11. Collective investments - Life assurance

Question 1

What is an endowment?

What is it used for?

Answer 1

An endowment is a regular-premiun investment-oriented life assurance contract designed to pay a capital sum on a pre-determined maturity date; it will pay a specified death benefit, the sum assured, if the policy holder dies before the maturity date.

• Combines life cover with a savings element
• Usually has lower charges relatie to protection policies
• Mainly used to target savings.
• The life asussrance component means the saving target is made even if the policy holder dies

Endowments are now no longer sold.

Question 2

Qualifiying life policies - key characteristics

Answer 2

• Premiums must be payable at least annually
• Term must be at least 10 years
• Death benefit must be at least 75% of the premiums paid over the term of the policy
  — whole‑of‑life policy term = age 75
  — endowments, the 75 per cent requirement is reduced by 2 per
  cent for each year the life assured exceeds age 55.
• premiums paid in any one year cannot exceed twice those in any other year
• Annual Premiums cannot be more than 12.5% of total premiums payable over the term.
• Total annual premiums cannot exceed £3,600. If multiple policies in tandem, the policy that takes the total premiums above this threshold is non-qualifiying.
• Policy must run for 75% of its term.

Question 3

An endowment running for 7.5 years out of its 10 year term would be?

Answer 3

A qualifying policy

Policy must run for 75% of its term to be qualifying

Question 4

How is the chargeable gain calculated for non-qualifying life policies?

Answer 4

The difference between the cash value of the plan and the** total premius paid **at the time of the chargeable event.

Question 5

Fund taxation for life assurance investment funds.

Answer 5

Subject to corporation tax on income and gains at the special rate of 20 per cent.
* This means that investor is treated as having already paid 20% income tax on the policy.
* This is regardless of their tax status
* Non-taxpayers cannot reclaim
* Higher and additional taxpayers will pay the difference
* Applies to non-qualifying and qualifying policies

Question 6

What is a with-profits fund?

Main characterstics or features? Risk? Investment vessel?

Answer 6

A type of conservative investment where profits are shared with policyholders as bonuses. It uses a smoothing process to balance returns, even in poor market conditions, but offers limited flexibility in terms of policy adjustments.

• Conservative Approach: Invests defensively to meet guarantees and pay bonuses.
• Smoothing Process: Balances bonuses by using reserves to maintain stability in poor-performing years.
• Investment: Significant portion in gilts, leading to lower potential gains but stability.
• Challenges: Prolonged poor performance can exhaust reserves, reducing bonuses and maturity values.
• Endowment Policies: Inflexible; usually cannot adjust sum assured, premiums, or term.

Question 7

What is a with-profits endowment?

Answer 7

An endowment that offers the potential for additional bonuses to the guaranteed sum assured - both annually (reversionary) and at maturity (terminal)

Term: 10-25 years with a guaranteed sum assured at outset.
Bonuses: Reversionary bonuses (annual) increase the sum assured; terminal bonuses paid at maturity or on death.
Types:
* Full Endowment: Guaranteed sum meets target value; bonuses are additional. Expensive compared to alternatives.
* Low-Cost Endowment: Lower guaranteed sum; relies on bonuses to meet target value, with risk of underperformance.**

Question 8

Unitised with-profit investments

Answer 8

• Units: Investor buys units in a with-profits fund; unit value cannot fall once allocated.
• Bonuses: Added in two ways—either by increasing unit value or by allocating more units.
• Flexibility: Allows switching between unit-linked funds.
• Market Value Adjuster (MVA): May apply on fund switches or early surrender during poor performance, reducing unit value to protect other investors.

Question 8

Charges on with-profit investments?

Answer 8

• Rarely transparent
• Monthly policy fee plus additional charges which are taken from the fund and so hidden from the investor

Question 9

What is a unit-linked endowment?

benefits?

Answer 9

Life policies linked to the performance of selected investment funds. They offer greater flexibility and fund choices than with-profit plans. However, maturity values are not guaranteed and depend on fund growth.

• Term: 10-30 years, with flexibility to extend.
• Premiums & Sum Assured: Can increase or decrease, subject to life assurance qualifying rules.
• Investment Choice: Offers a wide range of fund options (equity, fixed interest, property, etc.), similar to unit trusts.
• Maturity Values: Dependent entirely on fund performance—no guarantees.
• Flexibility: Allows changes to life cover and premiums; regular reviews (10th year, then every 5 years, annually in the last 5 years).
• Surrender: Early encashment yields the bid value of units, minus surrender charges.
• Benefit: Transparency in charges, linked to fund performance, and potential benefit of pound-cost averaging.

Question 10

What is a unit-linked fund?

Answer 10

A unit-linked fund is an investment vehicle where premiums are pooled into a life fund, which operates similarly to a unit trust.

The fund is divided into units, and investors buy units in the fund. The value of each unit is directly tied to the performance of the underlying assets in the fund, which can include stocks, bonds, property, or other financial instruments.

Key Features of a Unit-Linked Fund:

• Investment Flexibility: Investors can choose from various fund types (e.g., equity, fixed interest, property) depending on their risk tolerance and goals.
• Unit Value: The value of each unit fluctuates with the performance of the underlying assets.
• Transparency: Charges and fund performance are directly linked and more transparent compared to traditional insurance products.
• Risk: Unlike with-profits funds, unit-linked funds do not offer guarantees—investors bear the full risk and reward of market performance.
• Life Insurance Link: Often tied to life insurance policies, providing a death benefit alongside investment growth potential.

Question 11

Unit-Linked Investment Charging Structure

initial charge?

Answer 11

Initial Charge: Typically 5%, taken upfront to cover investment and adviser costs (difference between offer and bid price).

Setup Costs:
* Reduced unit allocation (e.g., 50% of premiums for the first 12-24 months).
* Early premiums may buy initial/capital units with higher management charges.

Life Assurance Charge: Deducted monthly from units.
Policy Fees: Monthly or annual, taken from premiums before unit allocation or by deducting units.
Annual Management Charge: Typically 1-2% of fund value.
Early Surrender Charge: May apply if the policy is surrendered early.

Question 12

Taxation of endowments?

Qualifying vs non-qualifying? CGT?

Answer 12

Qualifying Plans: No tax on proceeds if not encashed before 75% of the term or 10 years (whichever is earlier).

Non-Qualifying Plans: If cashed in early or made paid-up, the gain is taxed.
* Taxation: Gain added to income.
* Higher-rate taxpayers: Additional 20% tax due.
* Additional-rate taxpayers: Additional 25% tax due.

Gain Calculation:Proceeds minus premiums paid.
Basic-Rate Tax:No further tax liability; non-taxpayers cannot reclaim tax paid by the fund.

Question 13

What is a Traded endowment policy and when are they useful?

Answer 13

A traded endowment policy (TEP) is a with-profits endowment sold to a third party for a higher value than surrendering it to the insurer - typically surrender values are low:

• Definition: A secondhand with-profits endowment policy sold to a third party instead of being surrendered to the insurance company.
• Benefit to Seller: Higher cash value (typically 35% more than the insurance company’s surrender value).
• Benefit to Buyer: Guaranteed sum assured and bonuses accrued at purchase, with potential for further bonuses.
• Sale Process: Usually sold via auction or market makers.
• Policy Type: Only with-profits policies are traded due to guaranteed returns and stable value.

Question 14

Taxation of Traded Endowment Policies (TEPs)

Answer 14

Original Seller:

• No Capital Gains Tax (CGT).
• No Income Tax on qualifying policies if sold after 75% of the term or 10 years.
• On non-qualifying or early qualifying sales, higher-rate taxpayers pay 20% on gains (25% for additional-rate taxpayers).

Buyer:

• The policy becomes non-qualifying upon purchase.
• On maturity, the gain (final proceeds minus all premiums paid) is taxable under the income tax regime

Question 15

Investment bonds

11.3 Investment bonds

Answer 15

Structure: Whole of life assurance policy with three key differences:

1. Lump Sum Investment: Regular premiums not allowed.
2. Limited Life Assurance: Typically 101% of policy value on death, just to qualify as life assurance.
3. Non-Qualifying Policy: No guaranteed sum assured.

Investment Types: Can be unit linked or with profits, focused purely on investment.

Alternative: Used as an option to unit trusts and OEICs.

Types:

• Onshore Bonds: Offered by UK-registered insurance companies.
• Offshore Bonds: Offered by insurers outside the UK (e.g., Isle of Man, Channel Islands).

Taxation: Similar mechanics for onshore and offshore bonds, but with different tax treatments.

Question 16

Investmend bonds can be unit-linked - describe the key features of these investments

Answer 16

Investment Structure: Lump sum buys units in chosen funds; value rises/falls with fund performance.

Funds include: managed, equity, distribution, international, specialist. Professional management and access to diverse investment areas.

Flexibility:

• Can be surrendered anytime, but initial charges make early encashment less attractive.
• Fund switching allowed (free from CGT), with a limited number of free switches annually.
• Segmentation: Bonds divided into sub-policies for separate or partial encashment (tax advantages).

Charges:
* Initial charge: Typically 5%, though some bonds offer clean pricing (no initial charge).
* Annual management fee: 1–1.5% p.a.
* Switching fee: Charged after a set number of free switches.
Withdrawals: Can be made by cashing units or surrendering segments.

Open Architecture Bonds: Access to a range of market-wide funds, not limited to provider’s own funds

Question 17

Investmend bonds can be with-profits - describe the key features of these investments

Answer 17

Capital Guarantee:Original capital is guaranteed on encashment, but penalties may apply if cashed early or during unfavorable economic conditions.

Bonuses:

• Annual Reversionary Bonuses: Added either by increasing unit value or adding units.
• Some policies have a guaranteed minimum bonus after a set term (e.g., 10 years).
• Terminal Bonuses: Paid after 10 years or on final encashment if the policy runs for the required term.

Withdrawals:

• Penalty-free withdrawals allowed at certain points (e.g., every 5 or 10 years).
• Market Value Adjuster (MVA) may apply to early withdrawals under poor economic conditions.
• Regular withdrawals allowed within limits, without charge.

Risk Profile: Less volatile than unit-linked bonds but less secure than traditional with profits policies.

Charges:

• Initial charge and bid/offer spread apply.
• Management charge exists but is not transparent.

Switching: Policyholders can switch to other unit-linked funds.

Question 18

There are also guaranteed income and growth bonds - describe the key features of these investments

Answer 18

Type: Limited-term life insurance investment bonds with guarantees.

Taxation: Normal non-qualifying life policy taxation applies.

Guaranteed Income Bonds:

• Guarantees a fixed annual income for the bond’s term.
• Typically guarantees return of original capital at the end of the term.
• Up to 5% of original investment can be paid annually without immediate tax.
• Chargeable event occurs at the end, where all payments are added to the capital to calculate taxable gain.

Guaranteed Growth Bonds:

• Guarantees a set amount of growth at the end of the term.
• Growth is treated as a gain for tax purposes and taxed accordingly.

Question 19

Distributor bonds - key features of these investments (vs conventional bonds)

Answer 19

Conventional Investment Bonds:

• Income and growth accumulate within the fund, increasing unit value.
• Withdrawals are taken from capital by encashing units.

Distributor Bonds:

• Income and capital are separated.
• Investments made in a low-risk distributor fund focused on generating income.
• Income is paid out regularly (monthly, quarterly, or semi-annually) and counts towards the 5% annual withdrawal allowance.
• Capital is protected as income is paid from the fund’s income, not from the capital (subject to market risk).

Taxation and other aspects are the same as conventional bonds.

Question 20

Tax treatment of ‘onshore’ bonds

Answer 20

Tax Paid by Fund Manager: Corporation tax (20%) on gains is paid by the fund manager.
Basic Rate Income Tax: No further basic rate income tax liability for the investor; it’s deemed settled by the corporation tax.
Non-Taxpayers: Cannot reclaim the tax paid.
Non-Qualifying Policy: Unlike life policies, investment bonds do not qualify for special tax treatments beyond these similarities.

Question 21

5% withdrawal rule for investment bonds - what does this mean for higher-rate taxpayers?

Answer 21

• 5%of the original capital can be withdrawn each year tax free - treated as a return of capital
• This 5% rolls up - i.e. no withdrawals taken for 4 years = 20% can be taken
• 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.

Question 22

Chargeable events with IB?

Answer 22

Chargeable Events:
* Full encashment
* Death of life insured
* Excess withdrawals (over 5% cumulative)
* Assignment for money’s worth (sale or exchange)

Chargeable Gain: Gains added to the investor’s income in the tax year, potentially pushing them into a higher tax band.

Excess Withdrawals: Amounts over 5% allowance treated as gains, even if the bond shows no actual profit.

Higher Rate/Additional Rate: Gains may incur 20% or 25% additional income tax.

Top Slicing: A method to potentially reduce tax liability on chargeable gains.

Question 23

Calculation for the chargable gain

Answer 23

1. the surrender proceeds; plus
2. any withdrawals made; less
3. 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:
1. £35,000 (surrender value plus all withdrawals); less
2. £25,000 (initial investment plus excess withdrawals)
3. gain = £10,000.

Excess withdrawals are added to stop being taxed twice

Question 24

Top Slicing Relief - Part 1 - Tax liability

Answer 24

Step 1: Tax Liability (Full Gain in One Year)

1. Add the full gain to other income to find total income.
2. Apply starting-rate band or PSA where applicable.
3. Income order: (Non-savings, Interest, Dividends, Bond gains)
4. Deduct personal allowance from non-savings income first, then from interest and gains.
5. Apply starting-rate to interest/gains if applicable.
6. Apply appropriate tax rate to the gain.
7. Deduct basic-rate tax already paid (20%) within the bond from total tax due.

Question 25

Top Slicing Relief - Part 2 - Top slicing relief and final tax due

Answer 25

1. Annual Equivalent: Divide the total gain by the number of years the bond was held.
2. Calculate tax as in Step 1 using the annual equivalent (slice) instead of the full gain.
3. Deduct 20% tax on the slice and multiply by the number of years held.
4. Relieved Liability: Subtract this from the liability in Step 1.

Final tax due = The result after applying top slicing relief to the tax liability calculated in step one

Question 26

Segmenting (clustering) can be a tax efficient method of managing IBs - what is it?

Answer 26

Definition: Dividing a bond into smaller units (mini-bonds), often 100 or 1,000, to manage withdrawals more efficiently.

Tax Efficiency: Instead of taking partial withdrawals, the investor can fully encash a number of mini-bonds.

Benefit: Each mini-bond is taxed individually—losses are not taxable, while gains are taxed on their own merit.

Example: In Mr. Brown’s case (pg337), he could encash enough mini-bonds to meet his needs (e.g., £40,000) and potentially save tax by avoiding taxation on losses.

Question 27

What is one of the main reasons for investment in investment bonds?

Answer 27

Tax treatment - although the benefits only really apply to two types of investor

Tax Deferral: No immediate tax on gains or income as long as money remains in the bond.

Contrast with Unit Trusts/OEICs: Dividends from unit trusts, OEICs, and investment trusts are taxed annually based on income tax band (20%, 40%, 45%).

5% Withdrawal Facility: Investors can withdraw up to 5% of the original investment each year for 20 years without paying tax, ideal for supplementing income (e.g., retirement or school fees).

Higher Rate Taxpayer Advantage: Delayed tax payments until retirement when they may fall into a lower tax band, making it more tax-efficient than other investment types.

Beneficial for defering tax and drawing an regular income without tax 5%

Question 28

Two points for pensioners regarding investment bonds.

Answer 28

Exclusion from Care Fee Assessments: Investment bonds are excluded from assets considered when calculating contributions to later-life care, provided they weren’t purchased to avoid care fees (no deliberate deprivation of assets).

Limited Tax Advantage: Other tax-efficient options, such as ISAs and personal allowances, often provide better tax benefits for most pensioners.

Question 29

4 other reasons to invest in investment bonds - ignoring benefits for pensioners and income needs.

Answer 29

Access to Professional Fund Management:

• Invest in specialist sectors (e.g., geographical, lower-risk funds) with pooled investments.
• Minimum investment allows access to markets (e.g., Japan) not feasible with small amounts (e.g., £2,000).

Switching Between Funds:
* Usually free or low-cost (around £20).
* No CGT on fund switches, allowing tax-efficient flexibility for maximizing returns.

Simple Administration:
* Minimal paperwork (bond document and annual statement).

Favorable Tax Treatment:

Suitable for both hands-off investors and those seeking access to specialist markets.

Question 30

Onshore vs offshore investment bonds - key points

Answer 30

Onshore Bonds:

• Taxed within the UK: Gains subject to 20% corporation tax paid by the fund manager.
• Lower Charges: Typically lower than offshore bonds.
• 5% Withdrawal Facility: Tax-efficient access to funds without immediate tax.

Offshore Bonds:

• Gross Roll-Up: Gains accumulate without tax, leading to potential faster growth.
• Tax on Encashment: UK tax due when gains are realized; potential withholding tax from the host country.
• Higher Charges: Offshore bonds generally have higher costs.
• Eligible for Tax Relief: Gains can qualify for the starting-rate band and PSA.

Question 31

Offshore bonds - explain and key points

Definition, Tax advantage, Withdrawals, chargeable gains, tax treatment?

Pg 341 for comparison with onshore

Answer 31

Definition: Investment bonds offered by offshore subsidiaries of UK investment companies.

Tax Advantage: Fund growth is not taxed while invested; tax applies only upon encashment.

Withdrawal Facility: Similar to onshore bonds, investors can withdraw up to 5% of the initial capital each year without a tax charge.

Chargeable Gains: Considered savings income, impacting eligibility for the starting-rate band and personal savings allowance (PSA).

Tax Treatment: Gains are taxed last, after other savings interest. If other interest uses up the PSA, offshore bond gains may be fully taxable.

Example Scenario:

Earnings: £35,000
Building Society Interest: £1,200
Offshore Bond Gain: £4,000
Result: Basic rate taxpayer loses eligibility for the starting rate band and most of the PSA, resulting in full taxation of the bond gain.

Question 32

Two categories of annuity

Bonus: explain what an annuity is

Answer 32

Purchase annuity
* Purchased with any available funds
* Part of annuity payment is tax-free, as classed as a return of capital

Compulsory purchase annuity
* Purchased with the proceeds of a pension scheme

Question 33

Life annuity

11.4.1 Types of purchase annuity

Answer 33

Payment Structure: Income is paid for the individual’s lifetime and ceases upon death.

Income Type: Payments can be fixed or increase annually.

Guarantee Option:

• Payments can continue for a specified period (typically 5 to 10 years) even if the individual dies.
• Example: With a 10-year guarantee, if the annuitant dies after 5 years, the estate receives 5 more years of income.
• Outstanding income may be paid as a discounted lump sum in some cases.

Question 34

Temporary annuity

11.4.1 Types of purchase annuity

Answer 34

Temporary Annuity:

• Payments are made for a specified term (e.g., 5, 10, 15 years).
• Payments cease upon the individual’s death during the term.

Annuity Certain:

• A type of temporary annuity that pays until the end of the term, regardless of the individual’s death.
• Commonly used to fund expenses like school fees.

Question 35

Deferred annuity and immediate annuity

11.4.1 Types of purchase annuity

Answer 35

Immediate Annuity: Income payments begin right after the annuity is purchased.

Deferred Annuity:

• Investment made as a lump sum or regular premiums.
• Payments start on a predetermined future date (vesting date), such as at retirement or after a set period (e.g., five years).
• If the policyholder dies before payments start, premiums are returned, with or without interest, depending on the contract

Question 36

Escalating annuity

11.4.1 Types of purchase annuity

Answer 36

Definition: Payments increase each year, either by a fixed percentage or in line with inflation (RPI).

Inflation Mitigation: Helps counteract the effects of inflation on income.

Investment Strategy: Providers may invest in index-linked gilts to ensure payment escalation.

Initial Payment: Starts at a lower level compared to level annuities.

Question 37

Annuities can be With or without proportion, what does this mean?

11.4.1 Types of purchase annuity

Answer 37

Without Proportion: If the annuitant dies before the next payment date, no final payment is made.

With Proportion: A pro rata payment is made for the period between the last payment and the annuitant’s death.

Question 38

Capital‑protected annuity

11.4.1 Types of purchase annuity

Answer 38

Definition: A life annuity that guarantees at least the return of the initial investment upon death.

Payout Mechanism:

• Upon death, the initial investment minus any gross payments made is returned to the estate.

Example:
* John invested £50,000 and received £14,000 in payments.
* Upon his death, his estate would receive £36,000 (£50,000 - £14,000).

Question 39

Enhanced and impaired life annuities

11.4.1 Types of purchase annuity

Answer 39

Enhanced Annuities:

• Offer increased rates to individuals with specific medical conditions or smokers.
• Typically available without medical underwriting.
• Can increase the annuity rate by about 25%.

Impaired Life Annuities:

• Designed for individuals with serious life-shortening medical conditions.
• Subject to medical underwriting to verify the life risk associated with the condition.
• Can provide significant rate increases compared to conventional annuities.

Question 40

Investment‑linked annuities - unit-linked

11.4.1 Types of purchase annuity

Answer 40

Unit Linked Annuities:

• The pension fund buys units in a unit-linked fund.
• The annuitant selects an assumed rate of investment growth; higher growth allows for higher initial income by cancelling units.
• Income can maintain or increase if the fund grows as expected; if growth is lower, income may decrease.
• These annuities are riskier but offer potential for increasing income with realistic growth rates.

Question 41

Investment‑linked annuities - with-profits

pg 345 for ABR

Answer 41

With Profits Annuities:

• The pension fund is invested in a with-profits fund.
• The applicant selects an anticipated bonus rate (ABR) between 0% and 5% per annum; higher ABR leads to higher initial income but increased risk of later reductions.
• Annual income reassessment involves reducing by the ABR and adding the newly declared bonus, along with a temporary bonus in some cases.
• A guaranteed minimum level is set to prevent the annuity from falling below a certain amount.
• Selecting a realistic ABR can lead to rising income, while a higher ABR increases initial income but carries higher risk of reductions.

Question 42

Taxation of Purchase Annuities - Key Points:

11.4.2 Taxation of purchase annuities

Answer 42

Payment Structure: Payments consist of part capital (tax-free) and part interest (subject to tax).

Tax Treatment:

• Interest part treated as savings income.
• 20% income tax is deducted at source from the interest portion.
• Eligible for starting rate band and personal savings allowance (£1,000 for basic rate taxpayers, £500 for higher rate taxpayers).

Taxpayer Categories:

• Higher rate taxpayers pay an additional 20% tax on the interest.
• Additional rate taxpayers pay an additional 25% tax.
• Non-taxpayers can reclaim the tax deducted or receive gross payments, but gross payments do not apply to joint life annuities if one annuitant is a taxpayer.

Capital vs. Interest Split:

• Determined at the start based on life expectancy (government mortality tables) or the term of a temporary annuity.
• Calculation: Purchase price divided by expected years of life or agreed term.

Question 43

Compulsory purchase annuities key points - definition, income & rates, Types, tax treatement, etc.

Answer 43

Definition: An annuity arranged using a money purchase pension fund, subject to specific tax rules.

Income and Rates:

• Based on life expectancy and gilt yields, influenced by the Bank base rate.
• Higher gilt yields result in higher annuity rates; lower yields result in lower rates.
• Rates for a 65-year-old male ranged from 16% in the mid-1970s to as low as 4.4% post-EU referendum, increasing to around 7% in 2022-2023.

Eligibility: Annuities cannot typically be taken until the fundholder reaches age 55.

Annuity Types:

• CPA is a lifetime annuity with an optional guarantee period after death.
• Can be set up on a single life basis or to continue payments to a spouse at 50-100% of the original amount.

Tax Treatment:

• All income from pension annuities is taxable as earned income.
• Payments to a surviving beneficiary are:
• Tax-free if the annuitant dies before age 75.
• Taxed at the recipient’s marginal rate if the annuitant dies at age 75 or older.

Guarantee Benefits:
Ongoing guaranteed payments are tax-free if the annuitant dies before age 75; taxed thereafter.

Lump Sum Benefits:
* Paid tax-free if the annuitant dies before age 75; taxed at the marginal rate if they die at age 75 or older.

Fund Size Impact: Smaller funds generally provide lower annuity rates, with limited provider options for very small funds.