Contents:
Regular or Lump Sum Investments?
Managing Debt
Joining the Housing LadderPost Budget Inheritance Tax Planning State Pension Provision
Welcome to the summer edition of our quarterly newsletter.
We are delighted to announce that we have recently taken on a new member of staff. Vivien Powell has joined us from Abbey as our new Office Manager. She brings with her a wealth of industry experience and professional customer service. She is replacing Sharon Marsh, our office manager of four years who is now developing into a Mortgage Adviser with the business.
In the last three months both The Mortgage Professionals Ltd & Wealth Matters websites have been updated and improved to reflect our commitment to customer service. These websites now include downloadable forms including our new company brochure, useful website links and calculators that can help you to take an active interest in your personal finances. In addition, all of our previous newsletters can be found on the websites, containing topical articles that you may find interesting.
Some of you may already be aware of the advantages of using a wrap provider to administer your pensions, savings and investments. A ‘Wrap’ is a financial platform that enables you to view, transact and update all of your investments on one website and allows access to ‘whole of market’.
We have developed a link on the Wealth Matters website, which can be used to monitor investments with Transact, our preferred wrap provider.
In this newsletter we look at the topical subjects of: levels of personal indebtedness, pound cost averaging, post budget Inheritance Tax Planning & state pension provision.
We hope that you find the following articles of interest. If you have any comments, questions or views, please email us at: info@wealthmatters.co.uk
* Wealth Matters is a trading style of The Mortgage Professionals Ltd. The Mortgage professionals Ltd is authorised and regulated by the Financial Services
Regular or lump sum investments
It has often been said that regular savings are better than single investments, in order to benefit from what is known as pound cost averaging. But is this necessarily true? We have looked at this issue in detail.
Pound cost averaging is the expression used to explain the fact that if you invest the same amount of money on different dates at varying prices, you get more ‘units’ or ‘shares’ for your money when prices are lower, than when they are higher. This is something of a “truism”.
Conventional wisdom has it that the fluctuations over time will usually mean that you benefit from buying units over a period of time rather than all on one day. We decided to test this by looking at the FTSE 100 over three 27 month periods during the last six years, from January 2001 to March 2006. (These unusual periods were selected primarily because they are not used for investment performance comparisons.)
In each case, we assumed that £250 was invested each month or that £3,000 was invested at the start and after 12 months, while £750 was invested after 24 months. In this way a total of £6,750 was invested over the entire period. We took the value of the FTSE 100 over the period to represent constantly changing prices and ignored the effects of charges and tax; this is after all simply for comparison.
The three periods selected were one of a rising market, one of a static market and the third of a falling market.
In the case of the rising market, it would be natural to expect that investing a lump sum at the start of each period would do much better than regular investments, simply because all the units were purchased at the lowest cost. However, because prices seldom rise uniformly, there were times when the monthly investments actually purchased more units than at the outset. The net result of this was that while the lump sum investments actually outperformed the regular contributions, the difference was modest at just over 4% more than the regular contribution result for the same total outlay.
In the case of a broadly level market, the difference was even smaller at just under 2% more for the lump sum. This appears to fly in the face of conventional wisdom that regular contributions are better than lump sum investments because of pound cost averaging.
However, when we come to look at the impact of a falling market, the position is reversed. In our simulation, both methods of investment actually showed a loss, but that relating to the regular investments was smaller than that relating to the lump sums by more than 5%. In this case, the regular contributions were better. More importantly, because more ‘units’ were held at the end of the period, the result of any subsequent upswing in the market would be even more beneficial.
The conclusion of this simulation – which might not be replicated in other conditions – is that there is not generally a discernible difference in fluctuating markets between regular and occasional lump sum investments. Clearly, these examples are by no means likely to be replicated precisely and you should note that the potential for loss is by no means smaller that the potential for gain.
What is important is that investments are made, and in a pattern that suits you. But you must always remember that the value of investments is not guaranteed and you could receive back less than you invest.
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Managing Debt
According to a recent report in the Daily Mail, “1.5 million Britons are too far in the red ever to pay back (their) loans”. We look at the issues and some possible recovery strategies.
It has been estimated by Credit Suisse First Boston, that in addition to the 22,000 people a year in the UK who have entered into formal Individual Voluntary Arrangements (IVAs) with their creditors and the 60,000 a year who actually go bankrupt, there are also 250,000 people who have signed up to debt management plans with creditors and one and a half million people who can do no more than pay the interest and minimum balance on their credit cards, each month.
We could ask how we ever got into this situation, but the reality is that credit has been all too easy to obtain for far too long. Most people tend to be rational about their borrowing, but a rapidly rising housing market has left many people with substantial equity in their property, which has encouraged them to borrow more than they otherwise might, in the confident knowledge that they have assets to ‘cover’ their debts.
After all, if someone bought a home for £100,000 with a £95,000 mortgage five years ago and is now sitting in property worth perhaps £150,000, they have £55,000 tied up in their house. So it is unsurprising if they have built up additional debts on the back of the rising house values of up to £37,000 – which is the figure we are told is the average debt of those going bankrupt each year.
But the reality is that there are many ways in which this could all fall apart. Credit Suisse First Boston believes that much of the indebtedness is amongst young professionals with good jobs. Yet even ‘high fliers’ are susceptible to losing their jobs in an economic downturn; an event that many people suspect could be just round the corner, based on massive government borrowing and a rapidly deteriorating balance of payments.
And of course, massively rising energy costs will not only affect those on a tight budget. They could be sufficient to snuff out the flames of the housing market’s recovery and even result in a fall in home values, especially if interest rates were to be raised in order to increase the inwards flow in investment capital.
Blaming the banks for lending too freely for far too long is unlikely to be of any assistance to those who have severe financial problems, but it is important to recognise that if you do get into difficulties, your bank should be the first port of call; not to borrow more money, but to ensure that they are aware that you have a problem and to help with rescheduling debts.
What is not always in your best interest is to rush into a consolidating loan without considering the alternatives. In some cases there will be viable alternatives, which might include re-mortgages or secured borrowing.
While no strategy will work for everyone, the following steps will probably help put you on the right track.
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Review your income and outgoings together;
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Decide what you have to spend money on and what is non-essential;
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Stop spending on things that you can do without;
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See where you can save on ‘essentials’;
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Plan to pay off some of your debts as well as the interest; ideally at a rate well in excess of the minimum your credit card company asks for;
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Allow yourself some treats and rewards for success.
The key point is to look at this as a manageable and temporary problem. Even if your borrowings are greater than your income, you can draw up a plan to reduce their size within a few years; after that, things might not look so bad.
Anything is better than ignoring the problem, but getting professional help is a sensible course of action.
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Joining the housing ladder
Anecdotal evidence suggests that fewer than one of four ‘ twentysomethings’ own their own property. This is caused by a sustained long term rise in the housing market and, to some extent, fear that interest rates could rise again in the future, making massive loans difficult to sustain.
According to Halifax Bank of Scotland, the “standard” price for a first time buyer home in different parts of the country ranges from just over £86,000 in Scotland, to almost £205,000 in Greater London. Even in the heavily populated, but less expensive midlands area, average prices are not much under £120,000. This means that on a 95% mortgage, first time buyers will need to borrow £114,000 as well as finding a deposit of £6,000 and enough to cover legal costs and furnishing costs. At least the recent increase in the starting point for Stamp Duty land Tax to £125,000 will help in some areas, although average first time buyer prices exceed this level in East Anglia and most of southern England, so there is an additional 1% to be found in most cases.
This is a matter of deep concern not just to young people, but also their parents, who are wondering how young couples starting out together, and creating the next generation to help pay for our retirement, can ever buy a home of their own.
It is not just a question of the massive loan that is required to get started on the housing ladder – and finding the deposit. There is also often a substantial student loan that encumbers many of today’s young people; not a problem our own generations faced since fewer went to university in any event and, if we did, grants were frequently available.
The question must be what can we do to help?
Fortunately, lenders are waking up to the problem and creating products aimed specifically at the needs of this sector, helping them to borrow a higher percentage of property value and higher multiples of earnings than might normally be the case. Of course there are implications to this, including the question whether too much debt is being taken on and whether a parental or other third party guarantee will be required. Parental guarantees are not without risk and can result in the main family home being at risk if the children default on the mortgage.
It is also possible for property to be purchased jointly, perhaps by siblings or friends clubbing together, or through more formal shared ownership arrangements such as through housing associations or with government assistance. There are, of course downsides. In the former case, the arrangement relies on relationships not breaking down and can become complicated when one participant decides to form a new relationship that might put pressure on accommodation. In the latter case, not all the growth in property value benefits the borrower, but this is at least a step on the ladder.
Another option is for parents to help by providing a substantial deposit, although this must be clearly expressed as a gift or loan if future potential inheritance tax problems are to be avoided. Current rules on “previously owned property” should not cause difficulties, but who knows how the Chancellor will move the goalposts in future budgets?
Perhaps the real solution is to be found in the acceptance by young people that if they really want to get on the housing ladder, they simply have to ‘stop partying and start saving’.
All financial advice has to be paid for in some way or other. We offer clients the option to pay a fee for our services, the precise amount of this will be advised to you in advance, before any commitment is made by you. In some cases it may be possible to offset part or all of the fee due against any commission we receive from a lender or other source.
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Post Budget Inheritance Tax Planning
Rising house prices mean that many families who may never have had to consider the impact of inheritance tax may now have to do so. With the threshold at which this 40% ‘tax on family savings’ applies having been raised by just 3.6%, in the recent budget to £285,000 many homes will exceed this limit in most parts of the country.
This is a situation that has been creeping up on us for some time as the starting point for inheritance tax (IHT) has been rising at a far slower pace than the rise in average house prices recently. For example, while house prices over the past 5 years averaged 3.4% a quarter, the IHT threshold has risen by an average of 3.33% a year from £250,000 in 2002/3. This means that the gap is rapidly closing between house prices and the stage at which IHT starts to bite.
What is new is that the Chancellor has suddenly and without any form of warning imposed IHT for the first time on certain types of family trust that have historically been used in order to minimise the impact of IHT and help pass more of a family’s money down the generations.
There are two types of trust that are primarily affected, although some others could also be hit, including the sort of trust frequently used in connection with life assurance, in order to protect it from IHT – although the Finance Bill appears to exclude existing life assurance trusts, provided that the policy remains unaltered.
The principal arrangements affected are “accumulation and maintenance” trusts and “interest in possession” trusts. Without going into too much detail, both these arrangements are established with the intention of passing money down the generations. In the former case, the primary intention is to ensure that children or grandchildren receive the benefit of income generated by the trust, but cannot actually control it until they reach the age (usually) of 25. In the latter case, the aim is to allow a spouse to enjoy an asset – either the family home, or the interest from capital – during his/her lifetime while leaving the capital intact for the next generation.
The purpose of the arrangement is for the donor to place money into the trust (what is called a Potentially Exempt Transfer, or PET) and then survive a further seven years, so that there is no IHT on the money held within the trust.
The change Gordon Brown has made is to state that money being placed into a trust during the donor’s lifetime is no longer a PET, but is liable to tax at a rate of 20% in excess of the lifetime limit. What is more there will be an additional tax of 6% every ten years and a further 6% charge when the trust is wound up.
One anomaly of this is that IHT could suddenly become payable on gifts between husband and wife – a situation that has not arisen before in respect of UK assets.
People who have already set up such arrangements have until 2008 to alter them. In particular, it appears that beneficiaries will have to gain full control of their inheritance at age 18, if the new penalty taxes are not to apply. For those affected, the action that needs to be taken could well vary in each case.
Advisers will be looking at this closely as the legislation passes through parliament – there could well be changes, although by convention the House of Lords will not stand in the way of the elected government in respect of budgetary matters. However, opposition within the commons could be vociferous.
Taking no action simply will not be an option. Everyone with a will that creates a trust, or who has already established a trust during their lifetime should seek advice as soon as possible. However, you should be aware that there are currently more questions than answers; there will be no ‘quick fixes’ and little certainty until the Finance Bill is enacted and even then doubt can remain as HM Revenue & Customs practice develops.
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State Pension Provision
If the advent of pension simplification on 6 th April was not enough to confuse you wait until you come to terms with the so-called “Turner Report” on the future of state pension provision. One thing is quite clear. There is a problem.
The problem with an aging population is not just that we will require more carers in the future, as people live longer and require more social and medical support. The real issue is about the way state pensions are funded. Unlike an occupational or personal pension, no funds are being built up by current contributions in order to pay for future benefits. Instead, we rely on a hand-to-mouth system whereby today’s national insurance contributions are used to pay for today’s pensions.
By extension, tomorrow’s workers will have to pay for tomorrow’s pensioners. This might not matter if the working population was growing adequately, but government statistics over many years (most notably in a DSS report in 1998) indicate that the “support ratio” that is the proportion of workers to the retired, is set to fall during the next half century.
However, there are two other issues that need to be addressed. Firstly, state benefits are far from simple and the means-testing element of the pension credit system acts as a positive disincentive to those on lower incomes from making personal provision, as benefits are reduced as other sources of income increase. The second issue is that state pensions are linked to the Retail Prices Index. Unfortunately the index does not necessarily reflect the spending habits of the elderly whose reliance on heating, for example, can be far higher than that for younger people. Not only is this potentially inequitable, but the fact that earnings have historically tended to rise faster than inflation means that those with incomes tied to inflation become progressively worse off, compared with those still at work.
The solution proposed by Turner is that state benefits should be more generous and not be means tested but that as a quid-pro-quo the starting age at which state benefits become available should increase in stages to 68. He also proposes the introduction of a National Pension Savings Scheme (NPSS) which could become mandatory for those employers who do not offer an occupational pension scheme.
There are a number of problems related to this second proposal. Firstly, it is possible that some employers will close their existing arrangements in order to relay in what could be bureaucratic and inferior schemes. Similarly, people could believe that the NPSS is all they need to do in order to secure a decent standard of living in retirement and thus discontinue (or fail to start) personal provision.
The problem is that the proposed maximum charging structure leaves little or no scope for advice or professional fund management to be paid for. This could result in a small number of fund managers being given control of vast amounts of money – something that tends to be inefficient.
There are, of course, some benefits, in that those who may currently have no provision at all will at least have some. But this is potentially outweighed by the fact that such provisions are unlikely to benefit from any form of independent and professional advice.
We believe that it is essential that each individual should be properly advised and then accept personal responsibility for making provision for their retirement, either through membership of a properly constituted occupational pension scheme, or with personal pensions.
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