Investment of a Capital Sum

GENERAL STRATEGY

Cash reserve
Before considering investments, it is important to establish how much you need as a cash reserve. It is almost always desirable to have some cash to cover immediate or very short term needs. Some of these may be foreseeable, such as holidays, this year's school fees, the cost of replacing the car. But it is also worth having a contingency fund.

Long term investment approach
The choice of the right investments will depend on your attitude to risk as well as your personal circumstances. It is important to understand the real meaning of risk. In the long term, shares have generally provided substantially higher returns and protection against inflation for investors than cash deposits or fixed-interest securities. However, shares can fluctuate in value and should not normally be regarded as short term investments.

General approach to risk except for no-risk investors
In the longer term, if your fundamental aim is to increase the value of your capital. There are three main aspects to this:

• Inflation protection. Inflation is normally the most serious threat to the long term value of savings. If prices increase at 2.5% a year, for example, the value of the pound in your pocket reduces by a quarter every 12 years. Inflation protection is normally achieved by investing in shares and properties, which are asset-based investments and which historically have offered the best prospects of growing income and capital. Of course, the value of such investments can go down as well as up.
• Diversification. You can protect your investments by spreading them over a range of different areas. This should help to minimise the risk of poor performance by a single investment. It is normally advisable to spread your investments between shares, properties and fixed-interest securities, such as gilts. Shares can be spread over different companies, industrial and commercial sectors as well as different countries.
• Expert investment management. It is difficult for an individual operating from home and with many other business and family responsibilities to give the management of investments the constant attention that it needs. Full-time fund managers have sources of market information and resources, as well as skills, that few individuals acting alone can match.

Costs
Costs can be an important aspect to take into account. Some investments involve higher costs than others. If you buy a small property, for example, you would incur legal fees and other transaction costs. Especially for smaller amounts, open-ended investment companies, unit trusts, bonds and collective investments generally are able to benefit from the low dealing costs of the managing institutions. The cost of dealing in small quantities of shares can be very high.

Nevertheless, buying bonds or unit trusts also involves costs, so the investment normally needs to remain undisturbed for some time so that these costs can be recovered from increases in value.

Taxation
This is normally an important aspect of investment planning. Different investments are taxed in a variety of different ways, even though the underlying funds are broadly the same. Some are more suitable for starting and basic rate taxpayers, while others may be more appropriate for people who pay tax at the higher rate.

Investing in tax-free assets
By investing in assets that do not produce taxable income in your hands, such as individual savings accounts and single premium bonds, you may be able to keep your taxable income below the threshold for higher rate tax, £33,300 for 2006-07. This gives you the additional advantage that your savings income, e.g., interest on bank and building society accounts, as well as dividends on shares and distributions from unit trusts, will not be liable to further tax, thereby significantly increasing your savings rate tax band of 20%. If your income and investment inome take you above the higher rate tax threshold then a further liability is likely to be incurred.

CGT on realising existing investments
Realising assets to make reinvestment may give rise to a liability to capital gains tax (see appendix). Gains over and above inflation which accrued between 31 March 1982 and April 1998, and gains since April 1998 are generally subject to capital gains tax. Taper relief can reduce a chargeable gain on a disposal made after 5 April 1998.
(Cross reference appendix 8.)

CGT exemption
In addition, the first £8,800 a year of chargeable gains is exempt from tax. This exemption cannot be carried forward to subsequent years, and it is therefore essential that if able you use it in each tax year, otherwise the exemption will be lost. It may be possible to reduce this liability further, by spreading the realisation of assets over separate tax years.

REPAYING A MORTGAGE

Pay off the mortgage or invest
If you are faced with the choice between either using your capital funds to reduce your mortgage or leaving the mortgage outstanding and investing the capital. Investing the capital will only be worthwhile in comparison with paying off the mortgage if the net investment return after charges and tax is greater than the interest you pay on the mortgage. In the long term, overall returns from stock market-based investments have outperformed cash deposits in many periods (source: Barclays Capital gilt equity study) but this cannot be guaranteed.

INDIVIDUAL SAVINGS ACCOUNT (ISA)

Structure of ISAs compared to PEPs
Individual savings accounts (ISAs) were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax exempt special savings accounts (TESSAs). ISAs have many similarities to PEPs, but there are also significant differences.

ISA investment components
ISAs can consist of up to two investment components:

• The stocks and shares component. This can include virtually all quoted securities, as well as shares in open-ended investment companies (OEICs), unit trusts, and investment trusts and stakeholder medium term life assurance policies. The quoted securities allowed include equities listed on any Recognised Stock Exchange. You can also invest in corporate bonds, as well as government securities issued by a European Economic Area government.
• The cash component. This can be invested in bank or building society deposits and certain money market unit trusts.

No transfers are allowed between these two components.

ISA accounts and investment limits

There are two main types of individual savings account:

• A maxi ISA, which must have a stocks and shares investment component and may also include a cash and/or insurance component. The maximum that may be invested in a maxi ISA in 2006-07 is £7,000, made up as follows:
  
  o Up to £3,000 in any cash component.
  
  o The balance, up to the overall £7,000 maximum, in the stocks and shares component.
  
  For subsequent years up to and including 2009-10, the maximum investment will remain at £7,000. If you choose a maxi ISA you may not invest in any other ISA during the tax year.
  
  
• A mini ISA, which can only cover one investment component. The maximum that can be invested in each mini ISA in 2006-07 is as follows:
  
  o Up to £3,000 in a cash mini ISA.
  
  o Up to £4,000 in the stocks and shares mini ISA.

For subsequent years up to and including 2009-10, the investment limits will remain at £4,000 for a stocks and shares mini ISA and £3,000 for, the cash mini ISA.

If you choose mini ISAs and wish to maximise your investment, you must invest in two separate mini ISAs during the tax year, covering the two investment components. You cannot invest in both a mini ISA and a maxi ISA. The £4,000 limit on the stocks and shares component makes the mini ISA a less attractive investment option than its maxi counterpart. The maxi ISA effectively has a £7,000 stocks and shares limit.

Tax position
Individual savings accounts will have several major tax advantages until at least April 2010:

• Freedom from capital gains tax.
• Freedom from income tax on interest from corporate bonds and dividends from foreign securities.
• Freedom from income tax on interest earned in the cash component. Any deposit interest earned in the insurance or stocks and shares components is subject to 20% tax.

These mean that the investments should grow faster than comparable investments where tax charges are suffered.

You are free to draw from your plan at any time without adverse tax consequences.

OEICs/Unit trusts
Open-ended investment companies (OEICs)/Unit trusts are a suitable investment for individual savings accounts. They provide a wide range of holdings in different shares, thus offering much more security than would be available from buying shares direct with such a relatively small amount. Professional investment management provides two further benefits: specialist expertise that should achieve better performance and a reduction in the administrative burden of looking after individual holdings.

Definition of unit trust
A unit trust is a fund of stock market investments divided into equal portions called units. Their prices are calculated regularly - normally on a daily basis. Usually two prices are quoted: the higher - the offer or buying price - is the price the investor pays to buy units and the lower - the bid or selling price - is the price that the investor will receive on selling units. Unit trusts normally pay dividends to investors twice a year.

The price of units is governed by the value of the underlying securities in the fund. This price will rise and fall with movements in the price of assets in which the unit trust is invested. The value of a unit trust investment and the income from it can therefore go down as well as up.

There are both general unit trusts and specialist funds. Some may aim to generate longer term capital growth; others are expected to generate higher than average income. Some unit trusts cover the whole of the UK market; others specialise in particular areas. Unit trusts can be an excellent way to invest overseas, either through funds which concentrate on particular markets such as Europe, the Far East and North America or general international funds.

OEICs
Open-ended investment companies (OEICs) are similar to unit trusts. OEICs invest in shares of other companies and are managed in the same way as unit trusts. Instead of buying units, the investor buys shares in the open-ended investment company. The shares are usually priced daily. Investors who buy shares in an open-ended investment company pay the published share price plus an initial purchase charge. Sellers of shares receive the published price.

Open-ended investment companies now outnumber unit trusts and are gradually replacing the remaining trusts.

Investment trusts
An investment trust ISA is also a suitable ISA investment. Investment trusts are companies which invest in the shares of other companies. Thus the ultimate value of a holding in an investment trust is determined by the demand for its shares on the stock market. The share price of an investment trust is indirectly related to the value of the underlying securities. Investment trusts have a number of distinctive features:

• The share price of an investment trust may be less than the value of the underlying securities it effectively represents. This position is referred to as a discount and can lead to a higher income for shareholders. But discounts can increase, and when they do, the shareholder may see a capital loss which is greater than the reduction in the value of the underlying securities held by the investment trust.
• An investment trust can borrow to buy securities. If assets grow in value, the shareholder will gain proportionately more. But if they fall, the loss will be proportionately greater.
• Management charges for some investment trusts are relatively low. Some investment trusts specialise in generating income; others are designed for capital growth. There are general trusts as well as those that specialise in specific areas or markets such as Europe, the Far East or North America.

Corporate bond ISA
ISA investment can include corporate bonds and open-ended investment companies or unit trusts that invest in corporate bonds. The relatively high rates of interest on these bonds can be reinvested to generate steady growth. The value of the bonds should grow if interest rates fall and may reduce in value if interest rates rise.

With Profit Onshore Bonds
This type of investment provides the advantages of the strength and stability of a with profits fund. In the long term, the bond should provide a higher return than investing in bank or building society deposit accounts. However, this is not guaranteed and the current level of bonus rates may not be maintained.

The return also depends on the company's policy about distributing profits, in particular where policies are cashed early, in times of adverse market conditions or in other circumstances.

Advantages

With profits bonds offer a number of advantages to the more cautious investor:

• A relatively stable long term rate of return.
• Regular bonuses.
• Income withdrawal facilities.

Market value reduction factor
Once a bonus has been declared, it cannot be withdrawn. However, the value of your investment can go down as well as up because, in adverse market conditions, the life insurance company reserves the right to apply a 'market value reduction' factor. This means that while the market value reduction factor is applied, there may be a reduction in the value of your investment if you should decide to cash all or part of your bond, or if you wish to switch to another fund.

Early termination
These plans are intended to be a long term investment. If you withdraw from the plan in the early years, your fund could be significantly reduced. Moreover, the impact of charges on the value of the fund could be disproportionately high.

Surrender penalty
These plans are often subject to early surrender penalties which apply on a sliding scale. See the companies illustration for full details.

Investment Bonds

Unit-linked funds - choice of investment fund

There is an extensive range of funds available which maybe suited to your investment requirements.

Managed/balanced funds

These normally invest in a balanced portfolio of other funds. The main investments are normally equities, but managed funds also have significant holdings of fixed-interest securities, property and some cash deposits. They offer the opportunity to benefit from a well-diversified portfolio, where the insurance company may make some adjustments to its asset allocation according to the prevailing market conditions.

• Managed funds are typically the biggest funds of insurance companies and they are often regarded as their flagship funds in terms of investment performance.
• They are usually less volatile than equity funds, because of the level of property and fixed-interest investments that they hold. Managed funds generally under perform equity funds, but over the long term they often perform better than property or fixed-interest funds.

UK equity funds
UK equities have performed very well over the long term, although there have been many periods of short term fluctuation and negative returns. UK equities have a number of advantages as investments:

• The UK stock market is one of the largest in the world; it is well regulated and there is a well-developed culture of shareholder value.
• UK equities provide generally higher yields than are available from most major markets
• Most major UK companies are global businesses, with a substantial international exposure.

International funds

The main advantages of investing overseas are:

• Globally spread investments should be less volatile than purely UK portfolios. The economies of the world are often at different stages in their investment cycles. By investing in different markets, you can smooth out the overall volatility of your investments.
• Many of the world's best companies are located in other countries; by confining your investments to the UK, you could be missing valuable opportunities. In particular, the UK market has little or no exposure to certain types of businesses, such as automobile manufacturing.
• In general, there have been some economies that have grown consistently faster than the UK.

Funds that are invested wholly or partly outside the UK may be affected by exchange rate fluctuations.

Multi-manager funds

Multi-manager funds provide you with access to a range of investment managers under the umbrella of a single fund.

The selection of the investment fund managers is made by a professional who is skilled in fund manager selection. You therefore benefit from two layers of management expertise as well as considerable diversification.

• The performance of the chosen managers is regularly monitored and, if their performance is not acceptable, they are replaced.
• The fund is normally able to negotiate special terms that are not available to individual investors.

Gilt and fixed-interest funds
Gilt and fixed-interest funds invest in government and commercial securities that pay a fixed return. They generally provide a stable income that is reinvested in the fund to generate growth. Fixed-interest funds rise in value when interest rates fall and are vulnerable when interest rates rise. In general, fixed-interest funds are less volatile than equity funds, but they have tended to provide a lower rate of long term growth.

Property funds
One of the few ways to have a holding in a portfolio of good quality and diversified commercial properties is through a property fund. Property generally provides long term growth in both income and capital and is less volatile than equities

Main advantages of bonds
Bonds have several important features as an investment medium:

Switching
You can switch from one fund to another without a personal capital gains tax charge arising.

Lower tax on roll-up of fund
The funds benefit from the special taxation provisions which apply to life assurance companies. The rate of tax on the insurance company's income and capital gains is generally no more than 20%.

Compounding benefit of growth

The income from the investments in the selected fund is used to increase the value of its units. Thus, as the investment accumulates, no income would be payable to you but the value of the bond increases.

Capital gains tax
Tax on the fund's gains is currently subject to a special life company rate of 20%. This is considerably lower than the 40% rate which you would pay on capital gains.

Encashment
You may cash the bond in whole or in part at any time, to release your capital. Any gain you make as a result of cashing the bond completely will be free from basic rate tax and capital gains tax. Remember that these taxes are deducted from the underlying funds of the insurance company.

Tax position
However, cashing the bond may give rise to a higher rate tax charge on the top slicing principle as follows. First, the 'average gain' is calculated by dividing the gain by the number of complete years the policy has been in force. This 'average gain' is then added to your 'total income'. No grossing-up occurs for the tax suffered by the life company thereby further reducing the likelihood of any ultimate liability to tax.

Basic rate taxpayer
Provided your taxable income, including the 'average gain', is not more than the higher rate threshold in the year the bond is cashed, no personal tax would be payable on the gain.

Sole owner bond - independent taxation
Husbands and wives are liable to tax completely independently so that each party is entitled to their own allowance and starting and basic rate tax bands. If your spouse does not have much income of his/her own, it would be worthwhile for him/her to take out the bond on your joint lives as sole owner. In this way, when your spouse cashes the bond, no income tax liability should arise: this is because the addition of the profit from the bond (after 'top slicing' relief) to his/her other income will mean that he/she still remains below the higher rate tax threshold, currently £33,300. If this threshold is still exceeded a liability to tax may occur.

Cash in year of low income
By cashing bonds when your other income is low, e.g., after retirement you could reduce or even completely eliminate the personal tax liability. Furthermore, because the bond will be issued as a series of policies you will be able to cash full policies in separate tax years, which should further reduce the chance of a tax liability.

5% withdrawals later
If you need an income at a later date, you can withdraw up to 5% of the initial investment for each of the first 20 years. These withdrawals would be completely free of basic and higher rate tax at the time of withdrawal, although the underlying funds are subject to tax on the insurance company.

The 5% annual entitlement is cumulative; therefore, for example, if you do not withdraw any capital until year five, you would be able to withdraw up to 25% of the initial investment without incurring a tax charge. However, if the amount withdrawn is more than the cumulative total of the annual 5% entitlements, the excess may be liable to higher rate tax on the top slicing principle described above.

Bond as part of estate
If the bond is not cashed before death, any higher rate tax due on death would be deducted from your taxable estate for inheritance tax purposes, because your estate would include the value of the bond.

OFFSHORE BONDS

Main advantages of offshore bonds

Offshore bonds have several important features as an investment medium:
Switching
You can switch from one fund to another without a capital gains tax charge arising.

Lower tax on roll-up of funds
The funds benefit from the special taxation provisions which apply to exempt life assurance companies. No tax is paid on their income and capital gains although some withholding tax may apply on dividend income.

Compounding benefit growth
The income from investments in the selected fund is used to increase the value of its units. Thus, as the investment accumulates, no income would be payable to you but the value of the bond increases.

Encashment
You may cash the bond in whole or in part at any time, to release your capital. Any gain you make as a result of cashing the bond completely will be liable to income tax.

Tax position
The potential liability to higher rate tax may be reduced or even eliminated by 'top slicing' relief. This means that, firstly, the 'average gain' on the bond is calculated by dividing the gain by the number of complete years the policy has been in force. This 'average gain' is then added to the bond holder's 'total income'. Provided that their taxable income, including the 'average gain', is not more than the basic rate threshold, currently £33,300 in the year the policy is cashed, only basic rate tax is payable on the gain.