Silence is far from golden

UK money watchdog the Financial Services Authority has barked at millions of endowment mortgage holders, warning them that the billions invested in their policies may not grow fast enough to pay off their home loans.

But around a million other savers are to receive no such warnings, despite their financial futures depending on the same funds that have sometimes reduced homeowners to fear and despair. They are the holders of some of the most impenetrable investments on sale to the public - with-profits bonds.

The FSA says that the original investment return figures used by endowment compa nies to sell with-profits policies are no longer valid in the current investment and inflation environment. It now regards reviewing with-profits business as a "key project".

The bonds are lump-sum investments which offer annual gains while maintaining the initial capital. They have been on sale for more than a decade but their popularity has soared over the past five years as returns on bank and building society accounts fell with interest rates.

Typical high-rate savings accounts yield around 6% before tax, compared to the bonds, which promise 7.5% tax-free to basic rate taxpayers and give the impression that your capital is safe.

But these claims may not al ways be as watertight as they seem. (see opposite) The buyers of the bonds are mainly retired people or those approaching retirement. They are pouring around £15bn a year into them- often attracted by first-year rates that depend more on financial engineering than investment returns.

Now Barnstaple-based independent financial adviser Phillip Milton has broken ranks with a whistle-blowing booklet With Profits Bonds - Have You Been Myth-sold? which takes the lid off the steamy but very profitable world of the bonds.

And next month a working party at the Faculty and Institute of Actuaries - the insurance professionals whose decisions govern returns on with-profits investments - will warn of the dangers investors face if they place too much reliance on returns promised in marketing literature following an actuarial paper last June which told companies not to hype figures artificially.

But individual actuaries admit that it will need more than a warning to prevent financial advisers from puffing the plus points and deleting, as far as legally possible, the drawbacks. Commission on these products is very high - the Prudential has, in the past, offered some IFAs up to 7% on its top-selling Prudence Bond. Others include Eagle Star and Scottish Widows, also paying advisers up to 7% of what you pay in. Britannic and Sun Life pay a maximum 6.75%, and many others are at levels up to 6%.

Sums invested in these bonds are large, typically £25,000, therefore earning advisers up to £1,750. These commissions are twice the level paid to advisers when the recommend a unit trust. And while some advisers discount part or even all of this commission, many insurers are now paying annual "renewal" commission whose cost has, ultimately, to come from investors. Those working for banks and insurers directly do not generally rebate.

T he suspicion remains that the bonds are pushed by advisers simply because the pay more commission than unit trusts. Yet the advisers' own professional body, the Chartered Insurance Institute, says: "There should not be incentives that might create a bias towards plans where higher initial commission is paid to advisers."

But potential difficulties go beyond high commission. "These bonds have been gaining in popularity just when the bonus rates on which they depend have been dropping and the volatility of the funds has been increasing. These are supposed to be safe investments where the ups and downs are smoothed out but they are becoming increasingly risky as they become more reliant on equities to produce returns," Mr Milton says.

With-profits bond money is managed in a very similar way to endowment mortgages and with-profits pension funds. But returns from these funds are falling. This month, insurance companies are declaring annual bonuses and, according to figures from second-hand policy dealer Beale Dobie, of the ones to declare annual, or reversionary, bonuses so far, three have fallen, four are unchanged and one very small player has risen.

"The money going into with-profits bonds ends up in the same pots as used by endowment policies to fund mortgages like the ones now suffering awful performance projections and fears of mis-selling," says Mr Milton.

"People don't realise that mutual companies pay regulatory fines and compensation for mis-selling out of with-profits funds. Other companies may even try subsidising loss-making stakeholder pensions from with-profits funds," he adds.

We asked leading providers whether they offered high initial rates and how their rates had moved.

Friend s Provident has a first year guarantee ranging from 5% on £3,000 to 8.5% on £100,000. It justifies not alerting customers to the potential of falling rates because the plans do not have a target, unlike endowments.

Norwich Union had a 25% market share last year. It says it complies with PIA guidelines on projection rates used and supports the Faculty and Institute of Actuaries on the promotion or marketing of headline bonus rates. NU does not declare high first year bonus rates and will not be doing so in the future. Since 1997 rates have fallen from 7.25% to 5.75%.

Legal & General has a confusing variety of products but says each year's plan is managed separately. It is replacing penalties for withdrawal in certain circumstances by managing a combination of lower annual growth rates plus higher terminal bonuses.

Liverpool Victoria has around £4.5bn in its bonds which offer a guaranteed 7.5% over the first two years by "creating additional units."

Royal & Sun Alliance Annual bonuses have fallen from 7% in 1996 to 5% in 2000. It says: "Our aim is to be fair to all policyholders by offering appropriate bonus rates, rather than trying to attract business by offering inflated rates at the outset."

Standard Life has only been selling bonds since last August. Its bonus rate is 4.5%. There are no special deals.

Scottish Friendly guarantees 6% in the first year but it will not market using "an artificially high rate only to cut it dramatically in subsequent years". Bonus rates have fallen from 7% to 6% since 1998.

Prudential, Scottish Widows and Scottish Mutual were unable to reply.

Truth that lies behind the fanciful claims

With profits bonds have been one of the most successful investment products of the past decade - seeming to square the circle of safety combined with high returns.

But they are far harder to fathom than unit or investment trusts. And that lets the insurers try to weasel their way into potential buyers' affections with big print claims that could be too good to be true. Here we examine assertions and reality.

"Your money is safe - your capital can never fall. "

True, but only up to a point. Many bonds take up to 5% upfront to cover charges including commission. But despite the reputation with-profits funds have of never falling back, the bond companies have the market value adjustment or 'MVA' in reserve. They all say this is rarely used but many wanting their money back during the 1998 Asian crisis suffered an Equitable Life style deduction of around 10%. Bonds often offer MVA-free encashments on the fifth or ten anniversary and always on death. Most say they never (or hardly ever) apply the adjustment. But what happens if shares melt down as they did in Japan where the Nikkei index is little more than a third of its 1989 value?

"The returns on with-profits bonds are totally free of basic rate tax and capital gains tax."

Technically true but otherwise to be taken with a pinch of salt. Insurance funds are hit by corporation tax which is the equivalent of basic tax and capital gains tax. Non and lower rate taxpayers lose out while most basic rate payers do so as well as they cannot use their capital gains tax annual exemption - currently £7,200. This contrasts strongly with Isas. The only possible winners from the tax treatment are higher rate taxpayers and those caught in the age allowance trap.

"You can have tax-free withdrawals."

This is true up to 5% of the original sum paid in. But as the fund has already paid tax, further payments would would add up to double deductions.

"Bonds invest in a wide portfolio to provide a consistent return by smoothing out the ups and downs of the stock market"

That's what they should do. But to produce the rates investors demand (and sellers need to justify commissions), insurers have to use higher proportions of volatile shares. The effect is that annual growth rates are variable, not smooth. And if markets fall with a bump, the annual bonus will be very low, the terminal bonus practically non existent while exits will be barred by the MVA.

"You get an allocation of 103% of your original investment."

Sounds great - more money from the outset but this depends on what you regard as your original investment. Savers with £10,000 see it as £10,000. Insurers take off 5% upfront and call it £9,500 of which 103% is only £9,885.

"We rebate all the commission"

Ask what happens to any annual renewal payments - advisers cannot live on air.

"No annual management charges"

True as far as it goes. There are no explicit charges in with-profits bonds. But insurance actuaries adjust bonuses to take care of expenses.

"Higher current returns than on deposit accounts" Remains true but for how long - and will it apply to all bonds?