Life Assurance Products Flashcards
How do with profits plans work?
The earliest such investments were with-profits plans. Investment performance is smoothed out by actuaries. Each year a proportion of the investment return is given as a bonus. Once added, this annual or reversionary bonus cannot be taken away. The remainder of the return achieved is kept in reserve to pay bonuses in later years when returns may not be as high. When a claim is made before a bonus becomes payable an interim bonus may be paid.
How do MVR / MVA’s work?
Assume that the accumulated value of your investment is £107,000 made up of £70,000 investment and £37,000 of bonuses. These bonuses are guaranteed and will be paid to
you on a pre-set maturity date or on certain surrender points. If markets fall in value, the underlying assets that back this might not be worth as much as £107,000.
As long as surrender at full value only takes place on the pre-set or pre-agreed dates, this cash flow situation can be managed by the fund manager. However, if people seek to encash their investment simply because markets have fallen, this can lead to a run on the fund and leave those who remain in the fund worse off because a disproportionate percentage of the fund wealth has been taken by those who have gone. This is where an MVA/MVR
will be applied so that those leaving other than on the agreed points will have their values reduced to reflect the value of the underlying assets to which they are entitled.
How do with-profits funds work?
The earliest such investments were with-profits plans. Investment performance is smoothed out by actuaries. Each year a proportion of the investment return is given as a bonus. Once added, this annual or reversionary bonus cannot be taken away. The remainder of the return achieved
is kept in reserve to pay bonuses in later years when returns may not be as high. When a claim is made before a bonus
becomes payable an interim bonus may be paid.
What were traditional with profits contracts based on
Traditional with profits contracts were based on a guaranteed sum assured which then had bonuses added to it. Most modern contracts are now unitised – the policyholder has units in a with-profits fund and when bonuses are added either the unit price is increased (variable priced unitised with profits) or more units are added (fixed price unitised with profits).
What are some disadvantages of with profit funds?
Whilst with profits contracts offer smoothing which reduces volatility (and so risk) over the long term performance may
be lower than an equivalent unit linked fund since the actuaries have to keep back reserves rather than passing them straight on to the investor. They are also criticised for lack of transparency.
how we can measure whether a with profit fund is profitable
This opaque nature of with-profits investments means that the best measure of whether an investment is likely to be
profitable or not is the success of the life company itself. This can be gauged by assessing its assets against its liabilities – in other words, measuring the Free Asset Ratio
(FAR). The FAR along with fund performance and the asset allocation should be evaluated carefully before an investment is made.
can money be moved within a life insurance product without constituting a disposal?
Some life contracts will also allow for investment in the funds of external fund managers. One of the big positives of
life assurance investments is that money can be moved from fund to fund within the wrapper, without constituting a disposal and without triggering a tax liability.
what is one of the biggest problems with unit linked investments?
One of the big problems with unit linked investments is that the point at which you invest can be critical in the overall
return. As the unit price varies daily, investing on the wrong day can have a significant impact on returns. To counter
this, many people will invest over a period of months, drip feeding money into the fund and benefitting from ‘poundcost averaging’. This basically means that when unit prices are low, you buy more for your money, when prices are high you get less but over the period of, say, 12 months the
average price is achieved
what are the two most common regular premium plans?
Regular premium plans are generally either whole of life (will run until the death of the life assured or earlier surrender) or endowment (set for a specified term or until the earlier death of the life assured).
How are charges typically levied on regular premium life insurance contracts?
Charges are now typically levied
for the life assurance element of the contract and an annual management charge as well as a bid-offer spread. Older contracts often also have more punitive charges such as ‘initial units’ under which a higher annual management charge applies or a reduced allocation rate whereby only,
say, 95% of each premium is used to buy units.
What are the main rules regarding regular premium contracts
These rules are broadly that the contract must be a regular premium and that premiums must be payable for at least 10
years or ¾ term if this is shorter. Premiums in any one year cannot be more than twice the premiums in any other year nor more than 1/8 of the total premiums due over the term of the contract.
What is the contribution limit on qualifying policies?
Given the tax benefits associated with this qualifying status, such policies started to look like a good alternative to pensions
for those who were exceeding the ‘annual allowance’. To prevent this, the government introduced a limit of £3,600 per annum, per person on the contributions to qualifying policies. Where this is exceeded, the policy will lose its status and will be taxed under the harsher non-qualifying rules covered below.
What is a guaranteed income bond?
guarantee to pay out a certain level of income over a certain period with return of
capital on maturity. This type of contract is generally issued in ‘tranches’ by insurers with each tranche being for a certain
overall investment. Once it is fully subscribed, the tranche comes to an end. This is often to limit the capital exposure of
the insurer.
What is a guaranteed growth bond?
the same as guaranteed income bond, but with the guarantee being a set capital return
at maturity rather than an income.
What are distribution bonds?
unlike ordinary unit linked funds,
these separate out income and capital allowing for the income return to be paid out to the investor annually and capital return retained in the fund. No unit encashments are required to
produce the income.
What are Guaranteed / protected equity bonds / high income bonds
these are essentially a combination of a
high interest deposit and derivatives. A sufficient percentage of each investment is put into a high interest cash product such that at the end of the term, the capital
will be returned. The remainder is used to buy a derivative contract which secures a percentage of the rise in an index
such as the FTSE100. These are not very common at the moment since interest rates are very low, meaning that more of the money has to be kept in cash and less is
available to buy the derivative contract
What is the tax situation within a onshore (UK) life contracts
Both qualifying and non-qualifying
UK policies hold investments in UK life funds. These funds will be managed by a fund manager who will be liable to corporation tax on income and capital gains.
Dividends (UK and Overseas) are tax free, other income is taxed at 20%. Gains are also taxed at 20% (with gains on gilts and corporate bonds being exempt).
Expenses of the fund can be offset against unfranked income so if expenses are greater than income then there could be no tax to pay which in turn could mean higher
returns for investors!
Importantly, there is no ability for a non-taxpayer to reclaim this whether the policy is qualifying or non-qualifying. This
means that non-taxpayers are the least likely to benefit from investment in this type of contract
What is the tax situation on an investor investing in a qualifying policy?
An investor holding a qualifying policy, provided the qualifying rules are met, will be able to receive the benefits from the policy free of any further taxation at maturity - the tax paid by the fund manager is deemed to be sufficient.
There are, however, disadvantages such as the need to maintain premiums and the charges associated with the policy, including a minimum level of life assurance
necessary to maintain the tax treatment of the policy (for example, 75% of the premiums payable over the contract term or to age 75 for a qualifying endowment – (note: most policies are set up for a minimum of 10 years and must run
for a minimum of 75% of that to remain qualifying), so they aren’t for everyone. In addition, the £3,600 limit on contributions to such policies has significantly reduced the
attraction of their use for many.
How are non qualifying policies taxed on the investor?
Non-qualifying policies work similarly in some ways but very differently in others! Just as qualifying policies, the fund
manager pays corporation tax on income and gains and this is deemed to be sufficient to satisfy a basic rate liability (20%). Again, non-taxpayers cannot reclaim
tax paid, but unlike qualifying policies, there is a further
liability to tax for higher and additional rate taxpayers.
you should note that where a non qualifying policy has joint owners, any gain and subsequent tax liability will be spread equally across them.
How are partial withdrawals taxed on non qualifying policies?
This is done at the end of every policy year by adding all the withdrawals together.
Income tax is assessed in the tax year that the anniversary of the policy falls into.
5% of the original investment can be withdrawn without any tax liability on withdrawal.
The 5% is cumulative so if you don’t use it or don’t use all of it, the balance can be carried forward to the next year.
If the total withdrawals in the policy year are within the cumulative 5% then there is no chargeable event and no chargeable gain and therefore no tax to pay at that
time. If they exceed the cumulative 5% then a chargeable event occurs.
The chargeable gain on this chargeable event is the excess over the cumulative 5%.
It does not matter of the performance of the bond, however HMRC have said they will allow investors to apply to have the gain recalculated to account for it being disproportionate which incidentally in the end is HMRC’s decision
is the 5% return of capital rule cumulative?
the 5% allowance is cumulative. If it is missed in year one, up to 10% can be taken in year two. Secondly, it is based on full or part years, so where someone has had a bond for 2 years and 3 months and has made no previous withdrawals, they would be allowed to take up to 15%. Finally, it is
important to remember that the 5% is based on the original investment NOT the current value
Jim has a bond. He originally invested £100,000 into it and he has held it for 5 years and 7 months.
If he has made no previous withdrawals, how much can he take without there being an immediate charge to income tax?
He has held it for 5 full years and one partyear so this means that we round up to 6 years. He can take 5% of the original investment (£5000) for each of these years,
so he can take up to £30,000 this year.
work out this example:
Mary has a bond into which she invests £100,000. In year one she makes no withdrawal but in year two she
withdraws £17,000. She surrenders it after 5 years having made no further withdrawals for a value of £120,000.
The £17,000 withdrawal will be partly taxable. Her allowance is 2 x £5000 and so she will be taxed on £7000 at the time.
Assuming she is a basic rate taxpayer she will actually escape further tax, if she is higher or additional rate she will pay an
extra 20/25%. When she later surrenders the bond, she receives £120,000. To this we add the £10,000 deferred element from her withdrawal to give £130,000 and deduct her
original investment of £100,000. This gives her a £30,000 chargeable gain which may be subject to tax depending on her tax status. The £7000 that has already been taxed is not brought back into the equation – this has been dealt with. She may be able to use her personal savings allowance and then top slicing may be used to establish what further tax may be due.
If £100,000 was invested, in flat markets, 3 years later £30,000 withdrawn when the investment was still worth £100,000
What are the tax consequences when surrender one segment for the £30,000
single segment – cumulative 5% allowance
would be £15,000 (£5000 x 3 years), actual withdrawal £30,000 – chargeable gain £15,000. For a higher rate taxpayer assuming this was an onshore bond, there would be a tax charge of £15,000 x 20% or £3000 even though the bond has actually made no gain.
100 segments. 30 segments surrendered
If £100,000 invested, in flat markets, 3 years later £30,000 withdrawn when the investment was still worth £100,000,
segment surrender – 30 segments fully
surrendered. Each segment originally had £1000 put into it.
The value of each segment is still £1000. There has been no gain and as, on surrender, the chargeable gain is the actual
gain – there is no tax to pay.
Why might an investor not wish to surrender an endowment policy?
Many people with, particularly with-profits, endowments (qualifying policies) may no longer need the policy but may not want to surrender it because to do so would mean the loss of a potential bonus on maturity.
How can a holder of an endowment policy release funds and what are the tax consequences
The original policyholder sells the policy to a third party who takes over responsibility for maintaining premiums and then claims at maturity (or on the death of the life assured). Provided the policy has been running for more than 10 years or ¾ of the term (the shorter) no tax will be due on the policyholder. If the sale takes place within this term, the policy is effectively classed as a non-qualifying policy and is potentially taxable on the difference between the sales proceeds and the premiums paid.
The person buying the policy then falls due for capital gains tax rather than income tax on maturity using the purchase price paid as acquisition cost and allowing for the premiums paid after purchase as allowable
deductions. This is the only time that a capital gains tax liability will arise on a life assurance product. In other instances, it will be income tax not capital gains tax that
applies.
What endowment polices do friendly societies sell?
Friendly Societies sell small, tax free endowments limited by the maximum premium size. The maximum premium
level is £270 per year, £25 per month and £5 per week and applies to all policies owned by an individual.
what are the main differences when comparing offshore bonds to onshore bonds?
Offshore policies are similar in structure and treatment to onshore bonds with the exception that they are generally
established in jurisdictions with little or no taxation on the funds, such as the Isle of Man or Luxembourg, allowing for
what is often called gross roll up of returns within the wrapper.
What is the tax situation within offshore bonds?
Because no tax is paid within the fund, UK taxpayers are liable to their highest rate of taxation on gains when a chargeable event occurs. This can be beneficial to many policyholders, for example where they are higher rate taxpayers or additional rate taxpayers during their working lives but expect to be a basic rate taxpayer in retirement.
By controlling the timing of the full liability they may be able to reduce their overall liability to taxation. Any gain which does arise can be top sliced to determine whether a 20 or 40% liability applies or to determine whether a 40% or 45% liability applies. It cannot be used to prevent a
liability if the investor happens to be a non-taxpayer.
What is Time apportionment relief
An allowance known as Time apportionment relief is given to reduce the chargeable gain. However, the formula can be written
and applied in 2 different ways (but the answers are the same). .
How is time apportionment relief calculated as a relief?
Use it as a relief, which means to reduce the chargeable gain on an offshore bond by the number of days the person was not UK resident. So Chargeable gain is reduced by the percentage from the following fraction:
Number of days the policyholder was not resident in the UK
Number of days the policy run
What are personal portfolio bonds?
These are bonds where the policyholder effectively controls the underlying investments and the UK tax authorities have a clearly stated dislike for this type of policy. As a result of their view of these policies, a UK taxpayer with a personal portfolio bond will be taxed on a chargeable deemed gain of 15% a year regardless of the actual gain, along with other complex rules applicable to the deemed gain, such as, it’s in addition to the tax charge from a part surrender and that although standard rules for chargeable gains apply, there is no top slicing relief allowed, However it can be deducted from the gain on termination of the bond. Because of this, these bonds are very unattractive for UK resident taxpayers.
Are chargeable gains from a bond included in the adjusted net income calculation and does it take into account top slicing?
calculating adjusted net income,
chargeable gains have to be included without top slicing along with the other sources of income. This essentially
means that any partial withdrawals over the 5% allowance (remember this is cumulative) are treated as is the full gain on final surrender or encashment of the bond
what are the main benefits of placing a bond in trust?
Bonds are very popular as trust investments. Because they don’t produce an income, there is no need for the trustees to complete a tax return on an annual basis. Trusts pay income tax at much higher rates with no 0% personal allowance. The first £1,000 (standard rate band) is taxed at 8.75% for dividends and 20% other income. Anything above this is taxed at the rates equal to those that additional rate taxpayers
would pay i.e. 39.35% for dividends and 45% for other income.
Equally, the bond can be assigned out of the trust to a beneficiary without a tax charge, who can ultimately surrender it as their own. If the beneficiary is a basic rate taxpayer this could result in no further tax on an onshore bond, whilst with an offshore bond a non-taxpayer could potentially avoid any tax at all.
Can a bond be assigned out of a trust to a beneficiary without a tax charge?
The bond can be assigned out of the trust to a beneficiary without a tax charge, who can ultimately surrender it as their own. If the beneficiary is a basic rate taxpayer this
could result in no further tax on an onshore bond, whilst with an offshore bond a non-taxpayer could potentially avoid any
tax at all.
Obviously the same 5% cumulative allowance applies, and a trustee can pay this out to the beneficiary every policy year
without any tax liability at the time.
How is the settlor taxed if a chargeable event occurs in a bond in trust?
► On the settlor (the person who created the trust) as part of their income if they were alive and UK resident immediately
before the chargeable event. Tax paid by the trustees may be reclaimed.
How are the trustee(s) taxed if a chargeable event occurs in a bond in trust?
► On the trustees if at least one of the trustees is a UK resident and the settlor is either dead or a non-UK resident immediately before the chargeable event. Top slicing cannot be used. The gain for a discretionary trust would be subject
to the higher rates applicable to trusts. Remember UK policies are deemed to have paid 20% already so there would only be an additional 25% required to be paid by the
trustees on income over the first £1,000. Beneficiaries cannot reclaim this tax even if they were non taxpayers.
How are the beneficiary(s) taxed if a chargeable event occurs in a bond in trust?
► On the UK beneficiaries, tax accordingly (without top slicing) to the extent they benefit from the proceeds, where the trustees are non-UK resident. No basic rate credit (20%) is given either.
What are ETFs
These are index tracking funds listed on stock exchanges. They are traded like a share with prices updated throughout
the day. As they are shares the standard costs associated with share dealing will apply – though stamp duty will not
apply. Typical management charges are 0.5%. ETFs CAN be held in ISAs.
What are ETCs & ETNs
The equivalent of ETFs for tracking the performance of commodities are exchange traded commodities (ETC) and for niche markets exchange traded notes (ETN). An ETN is actually a form of bond issued by a bank – they have a maturity date but pay no interest. Instead the return comes from the movement in the index, less a fee.
What are the key differences between ETFs & ETCs
The key difference between ETFs and ETNs is that ETNs don’t actually own anything – they simply use derivatives to track indices.
how do Property Unit Trusts and Investment Trusts work?
Work similarly to other unit trusts and investment trusts. Like other unit trusts, property unit trusts cannot gear up while
investment trusts can. Property funds can delay redemption payments to investors for up to 6 months if necessary to allow them time to sell property if needed. In reality most redemption payments are met by new money coming in to the fund.
Briefly explain a PAIF
These are FCA authorised OEIC funds (they can only be OEICS), investing mainly in property (including investment in REITs ).
How are PAIFs taxed?
They are able to elect for special tax treatment moving the taxation on to the investor for all rental profits and related
income (as if they held the properties directly).
Therefore, inside the fund, income relating to property investment (e.g rental profits) is tax exempt.
Because a PAIF can invest in other areas any taxable Income that is not related to property is taxable under corporation tax at a rate of 20%.
This essentially creates two businesses within a PAIF, a property investment business and one that isn’t property related.
How are PAIFs taxed on the investor?
Income that is passed on to the investor as property income is paid out net of 20% and is taxable to the investor in the usually way (non-taxpayers can reclaim, basic rate
don’t pay anymore and higher/additional have to make up the difference). It is paid gross if the PAIF is held in ISA or Pension. Any income paid out in the form of interest or dividends are paid gross and taxed accordingly in the hands of the investor based on their tax position.
What are the qualifying rules for a PAIF?
The following 3 conditions must be met:
- In the accounting period at least 60% of net income must come from the exempt part (i.e. income relating to property)
- At least 60% of the total assets of the PAIF must come from the property investment business.
- No corporate investor is allowed to hold 10% or more of the Net Asset Value (NAV) of the PAIF.
what are the 3 main rules that a REIT must meet
UK resident
A closed ended company
Listed on a recognised stock exchange.
How is a REIT structured
A REIT is split into two parts; a property letting business which is ring fenced and therefore exempt from corporation tax, the only time that it may not be is on the
sale of property developments (see below) and the business that is not ring fenced which is essentially any other operation or activity of the REIT. A classic example
would be property management services. Corporation tax is paid on the gains and profits from the non ring-fenced business.
What are the qualifying rules for a REIT?
► At least 75% of total gross profits have to come from letting property (the ring-fenced bit) and at the start of every accounting period at least 75% of the total assets of
the business must come from the ring fenced part.
► Interest on borrowing must be at least 125% covered by rental income.
What is the taxation situation within a REIT?
Inside the REIT:
At least 90% of rental profits (income) from the tax exempt part, must be paid to investors as a dividend within 12 months of the end of the accounting period.
Property development can occur inside the ring-fenced business as long as it’s purpose is for rental income. If the developed property is not used for this purpose i.e.
developed and then sold for a profit then the profit is taxable to corporation tax, unless the property sale happens 3 years or more from when it was developed, then the profit would be tax exempt.
What is the tax situation on an investor investing in a REIT
A payment from the tax-exempt ‘pot’ to the investor will be treated as property income (paid out net of 20% unless the REIT is in an ISA or SIPP then it is paid gross) and is taxed in the normal way. Non-tax payers can reclaim it, basic rate taxpayers don’t pay anything extra as the 20% covers their liability and higher/additional rate taxpayers have to make up the difference of the gross amount to 40% and 45% respectively (so an additional 20% or 25%).
A payment from the non-exempt ‘pot’ to the investor is by way of a dividend and taxed on the investor accordingly. (e.g. £1,000 dividend allowance, 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for additional rate taxpayers)
If an investor sells their shares in a REIT and they make a gain then this is taxable to CGT, following normal CGT principles.
Can a REIT trade at a premium/ discount?
Just as with other investment trusts, the REIT can trade at a premium or a discount to NAV based on supply and demand. The same factors bringing about a narrowing or a widening of this premium / discount apply.
What are Insurance company property funds?
These products work as per any unit-linked insurance company investment but the underlying assets are commercial property - this makes the investment far more liquid than direct property investment.
There is no facility for the fund to be able to borrow to invest.
An investor may take out a regular or single premium contract with the fund itself paying tax at 20%.
The fund will fluctuate in value based on the value of the underlying commercial property
What is an EIS
This is essentially an investment in a single, unlisted company. There are rules which must be met by the investment, covering aspects such as the size of the company and the assets held by the company but where
these rules are met, the tax benefits can be significant.
How much can be invested in an EIS and what are the tax benefits?
For EIS up to £1m may be invested and receive income tax relief of 30% as a deduction from your tax bill. It is possible
to carry a contribution back to the previous year to be able to benefit from the maximum possible tax relief. The £1m
limit is increased to £2m if the excess over £1m is invested into ‘knowledge intensive companies’, broadly defined as one that spends 10% or more of its operating costs on research and development, innovating intellectual property and / or has skilled full-time staff.
are EIS disposals subject to CGT?
Disposals are generally free of Capital Gains Tax provided the shares have been held for three years but sale within this three-year period might not only result in a charge to CGT but also the withdrawal of the 30% income tax relief previously paid so this should definitely be seen as an investment for at least three years.
Can investors defer a gain when investing in EIS?
Investors can also defer gains on other investments by investing in EIS shares. This means that where an investor sells a second property, for instance, and realises a gain of
£100,000 it is possible to roll over the tax due on this gain by reinvesting it into EIS. Tax relief at 30% would essentially be
given on money that would otherwise belong to the taxman!
When the EIS is eventually sold, the original CGT liability must be paid but any extra profit made on the rolled over tax is tax free as long as they are held for 3 years
Is business relief available when investing in an EIS
100% Business Relief (formerly called Business Property Relief) for IHT purposes is available if shares are held for at least 2 years.
what are the rules that must apply for an EIS
The company may have no more than 250 full-time employees on the date on which the shares were issued (500 for knowledge intensive companies)
No tax relief is given if more than 30% of the capital is acquired – though CGT deferral may still be claimed
Gross assets of the company must not exceed £15m immediately before the issue of the shares nor £16m immediately afterwards
The company must not have raised more than £5m under all venture capital schemes in the 12 months ending on the date of the investment (£10m for knowledge intensive
companies) and no more than £12m in the companies lifetime (£20m for knowledge intensive companies).
Investment must be made within seven years of the companies first “commercial sale” (ten for knowledge intensive firms). unless the investment is for more than
50% of the last 5 years average turnover.
Subsidised energy companies are not acceptable from 6th April 2015.
What does the sharpe ratio measure
This measures the excess return over the ‘risk free’ return for each unit of risk taken. In other words, was it worth taking a risk? If the return achieved by taking a risk was no
better than could have been achieved with the ‘risk-free’ return, the investor has exposed themselves to risk for no
benefit. Risk in this context is once again measured by the standard deviation of the fund.
In other words, the excess return over the risk-free return divided by the number of units of risk taken. This effectively gives us an extra return (a risk premium) for each unit of risk.
What does the information ratio measure?
This is a more general form of the Sharpe Ratio which simply looks at the consistency of performance against a benchmark. It deducts the market return from the actual
return received and then adjusts for the risk taken, this time using ‘tracking error’ against a benchmark. The resulting number shows the effect of fund management over and above passive funds. A high score is a good thing, indicating that the manager is adding value. A low number suggests that the investor might have been better to stick with a passive approach through tracker funds or ETFs.
So, achieved return less benchmark return (the added value of the fund manager) divided by the tracking error
(the risk element).
