2 Non‑qualifying policies Non‑qualifying policies are those that fail to meet the qualifying rules, and they include investment bonds. Benefits from a non‑qualifying policy will potentially be taxable on encashment or death, depending on the policyholder’s tax status. The taxation situation will be covered in section 11.3.5. 11.1.3 Fund taxation Life assurance investment funds are subject to corporation tax on income and gains at the special rate of 20 per cent. The tax is paid by the fund manager and means that the investor is treated as having paid the equivalent of 20 per cent income tax on the policy. Regardless of their tax status, the investor will not have any further charge to basic‑rate income tax but non‑taxpayers are not able to reclaim the tax deducted. No further tax is applied to the fund, regardless of whether it is a qualifying or non‑qualifying policy. 11.2 Endowments An endowment is a regular‑premium investment‑orientated life assurance contract designed to pay a capital sum on a predetermined maturity date; it will pay a specified death benefit, the sum assured, if the policyholder dies before the maturity date. Endowments have generally lower charges relative to protection policies and are used mainly for target savings: school fees, mortgage repayment, etc. The life assurance element means that targets can be met even if the policyholder does not survive the term. A monthly or annual premium is established at the start of the contract. The premium is calculated to provide the target maturity value and guaranteed death benefit, providing ©LIBF Limited 2024. All rights reserved. 323 11: Collective investments – life assurance certain assumptions are met, but on most endowments there is no guarantee that the maturity target will be met. Endowments are available on a with‑ or without‑profits or unit‑linked basis. 11.2.1 With‑profits funds With‑profits funds are relatively conservative. They must invest in a way that will enable them to meet the guarantees built into policies, while at the same time making a profit to meet future expectations. At the end of each year, the actuaries will decide how much of the fund is needed to pay current and future liabilities, costs and guarantees. The balance is profit, some of which is used to bolster reserves and the rest is passed on to with‑profits policyholders as bonuses. The profit allocated to reserves allows the company to add bonuses in years when fund performance is poor and may not justify a bonus. This process is often referred to as ‘smoothing’ because the aim is to even out bonuses over the years and to some extent avoid the peaks and troughs of the markets. In order to meet the guarantees on maturity, with‑profits funds take a relatively defensive approach to investment, placing a significant amount in gilts, which means a lower potential for significant gains. For several years, relatively poor investment performance led to bonuses being largely funded from reserves. Continued poor performance led to exhausted reserves and the need to reduce bonuses significantly, which affected maturity values. The majority of investors who took out with‑profits endowments to repay their mortgage have been informed that their policy is unlikely to meet its target at maturity. As a result of the structure of with‑profits endowments and the guarantees they provide, they tend to be quite inflexible. It is not usually possible to increase or decrease the sum assured or premiums, and the initial term cannot usually be extended. 11.2.1.1 With‑profits endowments ‹ With‑profits endowments are written over an agreed term, typically between 10 and 25 years. ‹ A guaranteed sum assured is established at the outset and this sum is guaranteed payable on maturity or earlier death. ‹ The plan does not rely on bonuses to meet its target – they are literally a bonus. This sort of endowment is expensive in comparison with other alternatives. ‹ Each year a portion of the surplus fund, over and above that set aside to meet expenses and reserves, is distributed to policyholders through reversionary (annual) bonuses. These are usually calculated as a percentage of the sum assured and are added to the guaranteed sum assured, increasing the death and maturity benefits. ‹ In addition to the reversionary bonuses, a terminal bonus (also known as a final bonus) will usually be paid on maturity and often on death during the term. The terminal bonus depends on investment returns near to maturity, but is often a significant proportion of the final total. ‹ There are two types of with-profits endowment: — The ‘full’ endowment, where the guaranteed sum assured is equal to the policyholder’s target amount. The plan does not rely on bonuses to meet its target – they are literally a bonus. This sort of endowment is expensive in comparison with other alternatives. 324 ©LIBF Limited 2024. All rights reserved.  11.2 Endowments — A ‘low-cost’ endowment, where the guaranteed sum assured is considerably lower than the target maturity value, and the plan relies on projected reversionary bonuses to bring the maturity value to the target amount. There is a risk that the final value will be lower than the required amount. Unitised with‑profits With a unitised with‑profits policy, the investor buys units in a with‑profits fund. Once allocated, the value of the units cannot fall, and bonuses declared in the with‑profits fund are added in one of two ways. ‹ The value of each unit is increased by the addition of the bonus and cannot be reduced. ‹ Alternatively, the bonus is added by allocating more units to the policy. Most unitised with‑profits policies allow the investor to switch into and out of other unit‑linked funds. Switches out of the unitised with‑profits fund, or early surrender of the policy, might incur a market value adjuster or reduction (MVA/MVR), which means that the company will reduce the value of units transferred to protect the interests of other investors. This is usually invoked in times of poor fund performance. With‑profits charges The charges on a with‑profits policy are rarely transparent. Other than a monthly policy fee, most charges are taken from the fund and so hidden from the investor. There is no set charge in the event of the investor cashing in the plan before the maturity date. The provider will decide how much to pay and it is unlikely to include any bonus element. Non‑profit endowments Non‑profit, or without‑profits, endowments are very rare today because they are very expensive and rather outdated. They offer a guaranteed sum assured that will be paid on maturity or earlier death, regardless of the underlying fund performance. They do not participate in the company’s profits, which means that no bonuses are added. 11.2.2 Unit‑linked endowments Unit‑linked endowments are usually offered with a term between 10 and 30 years, although many offer the facility to lengthen the term subject to life assurance qualifying rules. In addition, it is often possible to increase or decrease premiums and the sum assured, again subject to qualifying rules. Unit‑linked funds are life funds that operate in a similar way to unit trusts, although they are subject to life fund legislation. Investors are offered a wide choice of fund links, allowing an opportunity for individual investment choice that is not available on with‑profits plans. This includes the facility to select a number of funds for the same plan. The range of funds depends on the provider, but will typically include: ‹ managed; ‹ equity; ‹ fixed interest; ‹ property; ‹ overseas equities; ‹ guaranteed. ©LIBF Limited 2024. All rights reserved. 325 11: Collective investments – life assurance As with unit trusts, the value of each unit is simply the value of the fund assets divided by the number of units in issue. The manager is able to create units on demand and must allow investors to sell the units back to surrender the plan. Unit‑linked endowments provide a guaranteed death benefit but differ from with‑profits plans in that maturity values depend entirely on investment performance – there are no guarantees. Each premium is allocated units in the selected life fund and, once allocated, will rise and fall in direct relation to the fund’s performance. When the plan starts, the provider will calculate the premium required to meet the target maturity sum, based on assumptions of fund growth, policy expenses, the cost of life cover and other benefits over the term. Plans are reviewed on a regular basis to ensure that the death benefit can be maintained and that the plan is on target to reach its maturity sum. The provider will review the actual fund growth and expenses to date, consider whether the previous assumptions are still valid, and then recalculate the premium and sum assured in light of the analysis. If the plan is on target, or ahead, no change will be required. If the plan is behind target the policyholder will usually be given the choice of increasing the premium, reducing the life cover or a combination of the two. On a typical plan the first review would be on the tenth anniversary and then every fifth anniversary, increasing to annual reviews in the last five years of the term. The unit‑linked method provides for more flexibility, allowing changes to life cover and premiums and the provision of a range of options. In the event of early encashment, the surrender value will be the bid value of the units less any early surrender charge, as outlined in the product details. Unit‑linking has become more common in recent times, offering a more transparent charging system, investment related directly to performance and the well‑documented benefit of pound–cost averaging. 11.2.2.1 Unit‑linked charges Charges are far more specific than with‑profits plans and will be set out in the policy details. They have the following characteristics. ‹ As with unit trusts, units are sold at the offer price and bought back from the investor at the bid price. The initial charge, typically 5 per cent, is taken on investment to cover the costs of investment and payments to advisers; it represents the bulk of the difference between the two prices. ‹ The costs of setting up the policy are usually taken in one of two ways: — by reducing the allocation to units for an initial period – for example, 50 per cent of premiums are used to buy units during the first 12 to 24 months, with the balance of the premium taken to cover costs; — by allocating early premiums to initial (or capital) units – these units carry an additional annual fund management charge throughout their lifetime, so will not grow at the same rate as standard units. ‹ The monthly charge for providing life assurance is deducted from units. ‹ There is likely to be a monthly or annual policy fee, which is either taken from the premium before unit allocation or sometimes by deducting units. ‹ Funds are subject to an annual management charge, typically in the range between 1 per cent and 2 per cent. ‹ There may be a charge for early surrender. 326 ©LIBF Limited 2024. All rights reserved.  11.2 Endowments Figure 11.1 Unit‑linked life assurance 11.2.3 Taxation of endowments Endowments can be classified as either qualifying or non‑qualifying plans, with the majority having qualifying status. For those plans that are qualifying, there is no tax to pay on the money received from an endowment policy, as long as it is not encashed before 75 per cent of the term has passed, or ten years if that is earlier. If the plan is cashed in or made paid up before the ten‑year/75 per cent limit, the policy becomes non‑qualifying. The gain made on encashment will be added to the investor’s income and, if they are a higher‑rate taxpayer, either before or as a result of the encashment, an additional 20 per cent of the gain will be payable. This represents the difference between the 20 per cent deducted within the fund and 40 per cent higher‑rate tax; an additional‑rate taxpayer would be liable for a further 25 per cent. The gain is calculated as the policy proceeds less premiums paid. Importantly, there is never a liability to the basic rate of tax; however non‑taxpayers cannot reclaim the tax paid by the fund. 11.2.4 Endowments – a comparison There is a significant degree of variance in terms of the risks associated with a traditional with‑profits endowment and a unit‑linked endowment. The traditional with‑profits endowment has a lower risk profile due to the guaranteed sum assured and reversionary bonuses being guaranteed on maturity once added. By comparison, the value of the unit‑linked endowment moves as unit prices vary, which means previous gains can be lost. However, unit‑linked policies are more flexible, offer more benefits and can be adjusted as necessary. Additionally, while an investor should not plan to take out an endowment and encash it early, there is a significant degree of variation in early surrender values. The future of endowments as an effective savings vehicle, particularly for higher‑ and additional‑rate taxpayers, has been thrown into doubt by the imposition of limits to premiums. In the past, endowments were seen as a tax‑efficient savings vehicle for higher earners who had used their ISA allowance and other suitable tax‑efficient vehicles. ©LIBF Limited 2024. All rights reserved. 327 11: Collective investments – life assurance 11.2.5 Traded endowment policies Investors take out endowment policies for long‑term saving needs. On occasion, they need access to the investment before the end of the term and wish to surrender the policy. Many life offices offer notoriously poor returns on with‑profits policies surrendered early. A market developed for secondhand endowments, within which the investor sells the endowment to a third party rather than surrendering it to the insurance company. These policies are known as traded endowment policies (TEPs) or, alternatively, secondhand endowment policies (SHEPs). The benefit to the investor is that a significantly higher cash value is paid by the third party: typically 35 per cent more than the surrender value offered by the insurance company. This is because buyers are prepared to pay a premium over and above the surrender value on policies that have already been allocated guaranteed bonuses and that are likely to pay out good returns on maturity. The policies are usually sold through an auction or to a market maker, who will then sell them on. Buyers will only consider with‑profits policies because the returns are partially guaranteed and the value of the policy at the point of transfer will not go down. Having bought the plan from the original policyholder, the new holder will continue paying the premiums until the end of the term and then collect the maturity value. From the buyer’s position, the attraction is the guarantee built into the policy. The guaranteed sum assured plus bonuses accrued up to the point of sale are certain to be paid, and there is the prospect of further reversionary and terminal bonuses. Insurable interest must exist at the start of the policy but not once the plan is in force. This means that the sale is perfectly legal and the second owner can reap the rewards. 11.2.5.1 Taxation The original seller of an endowment on the secondhand market will have no CGT to pay and there is no income tax to pay on the sale of a qualifying policy, providing the plan has gone past a period of 75 per cent of its initial term (maximum ten years). On a non‑qualifying policy, or a qualifying policy sold before the 75 per cent/ten‑year period has elapsed, a chargeable event occurs. A higher‑rate taxpayer will therefore be subject to higher‑rate income tax at 20 per cent (25 per cent for an additional‑rate taxpayer) on gains made. The sale of an endowment to another person is completed by assigning the policy for a consideration (the sale price). As a result, the policy becomes non-qualifying in the hands of the buyer, who will suffer a chargeable event when the policy matures. The gain will be the final proceeds less premiums paid by the original owner and the second owner, and the gain will be taxable under the income tax regime for non-qualifying policies. 11.3 Investment bonds In essence, an investment bond is a whole‑of‑life assurance policy. There are three essential differences between the bond and conventional policies. ‹ The investment is via a lump sum. Regular premiums are not possible. ‹ The ‘life assurance’ element is limited, usually to 101 per cent of the policy value on death and is arranged purely to ensure that the plan counts as a life assurance plan. There is no guaranteed sum assured. ‹ As a result of this structure, investment bonds are non‑qualifying policies. 328 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds Investment bonds can operate on either a unit‑linked or with‑profits basis and are geared purely towards investment. They are used as a direct alternative to unit trusts and OEICs and, for some investors, can offer tax advantages that we will consider later. Investment bonds can be ‘onshore’ (ie offered by UK registered insurance companies), or ‘offshore’ (ie offered by insurers – or a subsidiary – registered outside the UK, typically in the Isle of Man or the Channel Islands). The mechanics and general principles of both types are the same, but the taxation treatment is slightly different. 11.3.1 Unit‑linked investment bonds The lump sum investment sum buys units in the chosen life fund (or funds) and units will rise or fall in line with fund performance. The unit‑linked bond can usually be surrendered at any time, often without penalty, although the effect of the initial charge will make this an unattractive option in the early years. As an investment vehicle, the investment bond will usually offer a wide range of fund links, typically: ‹ managed; ‹ equity; ‹ distribution; ‹ international; ‹ specialist. Many bonds offer a range of funds on a par with those offered by unit trusts and OEICs. The risk can be spread through selecting different funds or by choosing a more conservative fund. The funds are managed by professional managers and enable small investors to invest in areas not usually accessible to them; both of these are particularly attractive advantages. It is possible to switch an investment to a different fund, free from CGT. This offers an advantage over unit trusts and OEICs, where a switch would be a disposal for CGT purposes. A certain number of switches are allowed each year free of charge, with a charge of around £25–£50 after that. Bonds are divided into ‘sub‑policies’, enabling each segment to be treated separately for encashment and partial encashment. Known as segmentation, this has distinct tax advantages, as we will see later. Regular withdrawals can be made by cashing units or by surrendering an entire segment. There has been a trend in recent times towards ‘open‑architecture’ bonds, where the provider provides access to a range of funds from across the market rather than to its own funds. Unit‑linked bonds will typically be subject to the following charges: ‹ Initial charge (typically 5 per cent) – investors buy units at the offer price and sell back at the bid price. Some bonds are now structured using the same ‘clean pricing’ principles as unit trusts and OEICs, which means the initial charge is reduced to nil. ‹ Annual fund management charge – typically 1–1.5 per cent pa. ‹ Fund switching charge – often a specified number each year are free. Note that some bonds do not have an initial charge but instead charge a penalty on withdrawal in the first few years. ©LIBF Limited 2024. All rights reserved. 329 11: Collective investments – life assurance 11.3.2 With‑profits investment bonds Some providers offer investment bonds with a unitised with‑profits fund as an option. This means that the original capital is guaranteed to be returned on encashment, although there could be penalties on encashment within a stated period or in certain economic conditions. The policy benefits from the addition of bonuses, depending on the fund performance, and once added these become part of the bond’s guaranteed value. ‹ Annual reversionary bonuses may be added, either by increasing the value of existing units by the bonus declared or by adding additional units to the policy. ‹ Some policies state a guaranteed minimum level of bonus that will be added at a specific point, typically after ten years. ‹ Others pay a terminal bonus after ten years or on final encashment, providing the plan has run for a specified minimum term. Most companies allow penalty‑free withdrawals at certain points in the bond’s life, typically every five or ten years. Withdrawals outside these dates may be subject to a market value adjuster (or market value reduction) to unit values if investment conditions are unfavourable; this is designed to protect existing policyholders. The return on this type of bond is not as secure as a traditional with‑profits policy, but is less vulnerable to day‑to‑day fluctuations than a unit‑linked investment. Most with‑profits bonds will allow regular withdrawals, up to specified limits, without charge, and will allow the holder to switch to other unit‑linked funds. As with normal unit‑linked funds, the unitised with‑profits fund will usually be subject to an initial charge, and units will be subject to bid and offer prices. There will be a charge for managing the fund, but this is not transparent. 11.3.3 Guaranteed income and growth bonds Some insurance companies offer guaranteed income or growth bonds, which are limited‑term life insurance investment bonds that offer certain guarantees. The normal taxation regime for non‑qualifying life policies applies. With a guaranteed income bond, the insurer guarantees a certain level of annual ‘income’ for the life of the bond, usually with a guarantee that the original capital will be returned at the end of the term. The income paid is subject to normal investment bond taxation, which means that 5 per cent of the original investment can be paid each policy year without a further tax charge at the time. At the end of the term the original capital is repaid, which triggers a chargeable event. At that point all payments are added to the final capital to determine the gain for tax purposes in the usual way. A guaranteed growth bond guarantees a set amount of growth to be added at the end of the term. Any growth will be treated as a gain for tax purposes and taxed accordingly. 11.3.4 Distributor bonds Conventional investment bonds accumulate income and growth within the fund and this process increases the value of units. Any withdrawal is taken from the capital by encashing units. 330 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds A distributor bond operates differently, in that income and capital are separated. Investments are made into a distributor fund, a fairly low‑risk unit‑linked fund designed to produce a reasonable level of income. Income from the underlying investments is collected and paid out on a regular basis, usually monthly, quarterly or semi‑annually. Although the income is technically counted as a withdrawal and subject to the 5 per cent annual allowance, it is actually paid from the fund’s income. This means that the capital is protected, subject to the normal risks of the market, because it is not eroded by having income payments taken from it. Other than the way in which the bond is structured, taxation and other aspects are the same as a conventional bond. 11.3.5 Tax treatment of ‘onshore’ bonds Because investment bonds are based on life insurance funds, onshore bonds share two similar tax features with life policies. ‹ The fund manager is responsible for paying corporation tax at the special life company rate of 20 per cent tax on any gains made by the fund. ‹ Any investor liability to basic‑rate income tax on the underlying investments is deemed to be settled by the fund manager paying the corporation tax in the fund. This means that the individual investor will never have a liability to basic‑rate income tax. It also means that non‑taxpayers are not able to reclaim the tax deducted. As investment bonds are non‑qualifying policies, the similarity to ordinary life policies stops at this point. 11.3.5.1 Withdrawals ‹ Up to 5 per cent of the original capital can be withdrawn each policy year without incurring a tax liability at the time – it is treated as a return of the original capital. ‹ The 5 per cent withdrawal figure is cumulative: if the full 5 per cent is not taken in any particular policy year, it can be used at a later date. For example, if no withdrawals are taken during the first four years, a withdrawal of 25 per cent could be made in the fifth year without a tax charge. Alternatively, the policyholder could withdraw 10 per cent a year for the next five years. ‹ The 5 per cent is permitted on the first day of the policy year. For example, Brian arranged a bond exactly four years and one day ago and has made no withdrawals so far. He would be able to withdraw 25 per cent today, which is the first day of the fifth year. ‹ Once the equivalent of 20 × 5 per cent withdrawals have been taken, any further withdrawals are treated as chargeable gains and potentially liable to further tax. ‹ The withdrawal facility makes bonds particularly attractive to higher‑rate taxpayers who wish to take an ‘income’ without immediate tax implications. 11.3.5.2 Chargeable events When a chargeable event occurs there may be a liability to income tax if a chargeable gain is made. The following are chargeable events: ‹ full encashment; ‹ death of the life insured; ©LIBF Limited 2024. All rights reserved. 331 11: Collective investments – life assurance ‹ excess withdrawals – partial withdrawals over 5 per cent per annum (cumulative); ‹ assignment for money’s worth – selling the bond or exchanging it for something of value. A chargeable gain is the actual or notional gain arising under a chargeable event. In the event of an excess withdrawal (over 5 per cent cumulatively) the amount over the cumulative 5 per cent allowance is treated as a gain. It is important to understand that the excess will be treated as a gain, regardless of whether the bond has made a gain or loss at that point. In very simple terms, the gain is added to the investor’s income for the tax year in which the gain is made, and if they are a higher‑rate/additional‑rate taxpayer, or the gain pushes them into the higher‑rate or additional‑rate band, further income tax at the rate of 20 per cent or 25 per cent of the gain is payable. A process called ‘top‑slicing’ may reduce the charge, as we will see in section 11.3.5.3. 11.3.5.3 The calculation Chargeable events must be reported to HMRC, and a calculation will be made to see if any tax is due. Apart from excess withdrawals, the chargeable gain is deemed to be the actual profit made. The gain is established by taking: ‹ the surrender proceeds; plus ‹ any withdrawals made; less ‹ the initial investment plus any excess withdrawals already dealt with. For example, Mrs Green invested £20,000 in a bond. During the term she withdraws £10,000, which included an excess withdrawal of £5,000. She cashes in the bond for £25,000. The gain would be: ‹ £35,000 (surrender value plus all withdrawals); less ‹ £25,000 (initial investment plus excess withdrawals); ‹ gain = £10,000. It might seem odd to add excess withdrawals to the initial investment, but it prevents the withdrawals being taxed twice as they would have been taxed at the time. The annual equivalent The ‘annual equivalent’ is a key element in the calculation. It is clearly unreasonable to assume that all of the gain made on an investment bond was made in the year of encashment – in most cases the gain has been made over a number of years, and when added to the holder’s other income for that year would result in an unreasonable tax bill. In recognition of this, the total gain is divided by the number of complete years the bond has been in force to find the annual equivalent gain, and it is this figure that is used in the initial calculation. The process is generally referred to as ‘top slicing’. Calculating the gain has become more complicated due to the introduction of the personal savings allowance (PSA) for basic- and higher-rate taxpayers because gains from life policies are treated as savings income. However, because onshore life funds are taxed internally and the tax cannot be refunded, the calculation involves a notional tax credit. We will look at this in more detail in the calculation process that follows. Legislation announced in the March 2020 Budget clarified how chargeable gains should be treated when calculating an individual’s income tax personal allowance. 332 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds The legislation came as a result of a tax tribunal case (Silver v HMRC) in 2015. Mrs Silver made a large chargeable gain on an investment bond when she cashed it in after a number of years. HMRC ruled that the entire gain should be added to her other income for the tax year to determine her personal allowance, which meant she lost her entire personal allowance. Mrs Silver and her advisers felt this was an incorrect interpretation of tax law and took the case to a tax tribunal, arguing that only the annual equivalent of the gain (the top slice) should have been used to calculate her personal allowance. The initial hearing found in favour of HMRC, but Mrs Silver appealed successfully against that judgement in 2019. HMRC lodged an appeal, but the government took action in the March 2020 Budget. From 11 March 2020 the annual equivalent should be used when calculating the effect of the gain on the personal allowance. Example An investment bond holder has income of £40,000 and makes a gain of £100,000 on a bond he has held for 10 years. Using HMRC’s previous approach, his income for the tax year would be £140,000, which means he would lose all of his personal allowance on the basis of a £1 reduction for every £2 of income above £100,000. Using the correct process, the annual equivalent of the gain would be £100,000/10 = £10,000. Adding the £10,000 gain to his income would be £50,000, well below the figure at which his personal allowance would be reduced. In late 2018, an update to the HMRC insurance policyholder taxation manual included changes to the calculation of the tax liability for a chargeable gain on an investment bond. This was mainly as a delayed response to the introduction of the starting-rate band and the PSA, because life assurance policy gains are potentially eligible for both allowances. Prior to the change, it was possible to use a shortcut method to calculate any further liability on a gain. Since the change, it is necessary to use the full calculation for any investor whose bond gain will push their total income close to, or above, the threshold for higher-rate tax. In simple terms, the changes mean that the previously relatively simple top‑slicing calculation now consists of three steps: 1. Calculation of the tax liability as if the whole gain was taxed in one year. 2. Calculation of the tax due if the annual equivalent was taxed in the final year – this gives the amount of ‘top-slicing relief’. 3. Deduction of the top‑slicing relief from the result of step 1 to establish any further tax payable. The calculation process – onshore bond Step 1 – tax liability, adding the whole gain to the current year ‹ Add the total gain to other income to establish the total income for the year and work out whether the starting-rate band or the applicable PSA amount apply. ‹ Income is dealt with in the following order: — non-savings income (earned/pension/rent); — interest; — dividends; — bond gains. ©LIBF Limited 2024. All rights reserved. 333 11: Collective investments – life assurance ‹ Deduct the personal allowance from non-savings income. ‹ Deduct any remaining personal allowance from interest first, then from gains. ‹ Apply the starting-rate band to interest and gains, if applicable. ‹ Apply the appropriate tax rate(s) to the balance of the gain. ‹ Calculate the total income tax due. ‹ Deduct basic-rate tax treated as paid within the life assurance fund from the total tax calculated above. If any unused personal allowance was set against the gain, the tax ‘paid’ will be 20 per cent of the gain minus the unused allowance. ‹ The result is the liability to further tax. Example – step 1 Non-savings income £45,000, gain £48,000 over 8 years. 1. Total income £93,000 – the higher-rate band for PSA applies (assume this is £500 for this example). 2. Personal allowance used by non-savings income (assume this is £12,570 for this example). 3. No starting-rate band, non-savings income too high. 4. Gain tax calculation: Non-savings income uses up the first £32,430 of the basic-rate band (assume this band goes up to £37,700 for this example). First £500 gain no tax (PSA), so £32,930 of basic-rate tax band used. Next £4,770 gain x 20% (uses up remaining basic-rate band) = £954. Balance of £42,730 x 40% = £17,092. Total tax liability on the gain is £18,046. 5. Deduct tax-credited £18,046 – £9,600 (£48,000 x 20%) = £8,446 tax liability. Step 2 – top-slicing relief 1. Calculate the annual equivalent of the gain (the slice) by dividing the gain by the number of complete years the bond was in force. 2. Calculate the tax liability as in step 1 using the annual equivalent instead of the total gain. 3. Deduct the tax credited on the annual equivalent (20 per cent of slice) and multiply the result by the number of years the bond was in force. The result is the ‘relieved liability’ or ‘top‑slicing relief’. 4. Deduct the relieved liability from the liability calculated in step 1 – the result is the tax due on the gain. 334 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds Example – step 2 1. £48,000/8 = £6,000 annual equivalent (slice). 2. Calculation – based on £6,000 slice: Non-savings income uses up the first £32,430 of the basic-rate band. First £500 slice no tax (PSA) – £32,930 of basic-rate band used. Next £4,770 slice x 20% (uses up remaining basic-rate band) = £954. Balance of slice – £730 x 40% = £292. Total tax on slice £1,246. Tax credit £1,200 (tax on slice in the fund). Tax liability on the slice £46. Multiply the liability on the slice by the number of years in force £46 x 8 = £368. 3. Step 1 minus step 2: £8,446 – £368 = £8,078 – the top‑slicing relief. 4. Deduct the top‑slicing relief from the tax liability in step 1: £8,446 – £8,078 = £368 further tax due. We can now look at two example cases, using the same allowances, rates and bands. ©LIBF Limited 2024. All rights reserved. 335 11: Collective investments – life assurance Example 1 Greg – non-savings income £48,000, bank interest £250, bond gain £56,000 over 7 complete years. Higher rate for PSA purposes. Step 1 – total liability As total income exceeds £100,000, the personal allowance is reduced by £4,250/2 = £2,125. Personal allowance is £10,445. Income Band Tax Non-savings £10,445 Personal allowance N/A Non-savings £37,555 Basic rate N/A Interest £250 PSA Nil Bond £250 PSA Nil Bond £55,750 Higher rate £22,300 Total liability on bond £22,300 Bond tax deducted at source (20%) £11,200 Tax liability on bond £11,100 Step 2 – top-slicing relief – bond slice £56,000/7 = £8,000 Income Band Tax Non-savings £12,570 Personal allowance N/A Non-savings £35,430 Basic rate N/A Interest £250 PSA Nil Bond slice £250 PSA Nil Bond slice £1,770 Basic rate – band now £ 354 used Bond slice £ 5,980 Higher rate £2,392 Total tax on slice £2,746 Bond tax on slice deducted at source £1,600 Tax on slice £1,146 Tax on slice x years (7) £8,022 Step 1 – step 2: £11,100 – £8,022 = £3,078 top‑slicing relief Further bond tax liability £11,100 – £3,078 £8,022 336 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds Example 2 Diana – pension £11,500, interest £4,000, bond gain £50,000 made over 10 years. Step 1 – full gain taxable Income Band Tax Pension £11,500 Personal allowance Nil Interest £1,070 Personal allowance Nil Interest £2,930 Starting rate Nil Bond gain £2,070 Starting rate Nil Bond gain £500 PSA Nil Bond gain £32,200 Basic rate – band now £6,440 used Bond gain £15,230 Higher rate £6,092 Total liability on bond £12,532 Bond tax deducted at source £10,000 Bond tax liability £2,532 Step 2 – top-slicing relief – bond slice £50,000/10 = £5,000 Income Band Tax Pension £11,500 Personal allowance N/A Interest £1,070 Personal allowance N/A Interest £2,930 Starting rate Nil Bond gain £2,070 Starting rate Nil Bond gain £500 PSA Nil Bond gain £2,430 Basic rate £486 Bond tax deducted at source £1,000 – more than tax on the gain, so £486 Tax on slice £0 Tax on slice x years (10) £0 Step 1 – step 2: £2,532 – £0 = £2,532 top‑slicing relief Bond tax liability - top‑slicing relief = further £0 tax liability: £2,532 – £2,532 It is important to realise that the calculation would apply even if the bond had made a loss, as we will see in the following example. ©LIBF Limited 2024. All rights reserved. 337 11: Collective investments – life assurance Example Mr Brown invested £100,000 in an investment bond 5 years and 3 months ago. He now needs to withdraw £40,000 from the bond, having made no previous withdrawals, but it has suffered from poor investment performance and is now worth only £90,000. He is a higher-rate taxpayer. The withdrawal is £10,000 above the cumulative allowance of £30,000 (£100,000 × 30%), so would be a chargeable event, taxed at 20 per cent. No doubt Mr Brown would feel hard done by – being taxed on a plan that has lost money. The next section will look at how segmenting could mitigate the problem. 11.3.5.3.1 Segmenting We have seen from Mr Brown’s example that it may be possible to make a loss and still have to pay tax on an excess withdrawal. This problem can be overcome to an extent by segmenting the bond, sometimes referred to as ‘clustering’, whereby the bond is segmented into perhaps 100 or 1,000 ‘mini‑bonds’. If we take Mr Brown’s case, we can see how this would work – we will assume his bond was split into 100 mini‑bonds at the start, each with an initial value of £1,000. Rather than taking withdrawals, he could completely encash sufficient mini‑bonds to provide the £40,000 he needs. As each bond would be worth £900 he would need to cash in 40 or 50 bonds, raising either £36,000 or £45,000. The key point is that cashing in bonds in this way would save him tax because complete encashment would be treated on its merits – a loss would not be taxable, whereas a gain would. Following the case of Lobler v HMRC (2015), the government instigated a consultation to investigate whether the existing rules were fair to those who suffered a disproportionate tax charge as a result of mistakenly taking excess withdrawals. FACTFIND Lobler vs HMRC is a complicated case, so we will look at a brief summary here. You can read the full case at: http://taxandchancery_ut.decisions.tribunals.gov.uk/Documents/decisions/ Lobler-v-HMRC.pdf Lobler v HMRC (2015) Mr Lobler invested a large sum of money in an offshore investment bond with Zurich Life, but then needed to withdraw most of the money from the bond to buy a house and repay loans. He failed to seek advice and did not tick an important box on the withdrawal form. As a result, Zurich Life took the withdrawals equally from all segments of the bond. Even though Mr Lobler had made little or no gain on the bond, and did not surrender the entire bond, the withdrawals fell within the ‘5 per cent’ rule and, as they were far in excess of 5 per cent, counted as large excess withdrawals. Later, Mr Lobler cashed in the bond, having made a small total gain on the original investment. His actions resulted in a huge tax bill, with an effective rate of 779 per cent, most of which was imposed on his own original capital. The box he failed to tick would have allowed the company to cash in sufficient segments to meet the withdrawal demands, which would have reduced 338 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds the final tax liability to no more than 40 per cent, as many of them would have been encashed at a loss or a small gain. The First Tier Tribunal of the Tax Chamber (FTT) heard his appeal. Although it sympathised with Mr Lobler, it concluded that HMRC was right to demand the tax and that Zurich had merely acted on his instructions and was not at fault. Mr Lobler then appealed to the Upper Tribunal, where the judge decided that Mr Lobler had a case for rectification of the mistake on the basis that it was a genuine error and not made to avoid tax. That meant that HMRC must treat the withdrawals as if Mr Lobler had used the most efficient method of withdrawing the cash. The result of the government consultation was that, since April 2017, an investor who faces a large tax bill as a result of major withdrawals that resulted in a gain that was wholly disproportionate to the ‘economic’ gain actually made will be able to apply to have the charge recalculated on a ‘just and reasonable basis’. While this is a good outcome for investors, it is clear that the sensible approach would be to ensure that advice is sought regarding the best way to take more than 5 per cent from a bond, which will usually be through encashment of segments. 11.3.6 Use of investment bonds to satisfy customer needs One of the main reasons for investment in investment bonds is to take advantage of the tax treatment, although the benefits only really apply to two types of investor. 11.3.6.1 Basic-, higher- and additional‑rate tax efficiency As long as an investor keeps the money in the bond, there will not be any further tax to pay on gains or income on the investment. This contrasts with unit trusts, OEICs and investment trusts where, assuming the dividend and personal savings allowances have been used, dividends received would be taxed according to the individual’s income tax band. FACTFIND Find out the tax rates on dividends at: www.gov.uk/tax-on-dividends Basic‑rate taxpayers would pay 20 per cent on an interest distribution, higher‑rate taxpayers 40 per cent and additional‑rate taxpayers 45 per cent. The benefits may be marginal for most basic‑rate taxpayers and may be offset by the higher charges. However, they could be of particular benefit to higher-/additional‑rate taxpayers who wish to invest for retirement outside a pension because they will pay no tax until retirement and can then withdraw 5 per cent a year to supplement their income for at least 20 years without paying tax. In addition, a higher‑/additional‑rate taxpayer can take advantage of the 5 per cent withdrawal facility to provide a tax‑efficient ‘income’ to pay expenses such as school fees or other regular outgoings, without incurring a tax charge at the time. The 5 per cent withdrawal facility is technically a withdrawal of capital and relates to the original investment amount. ©LIBF Limited 2024. All rights reserved. 339 11: Collective investments – life assurance 11.3.6.2 Pensioners Investment bonds do not offer tax advantages for pensioners, other than higher- and additional-rate taxpayers wishing to use the 5 per cent withdrawal facility. ISAs, collective funds and the personal savings and dividend allowances provide ample opportunities for most pensioners to reduce potential tax liabilities. However, there is still one attraction for some older people. Under the government’s guidelines for later‑life care provision, insurance policies, including investment bonds, are specifically excluded from an individual’s assets when assessing how much they should contribute towards their care. The main requirement is that they should not have invested in the bond in order to avoid care fees – that would be a deliberate deprivation of assets and would allow the local authority to include the value of the bond. 11.3.6.3 Other reasons to invest in investment bonds There are generally four other reasons for people to invest in a single‑premium bond. ‹ Access to professional fund management via single‑premium bonds can offer investors the opportunity to invest in any number of specialist geographical sectors as well as in lower‑risk funds, such as gilt funds. A secondary reason related to accessibility is the minimum investment allowable. It would not be practical or sensible to attempt to invest in, say, Japan, with only £2,000. Single‑premium bonds allow such access by pooling investments of smaller investors. ‹ Switching – owners of investment bonds can switch readily between the differing fund options available from the insurance company. This has two particular advantages: — Switching is usually free, or in some cases subject to a small charge of no more than £20 or so. — A switch does not count as a disposal for CGT purposes. This allows investors to seek the highest possible returns without incurring tax. ‹ Administration – the paperwork associated with investment bonds is very simple, being no more than the bond document and an annual statement. ‹ Tax treatment. The investment bond, then, has advantages for the investor who would like to minimise all investment decisions, as well as for the sophisticated investor wishing to access specialist markets. 11.3.7 Offshore bonds Offshore bonds are simply investment bonds offered by offshore subsidiaries of UK investment companies. The similarity includes the ability to withdraw up to 5 per cent of the initial capital each year without a tax charge. The significant difference is that the fund is not taxed while it remains invested. A chargeable event by a UK tax resident will cause a potential tax charge. The tax payable will be that applicable to the investor’s status, bearing in mind that no tax has been paid in the fund. Chargeable gains from offshore bonds are classified as savings income within the terms of the starting-rate band and the personal savings allowance. Gains are treated as the top part of savings interest, which means that all other savings interest is dealt with first before the gains. This has particular relevance for the starting‑rate band and the new personal savings allowance because, although offshore bond gains count as 340 ©LIBF Limited 2024. All rights reserved.  11.3 Investment bonds interest, all other interest is considered first before the gains. For example, an individual has earned income of £35,000, building society interest of £1,200 and a gain from an offshore bond of £4,000. They will not qualify for the starting‑rate band. They are a basic‑rate taxpayer, and so will be eligible for the PSA of £1,000. Their building society interest will be set against the PSA first, leaving £200 of that interest taxable. As the life policy gain is considered last, none of the gain from the bond will be within the PSA, and so it will all be taxable. In other words, gains from an offshore bond will only be included in the starting‑rate band or PSA if the individual does not have enough other savings income to use them up. The tax calculation is the same as for an onshore bond, using a similar three-step process. Step 1 – calculate the full tax liability, including the liability at basic rate. Although no tax credit is given, because no tax has been taken in the fund, a notional tax credit is given in the calculation for top‑slicing relief. Step 2 – calculate the tax liability on the slice, again deducting the notional 20 per cent tax credit for the purposes of the calculation. Step 3 – deduct the result of step 2 from step 1 to establish the top‑slicing relief, which is then deducted from the full tax liability (the liability without deduction of the notional tax credit). This is best shown through the example on the following page. Onshore vs offshore It is felt that the gross nature of the offshore fund growth is an advantage, offering quicker accumulation of capital gains. Remember, however, that the UK taxpayer will have to pay tax on encashment, and it is possible that the ‘host’ country might charge a withholding tax, which will reduce the tax advantages. Charges on offshore bonds are often higher than those in the UK and cannot be deducted from fund income for tax purposes. The main advantage of an offshore bond is that the gain is allowed to roll up on a gross basis and the compounding effect of this will potentially make the investment performance attractive, despite the higher taxation on encashment. Gains may be eligible for the starting‑rate band and the PSA. Table 11.1 Investment bonds Onshore Offshore Tax in fund 20% No – gross roll‑up Tax on gains Income tax Income tax Top‑slicing Yes Yes Starting‑rate band No Yes Personal savings allowance Yes Yes Non‑taxpayer gains No more tax No tax Basic‑rate taxpayer gains No more tax 20% on realisation Reclaim overpaid tax No Not applicable Higher‑rate taxpayer gains 20% 40% Additional‑rate taxpayer gains 25% 45% 5% withdrawals Yes Yes ©LIBF Limited 2024. All rights reserved. 341 11: Collective investments – life assurance Example Gary – non-savings income £49,000, bank interest of £250, offshore bond gain of £48,000 over 6 complete years. Assume a higher rate of £500 for PSA purposes, a personal allowance of £12,570 and that the basic-rate band goes up to £37,700. Step 1 – total liability Income Band Tax Non-savings £12,570 Personal allowance N/A Non-savings £36,430 Basic rate N/A Interest £250 PSA Nil Bond gain £250 PSA Nil Bond gain £770 Basic rate – band now £154 used Bond gain £46,980 Higher rate £18,792 Total tax on bond £18,946 Notional tax credit £9,600* Tax liability on bond £9,346 *The tax credit is purely for the purposes of calculating the top‑slicing relief. It is not given against the final tax liability for the gain. Step 2 – top-slicing relief – bond slice £48,000/6 = £8,000 Income Band Tax Non-savings £12,570 Personal allowance N/A Non-savings £36,430 Basic rate N/A Interest £250 PSA Nil Bond slice £250 PSA Nil Bond slice £770 Basic rate – band now £154 used Bond slice £6,980 Higher rate £2,792 Total tax on slice £2,946 Notional tax deducted at source* £1,600 Tax on slice £1,346 Tax on slice x years (6) £8,076 Step 1 – step 2: £9,346 – £8,076 = £1,270 top‑slicing relief Bond tax liability – top‑slicing relief = further £17,676** tax liability: £18,946 – £1,270 *The tax credit is purely for the purposes of calculating the top‑slicing relief. It is not given against the final tax liability for the gain **When calculating the full tax liability, the top‑slicing relief is deducted from the original full liability in step 1. 342 ©LIBF Limited 2024. All rights reserved.  11.4 Annuities 11.4 Annuities Annuities are generally offered by life assurance companies. The concept of an annuity is straightforward – the investor pays a lump sum in return for a guaranteed income for life or for an agreed term. In order to provide this type of return, a provider will invest in a range of gilts, both conventional and index‑linked. As a result, annuity rates are very sensitive to gilt yields and may reduce when interest rates go down for a sustained period. Annuities are based on the life expectancy of the applicant – directly, in the case of life annuities, and less so with temporary annuities. From 21 December 2012 the European Court of Justice ruling on gender equality meant that it was illegal for a provider to discriminate on the grounds of gender. This led to the same rates for men and women, which led to general reductions in male rates and increases in women’s rates. Some providers now use postcode information as an additional factor when calculating annuity rates because evidence shows that mortality rates are affected by location. Rates for towns such as Peterborough, Liverpool, Dundee and Newcastle tend to be higher than London and the South‑East. Annuities can be divided into two broad categories: purchase annuities and compulsory purchase annuities. Compulsory annuities are those purchased with the proceeds of a pension scheme and are considered in the Pensions area of AFA. 11.4.1 Types of purchase annuity When buying an annuity, an investor can choose to receive their payments in a number of different ways. The income from an annuity can be received monthly, quarterly, half‑yearly or annually in advance, or at the end of the payment period (in arrears). Payments in advance will result in a slightly lower income. Most providers offer the majority of the following types of annuity, many of which may be combined. 11.4.1.1 Life annuity With a life annuity, payments are made for the rest of the individual’s life and cease on death. The amount of income can either be fixed or increase annually. It is possible to build in a guarantee with a life annuity. The guarantee will provide that payments will continue for a stated period from the start of the contract – typically five to ten years – even if the individual dies. For example, if a ten‑year guarantee were to be arranged and the annuitant were to die five years after taking out the annuity, a further five years’ income would be paid to the estate. In some cases, the outstanding income may be paid as a discounted lump sum. 11.4.1.2 Temporary annuity Payment on a temporary annuity is made for an agreed term – 5, 10, 15 years, and so on. If the individual dies during the term, payment ceases and no further income is paid. An annuity certain is a temporary annuity that pays until the end of the term, even if the individual dies during the term. Temporary annuities, particularly in the form of the annuity certain, are frequently used to pay school fees. ©LIBF Limited 2024. All rights reserved. 343 11: Collective investments – life assurance 11.4.1.3 Immediate annuity With an immediate annuity, income payments begin as soon as the annuity is purchased. 11.4.1.4 Deferred annuity With a deferred annuity, the investment is made either as a lump sum or as regular premiums, but payment begins on a predetermined date in the future – the vesting date. This might be, say, five years from the date of purchase of the annuity, or at retirement age. If the policyholder dies before the income starts, the premiums will be returned, either with or without interest, depending on the contract. 11.4.1.5 Escalating annuity Escalating annuities enable payments to increase each year, either by a fixed amount (usually expressed as a percentage) or in line with inflation (usually the RPI). The rising annuity payment will mitigate the effects of inflation. The provider may invest in index‑linked gilts in order to guarantee this escalation. Escalating annuities start at a much lower level than level annuities. 11.4.1.6 With or without proportion If an annuitant dies before the next payment date, many annuities would not make a final payment – this is known as without proportion. If the annuity is with proportion, a pro rata payment would be made representing the period from the last payment until death. 11.4.1.7 Capital‑protected annuity A capital‑protected annuity is a life annuity that guarantees to pay out at least the initial investment. This means that, upon death, the initial investment less any gross payments already made will be returned to the investor’s estate. For example, John paid £50,000 for a capital‑protected annuity that paid him £3,500 a year. He died having received a total of £14,000 in payments. The provider would pay £36,000 to John’s estate. 11.4.1.8 Enhanced and impaired life annuities Enhanced annuities are a relatively new development, offering increased rates to applicants with specific medical conditions and to those who smoke. These annuities are usually available without medical underwriting and can increase the annuity rate by around 25 per cent. Impaired life annuities are available to those who have serious life‑shortening medical conditions. These annuities will be subject to underwriting, with the life company wishing to ensure that the applicant’s life really is at risk from the condition; this is the reverse of life assurance underwriting. Impaired life rates can provide significant increases compared with conventional annuities. 344 ©LIBF Limited 2024. All rights reserved.  11.4 Annuities 11.4.1.9 Investment‑linked annuities Many companies now offer investment‑linked annuities, in which the pension fund is invested in a with‑profits or unit‑linked fund. With a unit‑linked annuity, the pension fund buys units in a unit‑linked fund and the annuitant selects an assumed rate of investment growth; the higher the rate of growth, the higher the initial income, which is provided by cancelling units. If the fund grows in line with, or ahead of the assumed rate, the income can be maintained or even increase. If the growth is lower than anticipated, the income will reduce. Unit‑linked annuities are riskier than conventional annuities but do offer the potential for an increasing income if a realistic growth rate is chosen. For a with‑profits annuity the pension fund is invested in a with‑profits fund. The applicant selects an anticipated bonus rate (ABR) between 0 per cent and 5 per cent pa; the higher the ABR, the higher the initial income but the more the danger of a reduction later. Each year the income is reassessed – the annuity is reduced by the ABR and then the newly declared bonus is added, together in many cases with a one‑year temporary bonus. For example, if the annuity has an ABR of 3 per cent and an initial income of £1,000, and the company announces a new bonus of 4 per cent, the calculation would be: £1,000/1.03 = £970.87 – the base annuity. £970.87 × 4% = £38.83 new bonus, giving a new base annuity of £1,009.70. When the next reassessment is due, the calculation will start with an annuity of £1,009.70. If the next bonus declared is 2 per cent, the income will reduce: £1009.70/1.03 = £980.29 – new base annuity. £980.29 × 2% = £19.60, giving a new annuity of £999.89. The company may also add a one‑year temporary bonus, which would be removed before the next bonus was calculated. The temporary bonus is usually calculated as a percentage of the new base annuity, and the bonus amount is often multiplied by the number of years the policy has been in force. There is usually a guaranteed minimum level below which the annuity cannot fall, regardless of bonus performance. If the applicant selects a realistic ABR, there is the potential for a rising income. If the applicant selects a higher ABR, the initial income would be higher but there is a high risk that the income could fall due to low bonus rates. 11.4.1.10 Contingent annuities A contingent annuity is a term used for an annuity where payments are contingent (dependent) on a specific event occurring. A life annuity is a contingent annuity because it will pay out only while the annuitant is alive – the contingency. A widow’s annuity is contingent on the spouse’s death. An annuity certain pays out for a specified period, regardless of whether the annuitant is alive. This is a form of ‘non‑contingent’ annuity as payment is fixed and does not depend on any events once set up. ©LIBF Limited 2024. All rights reserved. 345 11: Collective investments – life assurance 11.4.2 Taxation of purchase annuities The payments from a purchase annuity are treated as part capital and part interest. The capital part is tax‑free. The interest part of the payment is treated as savings income and 20 per cent income tax is deducted at source. Purchase annuity interest is savings interest eligible for the starting‑rate band and personal savings allowance. ‹ The interest element is included in savings income for the purposes of the personal savings allowance of £1,000/£500. ‹ Higher‑rate taxpayers will have a further 20 per cent tax to pay. Additional‑rate taxpayers have a further 25 per cent to pay. ‹ Non‑taxpayers can reclaim the tax deducted or arrange to receive the annuity payments gross. Gross payment does not apply to joint‑life annuities where one of the annuitants is a taxpayer. The split between the capital portion and interest portion of payments from a purchase annuity is set at the start and defined either by reference to the annuitant’s life expectancy, as stated in government mortality tables, or to the term of a temporary annuity. In simple terms it is the purchase price divided by the number of years that the annuitant is expected to live, or by the agreed term. Example – purchase annuity taxation A basic‑rate taxpayer buys a purchase life annuity and receives a level income of £741 pa. They have already used their personal savings allowance. The capital content is established as £619 pa, leaving £122 taxable (tax £24.40). This will result in a net income of £716.60 pa. In comparison, a compulsory purchase (pension) annuity would give the same investor £732 pa, all of which would be taxable at 20 per cent, leaving a net income of £585.60. 11.4.3 Compulsory purchase (pension) annuities When a money purchase pension fundholder wishes to take an income from the fund, the conventional approach is to arrange an annuity. An annuity arranged using a pension fund is referred to as a compulsory purchase annuity (CPA) and is subject to a specific tax regime. CPAs will be considered in more detail in the Pensions area of AFA, so at this point we will consider them in overview. Compulsory purchase rates are based primarily on a combination of life expectancy and gilt yields, which in turn are affected by the Bank base rate. High gilt yields lead to high annuity rates, and low gilt yields lead to lower annuity rates. For example, in the mid-1970s, a time of very high inflation, the Bank rate led to high gilt yields and annuity rates for a 65-year-old male reaching 16 per cent. Rates remained above 10 per cent until the late 1990s. In more recent years, a low Bank rate led to lower gilt yields, and annuity rates for a 65-year-old male slipped as low as 4.4 per cent immediately after the EU referendum result. Increases in the Bank rate during 2022 and 2023 to combat inflation led to increased annuity rates of around 7 per cent for a 65-year-old male. The implementation of the EU gender equality ruling in 2012 further reduced rates for males, although women’s rates have generally increased (Hargreaves Lansdown, 2018). ‹ The annuity cannot normally be taken until the fundholder reaches 55. 346 ©LIBF Limited 2024. All rights reserved.  11.4 Annuities ‹ The CPA is a lifetime annuity, but a guarantee can be added at the start so that payment continues for any chosen length of time in the event of the annuitant’s death. ‹ The annuity can be arranged on a single‑life basis, or to provide a continuing income for a spouse on the annuitant’s death, at a rate between 50 per cent and 100 per cent of the original annuity. ‹ Unlike purchase annuities, all income from pension annuities is taxable in the same way as earned income. An annuity can be arranged on the lives of the plan holder and any other chosen beneficiary. ‹ Annuity payments that continue to pay to a surviving beneficiary will be: — tax‑free if the annuitant dies before the age of 75; — taxed at the recipient’s marginal rate of tax if the annuitant dies aged 75 or over. ‹ Ongoing payments from a guaranteed annuity can be paid to any beneficiary for the remainder of the term and will be: — tax‑free if the annuitant dies before the age of 75; — taxed at the recipient’s marginal rate of tax on the annuitant’s death from age 75. ‹ Lump sum benefits from a capital protection arrangement can be paid to any beneficiary: — tax‑free if the annuitant dies before the age of 75; — taxed at the recipient’s marginal rate of tax if the annuitant dies aged 75 or over. The level of annuity will depend on the size of the fund. Smaller funds generally provide a lower annuity rate, and holders of very small funds often have little choice of provider. Table 11.2 shows example compulsory purchase annuity rates based on a single life annuity with a five‑year guarantee from a £100,000 fund (July 2023). Table 11.2 ‘Best buy’ compulsory purchase annuity rates based on a single life annuity with a five‑year guarantee from a £100,000 fund Age Level RPI Increase 60 £6,434 £3,839 65 £7,168 £4,743 70 £7,968 £5,625 Source: Hargreaves Lansdown (2023) The introduction of single‑sex annuities has resulted in reductions in male rates and an increase in female rates. Smokers and those with certain medical conditions may be able to obtain higher ‘enhanced’ annuity rates. ©LIBF Limited 2024. All rights reserved. 347 11: Collective investments – life assurance Topic summary ‹ Life assurance provides an alternative to unit trusts and other collective investments. Unlike protection‑orientated life policies, endowments combine the benefits of collective investment with an element of life cover, albeit at a higher cost than unit trusts and other collective schemes. The regular premium nature of the contract is attractive to those who want to invest on a regular basis, and qualifying status provides tax advantages. ‹ The basic principle and investment range of investment bonds are similar to unit trusts and OEICs, but the unique tax treatment makes them an attractive alternative for some higher earners. ‹ Annuities provide a guaranteed income for life or an agreed term. For many investors they provide the foundation for retirement planning. ‹ In this topic, we looked at: — life assurance qualifying rules; — endowments; — investment bonds; — annuities. 348 ©LIBF Limited 2024. All rights reserved.  Review questions Review questions The following questions are designed to consolidate and enhance your understanding of the material that you have just studied. Answers to the questions are contained at the end of this book. 1. Sharon is considering a life policy as a savings plan. The details are as follows. Monthly premium £75, increasing by 5 per cent on each policy anniversary. Sum assured £6,500. Term – ten years. What is the taxation position with this policy? Why? 2. Philip, who has taxable income of £36,530 after allowances, invested £50,000 in an investment bond six and a half years ago and left it untouched. It now has a value of £62,000 and Philip would like to withdraw the maximum amount without creating a tax charge. How much could he withdraw? ©LIBF Limited 2024. All rights reserved. 349 11: Collective investments – life assurance 3. Complete the table below relating to the taxation of investment bonds. Onshore Offshore Tax in fund Tax on gains Top‑slicing Non‑taxpayer gains Basic‑rate taxpayer gains Reclaim overpaid tax Higher‑rate taxpayer chargeable gains Additional‑rate taxpayer chargeable gains 5% withdrawals 4. Wendy arranged a with‑profits annuity with an ABR of 4 per cent and an initial annuity of £6,000 a year. On the first policy anniversary, the insurer announced a bonus of 2.5 per cent and a temporary bonus of 1 per cent. Calculate Wendy’s new annuity income. References Hargreaves Lansdown (2018) A brief history of annuity rates [online]. Available at: www.hl.co.uk/news/articles/ archive/a-brief-history-of-annuity-rates Hargreaves Lansdown (2023) Best buy annuity rates [online]. Available at: www.hl.co.uk/retirement/annuities/ best-buy-rates 350 ©LIBF Limited 2024. All rights reserved.