Personal Finance: Can you spy a weakness in bond's future?

`Smooth returns' sustain interest when markets wobble

LET'S FACE it. Investing at least some of your cash in a low-risk fund is a sound concept. But if your money isn't earning what it should, there is not much point of placing it in that savings vehicle in the first place.

This fact applies as much to with-profits bonds as it does to any other investment. The question any investor must consider is whether bonds are likely to continue paying out as much as they have done. If they are set to pay out less, are they still a worthwhile place for your money?

To answer these questions, it is necessary to start with how with-profits bonds actually deliver returns to savers. As has been described before in this series, they work by a mixture of two separate calculations.

Returns are in the form of so-called "reversionary" bonuses, added annually to the bond.

Once added they cannot be taken away. In addition, some companies may also offer a "terminal" bonus when the bond is cashed in. This terminal bonus, together with the annual ones, give the final maturity value - the overall return on a policy over its investment period.

The bonus system allows companies to "smooth returns", delivering reliable levels of growth. When times are good, a life company may hold on to some of the growth in the fund's value and allocate a smaller annual bonus. In turn, when times are bad this allows it to store up some of the money and pay a larger bonus than would otherwise be the case. This smoothing effect, combined with the fact that bonuses are attached for a policy's lifetime, mean that investment growth should continue to follow an uphill path, no matter what happens to UK or world stockmarkets.

Terminal bonuses, where they are used, are a means of adding what the company feels you are owed, minus expenses, during the bond's investment period.

The issue of whether it is better to look for a large annual bonus, coupled with a smaller terminal one - or vice versa - is a difficult one. At times of stockmarket uncertainty, paying a large annual bonus could be seen as foolhardy. Equally, if bonuses are consistently smaller than the norm, that could indicate poor investment performance from that particular bond.

That said, how can one measure performance? Overall, it probably makes sense to do so by looking at the net annual bonus rate, the amount which each company declares it will add to a policy every year. The table below indicates what these rates are.

One important point to note is that bonus rates overall have been falling compared to a year ago. However, they are still vastly superior to the rates paid by most savings accounts, which have in many cases dropped to little more than 3 or 4 per cent gross. As we have seen, the option to take income, free of tax, is an additional feature of with-profits bonds (for lower-rate taxpayers).

For example, the companies announcing their net annual bonus rates include CGU and Scottish Provident, which are paying 6.25 per cent, Friends Provident and Scottish Equitable, both paying out 6 per cent, NPI, Clerical Medical and Norwich Union, whose bonus rate this year is 5.5 per cent, while Scottish Widows, is down to 5 per cent.

The rates, while down an average of between 0.5 and 0.75 per cent on last year, are still comfortably in excess of most building society rates, particularly when you consider that you can take up to 5 per cent income from your with-profits bond as income without paying tax. By contrast, a lower-rate taxpayer with the same amount of money in a building society would lose 20 per cent of his or her income to the Inland Revenue.

This means that in most cases, it still makes sense to consider bonds as a low-risk investment. As always, returns won't be stratospheric, but at least you know that the value of your portfolio is reasonably safe.

`The Independent' has produced a free 24-page Guide to With-Profits Bonds. Written by Nic Cicutti, personal finance editor, the guide examines the pros and cons of investing in bonds. For your free copy, sponsored by the With-Profits Bonds Shop, call 0845 2711007