Bond is back: licenced to rip off

Are financial advisers recommending an investment that's more beneficial to them than their clients?

Why do we invest so much of our money into investment bonds? Perhaps because the notion of investing into them carries with it a spurious air of tradition of City gents managing our money with our best interests at heart.

It seems almost cynical to suggest another reason: that bonds now pay a higher up-front commission than any comparable type of retail financial product currently available in the UK. This up-front commission is usually set at 5 per cent of the gross amount invested. Most bonds are sold through independent financial advisers (IFAs). In return for persuading you to invest, say, pounds 10,000, an IFA will receive pounds 500 - generous remuneration for no more than a couple of hours' work.

Meanwhile, the average commission on unit trusts and ISAs is just 3 and sometimes as little as 2 per cent of the amount invested. There are of course some much-rehearsed arguments in favour of bond investment. These hinge in part on the tax advantages enjoyed by bonds against other types of investment. The equivalent of both income and capital gains tax are paid in the fund at a rate of 22.5 per cent after the deduction of allowable management expenses.

You can also expect to be told that you can withdraw up to 5 per cent of the original amount invested tax free each year over a 20-year term. Watch out for promises of tax deferral. Finally, you will be told that bond withdrawals leave "age allowance" unaffected.

Needless to say, bonds sell well with those planning, and in, retirement. Skandia says its bond holders have an average age of 57. Most other life companies suggest their average investment age is 55 or more. For this reason alone, these supposed tax benefits need close scrutiny. Start with capital gains tax (CGT). The current annual exemption is pounds 7,100 or pounds 14,200 for a couple. Remember, this is the amount you realise before paying any CGT.

Each year only some 34,000 of us pay CGT arising from the disposal of investments, according to the Inland Revenue. The huge majority of those buying bonds stand no chance of paying it anyway.

Next comes income tax, starting at a lower rate of 10 per cent on the first pounds 1,500, a basic rate of 23 per cent on the next pounds 26,500, and at a higher rate of 40 per cent on any income over pounds 28,000. Most bond owners live on pension and pay no more than basic rate income tax. For them, it is difficult to see any cash saving to be made by investing in bonds.

The crux of the matter is that neither the income nor capital gains taxes paid in bond funds are recoverable by a taxpayer, even if they have not used up their personal allowances. Consider a bond fund worth, say pounds 100m, which rises in value by 25 per cent before tax, including income of 5 per cent. After tax at 22.5 per cent, this return falls to 19.38 per cent.

But the same returns on a unit trust, paying basic rate income tax, but no CGT, would be 23.85 per cent. The truth is that for a basic rate taxpayer with unused CGT allowances, bonds cost more in tax than unit trusts, PEPs, ISAs, investment trusts or ordinary shares.

For someone aged 65-74, the age allowance increases the basic personal allowance from pounds 4,335, to pounds 5,720, with the effect of saving about pounds 318.55 basic rate income tax. It does not take long to work out that this "saving" can be easily outweighed by the irrecoverable CGT paid in a life fund. As little as pounds 20,000 in bonds with gross capital growth of 10 per cent would "cost" some pounds 450 in CGT paid in the fund.

Inland Revenue statistics show that not that many pensioners would lose any age allowance anyway: in the last tax year, out of a total of some four million tax-paying pensioners, some 380,000 lost all their age allowance because of income levels, while a further 350,000 claimed tapering relief. The conclusion must be that bonds only offer real tax savings to high rate income taxpayers with an existing CGT liability.

One way round this is to argue that they offer investment funds not otherwise available. This is true of "with-profits" bonds, investing into shares, cash, gilts and property. However, all the other main types of bond fund - distribution, managed growth, high yield - are available in very similar unit trusts.

The question this raises is just why IFAs are permitted to get away with recommending bonds as best advice, when for very many of us they clearly are not.