Overcoming Home Bias: Why You Should Invest Globally

Not surprisingly, for vast majority of British investors, domestic stocks and particularly the FTSE 100 index represent a substantial portion of their portfolios – often to the extent of neglecting or completely ignoring other markets. Today we will have a closer look at this phenomenon, known as home bias, and discuss the benefits (and costs) of taking a more global approach to asset allocation, particularly in light of the uncertainties ahead.

Home Bias

The home bias, or the home bias puzzle, was first recognised in the early 1990’s. It has been observed that investors tend to over-allocate funds to their domestic market – more than what would be justified when taking a purely rational risk and return optimisation approach. Numerous research reports have been published by bank analysts and academics, examining the causes of home bias and its effects on investment performance and risk.

Costs of International Investing and Causes of Home Bias

In general, there are three groups of factors which discourage investors from investing internationally:

  • Financial, such as currency conversion costs, higher fund management fees or custody fees. The significance of these has declined (but not disappeared) in the last two decades due to technology and the rise of ETFs and other passively managed funds.
  • Administrative, such regulatory restrictions, paperwork or tax issues.
  • Psychological. For instance, for someone living in the UK it makes more sense to invest in shares of familiar companies like Tesco or Marks & Spencer, rather than their foreign counterparts. Being able to see actual products or stores behind a stock symbol helps with trust and comfort – essential ingredients of the psychology of investing.

Benefits of International Investing.

If your portfolio only contains a negligible portion of international equities, or even worse, if you have all your funds in the FTSE 100, your risk and return profile is far from efficient. It is very likely that in the long run you will see lower performance and higher volatility than you otherwise would with a portfolio containing just a bit more of international equities. Of course, the actual future performance of equity markets in individual countries is impossible to predict, but it is the probabilities and the outcomes across a wide range of possible scenarios which must be considered. In one word, diversification.

Geographical, Sectoral and Idiosyncratic Diversification

One argument against international investing is that shares in the domestically listed corporations already provide sufficient exposure to economic developments in other regions, as many of these companies trade worldwide. The FTSE 100 is a good example, as 77% of its constituents’ revenues come from outside the UK.

That being said, the FTSE 100 lacks sufficient exposure to important parts of the global economy which you may not want to ignore. It is traditionally heavy in consumer staples and energy, but severely underweight in the technology sector. If your portfolio mimics the FTSE 100, you have over 8% of your funds invested in a single energy company (Royal Dutch Shell), but you completely lack exposure to companies such as Google, Apple or Amazon, for instance. These are at least as important to the global economy, and to the British economy too.

How Much Is Enough?

According to a recent report by Vanguard, which refers to the latest available (31/12/2014) IMF statistics, British investors hold 26.3% of their equity investments in domestic stocks – on average. In line with the home bias theory, this is much higher than the UK’s share on global market cap (7.2%) or GDP (4% nominal / 2.5% by PPP).

Does this mean you should only have 7% or 4% of your portfolio in British equities? Of course not. After all, if you live in the UK and your general interests, liabilities and future expenditures are in this country, there is nothing wrong with British assets representing a significant portion of your investments. The exact optimum weight of foreign equities is subject to personal circumstances, such as your income, other assets and liabilities. For instance, the property you own represents substantial exposure to the future well-being of the British economy, justifying a higher share of foreign equities.

Does Brexit Change Anything?

The Brexit uncertainty does not enter the equation, unless you personally have a strong opinion regarding the future development and want to gamble on that. If you don’t, remember that in line with the Efficient Market Theory, the stock prices (and the pound’s exchange rate) are already reflecting the market’s consensus and thereby all the currently available information.

In the long run and under the “hard Brexit” scenario, looser economic ties with Europe might result in a decrease in correlation between the UK and EU in terms of economic and stock market performance, increasing the diversification potential of European equities. However, this effect will most likely be marginal, if any.

Understanding Property Capital Gains Tax in 2016/17

Since April British investors enjoy some of the lowest capital gains tax (CGT) rates among developed nations, following the decrease from 18% to 10% and from 28% to 20% for basic and higher rate taxpayers, respectively. However, this does not apply to residential property where the old rates (18% or 28%) still apply. Property taxation has been a sensitive issue in the last years due to the large number of taxpayers affected, large amounts of money (and tax) involved and Britain’s notorious housing shortage. As a result, the rules are quite complex and hard to understand to many. Let’s put some clarity into them and their implications for your financial and tax planning.

How CGT Works for Most Investments

When you sell investments such as shares or funds (held outside a tax wrapper like a pension or ISA), your gain (selling price less purchase price) is subject to CGT of 10% (if you are a basic rate taxpayer) or 20% (if you are a higher or additional rate taxpayer).
There is an annual CGT allowance, which is independent of (in addition to) your personal income tax allowance and lets you earn the first £11,100 (for 2016/17) of capital gains tax-free. Beyond that amount the CGT rates apply.

Residential Property

The general mechanism is the same with residential property, but there are a few specifics worth knowing.
The rates remain at 18% and 28% – effectively there is now an 8 percentage point surcharge on capital gains made on residential property vs. other investments. When announcing the changes in the 2016 Budget, the former Chancellor George Osborne stated that the intention was to create an incentive for people to invest in businesses (and help grow the economy) rather than property (and help grow property prices).
The CGT allowance applies to property in the same way as to other investments. Therefore, if you have made capital gains on both property and other investments in a given tax year, it makes sense to first use the allowance on the property portion to save a higher amount of tax.
With property there are generally more opportunities to deduct costs when calculating taxable gains. You can deduct transaction or administrative costs such as estate agent’s and solicitor’s fees. You can also deduct the cost of improvements which increase the value of your property, such as extensions, but not the cost of regular maintenance or decorations.

Private Residence Relief

If you are selling your own home (“your only or main residence”), or part of it, chance is you won’t have to pay CGT. This is covered by the so called Private Residence Relief. The rules what qualifies are quite complex, but the key points are the following:
You must have lived in the property the entire time, with some exceptions, such as a short period at the beginning (to allow time to prepare the home and move in) or when you had to live elsewhere due to employment duties.
It must have been your main residence. Second or holiday homes don’t quality and are always subject to CGT. Also note that if you are married or in a civil partnership, you can’t have a different “main residence” than your partner, unless you are separated.
It can be a house, flat, houseboat or fixed caravan.
It also includes the grounds, such as a garden and any buildings on it, but not larger than the “permitted area” (0.5 hectares or 5,000 m2 including the buildings). Any part beyond that does not qualify for the relief.
Any part of the property must not have been used exclusively for business purposes at any point of your ownership period.
You have not let part of the property to others at any time, except when having a single lodger.
You can find detailed official information, as well as some examples, on gov.uk.

CGT Liabilities for Non-Residents

Keep in mind that being an expat or non-resident in the UK is no longer a way to avoid CGT duties. Since April 2015 British expats and non-residents who have sold or disposed of UK property are required to report this to HMRC and CGT is payable on gains made after 5 April 2015.
You must inform HMRC even if there is zero tax to pay. The deadline is quite harsh – 30 days after the ownership transfer date.

Conclusion

Taxpayers often underestimate the importance and potential of CGT in their tax planning. Unlike regular income, such as salary, you often (though not always) have more control over the timing of your investment sales and which tax year the particular capital gains are attributed to.
The first rule is to try to use the CGT allowance in full every year.
The second rule is to take advantage of tax wrappers like pensions or ISAs, or other ways to reduce or defer your CGT liability, depending on your circumstances.

Have You Worked Overseas? You May Qualify for LTA Enhancement

If you’ve been working abroad, then you might qualify for the benefits of the LTA Enhancement

That’s because the Lifetime Allowance (LTA) is available to anyone who has contributed to their UK pension whilst they’ve been working overseas.
If you think you may qualify then please read on. As we’ll explain how the LTA works, if it applies to you and, if it does, what you need to do next to take advantage of any tax savings that could be available.

The LTA Enhancement and UK Non-residents

Governments aren’t generally known for their generosity to tax payers. However in this case the LTA Enhancement specifically helps compensate individual taxpayers who have suffered as the result of unexpected and unfavourable changes in legislation.

In short, the LTA Enhancement is great news for UK non-residents. As all those tax payers who have been contributing to a UK pension scheme whilst working abroad (and being tax resident overseas) have not had access to the UK’s tax relief on their pension contributions, as they have been paying their income tax in a different country’s tax system.

Which is possibly why it was felt that it has been unfair to apply the British LTA and the corresponding tax charges to this part of an individuals pension saving, if they are paying income tax overseas. So the non-residence based LTA enhancement provision (sections 221-223 of the Finance Act 2004) now compensates these taxpayers by increasing their LTA.

So, the important question – Do you qualify?

If you’ve spent time working abroad and were not resident in the UK for tax purposes, but you were contributing to a UK pension scheme, then you could qualify.
If you have been working for a British company (or subsidiary or related organisation) outside of the UK and, at the time you made your pension contributions, you were deemed to have been a “Relevant Overseas Individual”, then that would apply for the tax year as a whole and you would qualify.

However, you would only qualify if your were not residing in the UK and had no income subject to UK income tax and that you were not employed by a UK tax resident entity in any part of the given tax year.

It can sound complicated, so lets look at an example. If you were to have left the UK on 15 November 2010, you would have only become a “Relevant Overseas Individual” from the start of the next tax year. Which means that any contributions you made prior to 6 April 2011 (including all those from 15 November 2010 to 5 April 2011) would not qualify for LTA. In the same way that, if you returned to the UK in the middle of the tax year, you wouldn’t qualify for the entirety of that tax year.

The other important factor for qualification for LTA, is that your employer must not have been a tax resident entity in the UK. This would disqualify anyone sent overseas by a British employer, if you performed duties for, and were paid by, that British employer.
However, if your British based employer sent you overseas to work for another non-UK company, you would qualify. What’s more, you would qualify even if you formally had that contract with your original British based employer and was a member of their pension scheme.

If you qualify, then you must tell HMRC.

Despite the fact that you may well qualify for LTA, your entitlement will not be picked-up and acted upon by HMRC.
It is your responsibility to inform HMRC and to claim what could be a considerable saving. So if you have spent any substantial time working outside of the UK and you contributed to your UK pension, then you really should get in touch with HMRC.

You can notify HMRC by using form APSS 202; deadlines apply (generally 5 years from the 31 January following the date when you either stopped contributing or returned to the UK). More details are available on HMRC website (link out Google loves them for SEO), or you can contact us and we’ll be happy to provide you with assistance or advice.

You may well be able to significantly increase your LTA and save a great deal of money on the related tax charges.
As with most things, timing is critical – and there is a time limit applicable here! So if you do qualify you should act soon, as failure to do so could result in hundreds of thousands of pounds being unnecessarily deducted from your pension fund.

As it’s such a complicated area, you may wish to get some help and advice with your personal circumstances. So please ensure that whomever you speak to is UK based and a regulated IFA who holds a specialist qualification and whose firm is authorised by the FCA to provide advice on pension transfers.

Using Your Pension to Buy Business Premises

Using Your Pension to Buy Business Premises

You might have heard that you can save tax if you buy your business premises using your pension. This topic has received increased attention in light of the recent pension reform and the Government’s tapering of annual allowance for high earners. If you are a self-employed professional, work in a partnership or have a company, using your pension to buy your premises can bring numerous benefits, which are not limited to tax savings.

How It Works

Your pension plan, which is legally a different entity from you and from your business, is the owner of your business premises, such as your office or shop. Your business is the tenant and pays rent into your pension.

Benefits

  • The rent is of course a cost for your business, lowering its taxable income. At the same time, a pension plan can receive rental income tax-free. Once paid into your pension, it can be reinvested for further tax-free growth. These tax savings can compound over the years.
  • Besides no tax on rental income, there is no Capital Gains Tax within your pension if you sell the property later.
  • The rent is not considered a pension contribution; therefore it does not use your annual pension contribution allowance and is an effective way to grow your pension pot faster if annual allowance is a problem (particularly for high earners).
  • If you have registered for protection against the Lifetime Allowance (LTA) decrease, or planning to do so, one of the conditions is to stop making further contributions. Because rental income is not considered a pension contribution, this restriction does not apply.
  • There is of course the significant benefit of being your own landlord, having complete control over the premises and avoiding the common pitfalls of landlord-tenant relationships.
  • At the same time, when your property is owned by your pension rather than your company, it is protected against creditors in case your business gets in trouble.
  • If you or your business already own the property, transferring (i.e. selling) it to your pension can free up cash, which can then be used to finance further business activities or personal needs, or even to make additional contributions into the pension plan to attract further tax relief.

Joint Purchases and Partnerships

Your own pension does not need to be the sole owner of the property. If you work in a partnership, like a firm of solicitors or consultants, individual partners can use their pension plans to buy the premises together. Your pension can also buy property in conjunction with yourself or your company.

Types of Property Which Qualify

You can use a pension plan to buy various kinds of commercial property, including office space, retail shops, hotels, industrial premises and even farmland. On the contrary, residential property does not qualify – you can’t buy your house or holiday home via your pension (not even if you work from home).

Risks, Costs and Limitations

Buying property with your pension is a big decision which must not be taken without careful consideration of all risks (commercial property prices are highly sensitive to the state of the economy) and costs (such as stamp duty, valuation, administration and legal fees). You must also understand the tax implications and compliance issues for all parties – yourself, your business and your pension plan.

Not all pension schemes can hold property. In some cases you may need to transfer your pension to a more modern and flexible scheme. Besides universal legal requirements, individual pension providers often have their own rules and restrictions in place. For instance, they may insist that you use their own solicitor or mortgage provider. Make sure to check all these rules (and all charges) before making any decision.

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Brexit …

Brexit becomes reality and the markets react with heavy selling of risk assets, particularly British and European stocks and the pound. The fears have materialised and the issue is taking its toll on investment portfolios. That said, the worst thing an investor can do at the moment is acting based on emotions rather than careful analysis of the situation. With the extreme levels of volatility that we are seeing now, a bad decision can have very costly consequences.

Market Volatility

The markets’ reaction can be best observed on the pound’s exchange rate against the dollar. In the last days before the referendum, it appreciated from 1.40 to 1.50 (7%), as polls started to predict a narrow Remain victory. This morning after the actual outcome it dropped to 1.32 (12% down), but at the time of writing this article it is trading around 1.39 (5% up from the morning low). Similar volatility can be observed on stock prices (British, European and worldwide), commodities and other assets.

The Market’s Reaction Is Not Unusual

While the fact of Britain leaving the EU is unprecedented and extraordinary, the way the markets react to the decision is not unusual. It is similar to the way markets react to other surprising outcomes of scheduled events, such as central bank interest rate decisions or (on the individual stock level) company results. We see a sharp initial move triggered by the surprising outcome (this morning’s lows), followed by corrections and swings to both sides, as the market tries to digest further information that is gradually coming in and establish a new equilibrium level. These swings (although perhaps less extreme than today) will most likely continue for the next days and weeks.

What We Know and What We Don’t

At the moment the actual effects of Brexit on the economy are impossible to predict – we will only know several years from now. Even the timeline of next steps is unclear. The only thing we know is that David Cameron is stepping down as PM (that means succession talks and some internal political uncertainty in the coming months) and that the process of negotiations of the actual EU exit terms will be started in the next days or weeks.

We don’t know what the new UK-EU treaties will look like. There are some possible models, like Switzerland or Norway, but Britain’s situation is unique in many ways. We can also expect the British vote to trigger substantial changes within the EU, as the first reactions of EU representatives have indicated; therefore we don’t know who exactly we will be negotiating with. In any case, this is not the end of trade between the UK and EU countries. The EU can’t afford to not trade with the UK or apply punitive protectionist measures against us.

Where Will the Markets Go Now?

Under these circumstances, no one can predict where stocks or the pound will be one month from now or one year from now. Nevertheless, for a long-term investor, such as someone saving for their pension, these short time horizons don’t really matter. If you invest for 10 years or longer, our view is that you don’t need to fear the impact of yesterday’s vote. Leaving the EU might take a few percentage points from the UK’s GDP and from stock returns, but in the long run it won’t change the trend of economic growth, which has been in place for centuries.

The greatest risk that the Brexit decision represents for a long-term investor is not what the market will do. In any case, it will recover sooner or later. The main risk is the investor acting on emotions, under pressure and without careful analysis of all consequences. The investors who lost the most money in past market crashes such as in 1987, 1997 or 2008 were those who panicked and sold at the worst moment, when it seemed like the economy and the financial system was going to collapse. Those who were able to take a long-term perspective and stayed invested have seen their investments recover and even surpass previous levels.

Our Recommendation

We recognise that this is a momentous event and it will take time to fully digest the implications. For now, it is important that investors maintain their disciplined approach and do not act in haste to sell off their investments. This would only serve to crystallise losses which currently only exist on paper. We recommend that they sit tight unless their goals have materially changed. We also ask them to note that we are not taking this lightly and will be maintaining our portfolio structures under review in accordance with our overall investment philosophy. If we judge that changes need to be made we will provide advice as appropriate and this will be dealt with as part of our normal review process.

 

 

Lifetime Allowance Falls to £1m: Could you be caught?

Pension Lifetime Allowance (LTA) decreased to £1m on 6 April 2016. In combination with previous reductions, it has fallen almost by half from its 2012 high of £1.8m. High net worth professionals like solicitors, barristers and accountants often underestimate the risk of exceeding their LTA. That might become very costly in the future. Above LTA, pension income is subject to 25% tax and lump sum a whopping 55%.

Example
Consider George. He is an accountant and has his own accounting business. He is in his 40’s, approaching halftime of his career. His pension pot is worth about £400,000. George considers himself comfortable, but not particularly rich. He’s heard the news about the falling LTA, but £1m sounds like different world. He’s nowhere near a millionaire after all, so he doesn’t need to worry about LTA.

Truth is, if George continues to contribute to his pension plan at the same rate, or (more likely) increases his contributions a little bit in the later years of his career, he can easily get dangerously close to the £1m mark, or even exceed it. This does not mean that he should stop contributing, but the sooner he becomes aware of the issue and starts planning, the wider options he has.


What are the options for senior professionals at risk of exceeding the new LTA?

LTA Protection
First, if you are likely to exceed the new reduced LTA (£1m), or already have, you can apply for LTA Protection, which is a transitional scheme to protect taxpayers from the unexpected LTA reduction. Depending on your circumstances you have two main options:

  • Individual Protection for those with pension pots already worth over £1m. Your LTA will be set to the lower of 1) the current value of your pension 2) £1.25m (the old LTA).
  • Fixed Protection for those with pension pots below £1m at the moment, but likely to exceed it in the future. Your LTA will be $1.25m, but no further contributions are allowed.

Other conditions apply and many factors must be considered when deciding whether LTA Protection is worth it in your case. Also note that a similar LTA Protection scheme has been in place for the 2014 decrease in LTA (from £1.5m to £1.25) – you can still apply until 5 April 2017.

LTA Planning Options and Alternatives
If you have higher income and want to save more than the LTA allows, the first thing to look at is an ISA. It won’t help you reduce taxes now, because it’s always after-tax money coming in, but in retirement you’ll be able to draw from your ISA without having to pay any taxes – capital gains, interest and dividends are all tax-free within an ISA. There is no lifetime allowance on ISAs, only an annual allowance, currently at £15,240 and rising to £20,000 in April 2017. Furthermore, you don’t even have to wait for retirement – you can withdraw from your ISA at any time.

Another alternative is to invest in stocks, bonds or funds directly, outside a pension plan or ISA. Capital gains, interest and dividends are subject to tax in this case, but there are relatively generous annual allowances which you can take advantage of – the most important being the CGT allowance, currently at £11,100 (the first £11,100 of capital gains in a tax year is tax-free).

These two options alone provide a huge scope for tax-free investing when planned properly. Those on higher income may also want to consider more complex solutions, such as trusts, offshore pensions or offshore companies, although the use of these always depends on your unique circumstances and qualified advice is absolutely essential – otherwise you could do more harm than good.

Conclusion
LTA planning must be taken seriously even when it seems too distant to worry about at the moment. Pensions are the cornerstone of retirement planning, but not the only tool available. With careful planning, a combination of different investment vehicles and tax wrappers is often the most efficient, especially for higher net worth professionals.

New Pension Freedoms Bring Opportunities As Well As Risks

Recent years have seen some significant changes to the tax treatment and rules governing pensions and death benefits. Many of these changes have been quite favourable, bringing new freedoms and tax saving opportunities. However, these freedoms go hand in hand with responsibilities and risks. We will look at the most important challenges and ways to ensure your investments achieve the best possible performance, serve your income needs and at the same time remain tax efficient – both in retirement and when your wealth eventually passes to your heirs.

The Changes

The Government has recently changed financial and tax legislation in many areas, but there are two things which are particularly important when it comes to retirement and inheritance tax planning.

Firstly, you now have greater freedom to decide how to use your pension pot when you retire. You can take the entire pension pot as lump sum if you wish (25% is tax-free, the rest is taxed at your marginal rate), you can take a series of lump sums throughout your retirement, you can buy an annuity or get one of the increasingly popular flexible access drawdown plans.

Secondly, you now have complete freedom over your death benefit nominations. Before the reform, which came into effect in April 2015, you could only nominate your dependants (typically your spouse and children under 23). Now you can nominate virtually anyone you wish, such as your grandchildren, siblings, more distant relatives, or even people outside your family. Furthermore, the taxation of death benefits has become more favourable. If you die before 75, death benefits are tax-free (lump sum or income, paid from crystallised or uncrystallised funds). If you die after 75, death benefit income is taxed at marginal rate of the beneficiary (lump sum is subject to 45% tax, but that may also change in the near future). The reform has turned pensions and death benefits into a powerful inheritance tax planning tool.

The Challenges

While the above is all good news, there are some very important restrictions and things to watch out for. Neglecting them can have costly consequences. For instance, the Lifetime Allowance not only still applies, but has been significantly reduced in the recent years (it is only £1m now). Besides the annual pension contribution allowance it is one of the things that require careful planning long before you retire. In retirement, pension income is typically subject to income tax, which must be considered when deciding about the size and timing of withdrawals, particularly if you have other sources of income.

Asset allocation and investment management is another challenge. Maintaining a good investment return with reasonable risk is increasingly difficult in the world of record low interest rates. It is tempting to completely avoid low-yield bonds and other conservative investments in favour of stocks, but such strategy could leave you exposed to unacceptably high levels of risk, particularly in the last years before your retirement. A balanced portfolio of stocks and bonds is often the best compromise, but asset allocation should not be constant in time – it should be regularly reviewed and should reflect your changing time horizon and other circumstances.

Death benefit nominations are another area where changes in financial and life circumstances may require reviews and adjustments, particularly after the age of 75, when potential death benefits are no longer tax-free. For example, if your children are higher rate taxpayers, you may want to change the nominations in favour of your grandchildren, who may be able to draw the income at zero or very low tax rate, allowing you to pass wealth to future generations in a tax-efficient way. If you have other sources of income and are a higher rate taxpayer yourself, you may even choose to not draw from your pension at all and keep it invested to minimise total inheritance tax.

Conclusion

The above are just some of the many things to consider. Depending on your particular situation, there might be tax saving opportunities which you may not be aware of. Conversely, ignorance of little details in the legislation or mismanagement of your investments may lead to substantial losses or tax liabilities. The new freedoms (and related challenges) make qualified retirement planning advice as important as ever before.

 

 

Sell in May and Go Away – Should You?

If you’ve been investing for a while, it is very likely you’ve heard the “Sell in May and go away” adage many times. This time every year, all major financial media outlets publish their own pieces on it. The recommendations in such articles range from “it is nonsense – stay invested” to “it’s true and really improves returns”, often also including the very popular “but this year is different”. Where is the truth? Is “Sell in May” just a myth, or does it have a sound foundation? What should you do?
Sell in May and Go Away Origin
It is not known who came up with it first and when. The saying is based on (perceived) stock market seasonality and it generally means that market returns tend to be higher in the first months of a year and lower in the next months. Therefore, it is better for an investor to sell stocks in May to avoid the weaker period that follows.
Unfortunately, the saying is very vague about the exact timing. Should you be selling on the first day of May or the last? Or the 8th May, for instance? Additionally, if you sell your shares, when should you buy them back?
You will find several different variations and interpretations of the saying. Probably the most popular version is one that divides the year into two halves, one running from November to April (better returns – hold stocks) and the other from May to October (stay out). Others suggest you should stay out of the market until year end. Yet another version is “Sell in May and don’t come back until St Leger Day” (the September horse race, or the end of summer).
Are the Returns Really Different?
Despite its vagueness, the “Sell in May” adage (particularly the May to October version) is indeed based on some statistically significant differences between stock market returns in different parts of the year (seasonality). Various studies have been done working with different time periods and stock indices in different countries. Many of them have concluded that there are parts of the year when average historical returns have been higher and volatility lower than in other parts of the year. The month of May seems to be the dividing line between the good and the bad period, although exact date, as well as extent of the return differences, depends on the markets and years included in the research.
In short, historical data suggests that market returns tend to be weaker in the months starting with May, so the “Sell in May” saying does have some foundation. Does it mean you should sell? No, and there are several reasons why not.
Lower Returns vs. Negative Returns
While much of the research shows that returns tend to be lower in summer and early autumn, that doesn’t mean stock investors are, on average, losing money in that period. Although the market declined in some individual years, if you were holding stocks from May to September, May to October, or May to year end every year in the last 20, 30 or 50 years, you would have made money in the end.
When deciding whether to sell in May or not, do not compare the average or expected stock market returns to those in the other period. They must be compared to the alternative use of your capital.
To Sell or Not to Sell in May
When making the decision, you are comparing two scenarios:
1. Stay invested in the stock market. Your return is a combination of the increase or decrease in stock prices and dividend yield (do not underestimate dividends).
2. Sell stocks, invest the money elsewhere (often a savings account or a money market fund) and buy stocks back at some point. Your return is the interest earned, but you must deduct transaction costs, which can be significant and sometimes higher than the interest earned. Furthermore, buying and selling will have tax consequences for many investors.
Returns of option 1 are less predictable and can be very different in individual years, as they depend on the stock market’s direction. Returns of option 2 are more stable, but with transaction costs and today’s low interest rates they will be extremely low or even negative. It’s the good old risk and return relationship.
If your time horizon is long and the outcomes of individual years don’t matter, option 1 (staying in stocks), repeated consistently over many years, will most likely lead to much higher return than option 2. If your time horizon is short (for example, you are approaching retirement), you should consider reducing the weight of stocks and other risky investments in your portfolio – not just in May, but throughout the year.

CGT and Dividend Tax Changes: Time to Review Your Strategy

The new tax year has brought important changes in the ways investments are taxed, including a considerable reduction in Capital Gains Tax (CGT) and a complete overhaul of dividend taxation. The scope of these changes merits a review of your investment strategy and portfolio structure. Although the conclusion for many investors will be that no action needs to be taken, make sure your investments remain tax efficient under the new regime.
Dividend Tax Changes
Let’s start with dividend tax changes, which have been known for some time and finally came into effect on 6 April 2016. Under the old system, which involved the somehow confusing 10% notional tax credit, effective dividend tax rates for basic, higher and additional rate taxpayers were 0%, 25% and 30.6%, respectively. On 6 April the notional tax credit was abolished and a new £5,000 dividend allowance was introduced, making the first £5,000 of your dividend income entirely tax free, regardless of your tax bracket (this is on top of any tax-free dividends received under a tax wrapper such as an ISA). At the same time, the rates applying to dividend income beyond the first £5,000 have increased by 7.5 percentage points. The new dividend tax rates for basic, higher and additional rate taxpayers are 7.5%, 32.5% and 38.1%, respectively.
In sum, these changes will result in most taxpayers paying more in dividend tax. The only exception is higher and additional rate taxpayers with relatively small dividend income, who might pay less tax overall thanks to the new allowance (even if your dividend income is a bit higher than the £5,000 allowance, e.g. £7,000, the average effective tax rate might still be lower than under the old regime).
Capital Gains Tax Reduction
While the dividend tax changes have been rather mixed, the changes in CGT, quite surprising and only announced in the 16 March Budget speech, are clearly positive. Effective from 6 April 2016, CGT rates fall from 18% to 10% for basic rate taxpayers and from 28% to 20% to higher rate taxpayers. Most taxpayers can benefit from the annual CGT allowance, which makes the first £11,100 of capital gains free of CGT (the amount for this year is the same as in 2015-16).
Income vs. Growth
In light of the above, the simple conclusion could be that taxation of capital gains has become lower, while taxation of dividends has become less favourable for most. Does this mean you should restructure your portfolio? Should you increase the weights of growth stocks (which tend to pay lower dividends and deliver most of their returns in capital gains) and sell some dividend stocks? If you invest in funds, should you change your focus from income funds to growth funds?
These are valid questions and you should be asking them, but keep in mind that the tax treatment of investments is only one of the many factors you should be considering when deciding your asset allocation and portfolio structure. There are many other factors, with some of them more important (and with much bigger potential financial consequences) than taxes – such as risk and diversification. To conclude, be prepared to make adjustments to optimise the tax position of your portfolio, but selling all income stocks and going all growth is probably a bad idea.
ISAs, Offshore Bonds and Other Options
Importantly, the above applies to direct investments in stocks or funds, but does not necessarily apply to investing via wrappers such as pensions, ISAs or offshore bonds. Particularly the latter has often been mentioned as an alternative in reaction to the dividend tax changes. While relatively simple (and completely legal and transparent, in spite of the “offshore” word), an offshore bond allows you to defer and reduce taxes payable, which may substantially enhance net return in the long run.
If your portfolio is relatively small, you are covered by the dividend and CGT allowances and probably don’t need to worry about taxes. However, with a larger portfolio and/or a longer time horizon, tax issues become a concern. Most people underestimate the effect taxes have on returns when compounded over longer periods of time.

Budget Statement 2016: Key Takeaways

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Budget Statement 2016: Key Takeaways

Chancellor George Osborne delivered his annual Budget speech yesterday. While there are winners and losers as usual, this year’s Budget can be considered quite favourable to middle income families and savers. The pension tax relief is safe (for now) and Capital Gains Tax goes down, among other things. Whilst the Budget contained a wide range of measure, our analysis concentrates on those aspects, which are most important to our clients, namely, taxes, pensions and investments. The full speech is available here.

Personal Allowance and Higher Rate Threshold Up

The Personal Allowance, which is the amount you can earn without having to pay Income Tax, will increase from the current £10,600 to £11,000 for the 2016-17 tax year and £11,500 for 2017-18 (up from the previously announced £11,200).

The higher rate threshold will rise from the current £42,385 to £43,000 for 2016-17 and £45,000 for 2017-18. It is estimated that about 585,000 taxpayers will fall out of the 40% tax bracket as a result.

Both of these are in line with the Government’s previous promises to increase the Personal Allowance to £12,500 and the higher rate threshold to £50,000 by April 2020.

Pension Tax Relief Remains

The fears of pension tax relief cuts or other radical changes to the existing pensions system have not materialised, at least for now. In light of the loud opposition to these plans, pointing out that such measures would discourage people from saving for retirement, the Chancellor has decided to not proceed at this point. The only reference in his speech was the following:

“Over the past year we’ve consulted widely on whether we should make compulsory changes to the pension tax system. But it was clear there is no consensus.”

Of course, this does not mean the issue is safely off the table forever. The Chancellor still needs to find ways to meet his goal of “surplus by 2019-20” and pensions certainly remain among the possible targets. For the 2016-17 tax year though, the allowance stays at £40,000 (for those earning under £150,000), with pension tax relief equal to your marginal tax rate. As previously announced, the Lifetime Allowance falls to £1m effective from April 2016.

ISA Allowance £20,000 and New Lifetime ISA

While pensions have been subject to shrinking allowances in the last years, the trend has been the opposite with ISAs, apparently one of the Government’s preferred ways for people to save for retirement. This time the Chancellor has announced that the annual ISA allowance would jump to £20,000, although only from April 2017. For the 2016-17 tax year the allowance remains at £15,240, same as this year, as previously indicated.

A completely new type of ISA will be introduced in April 2017, called Lifetime ISA. Young savers will be able to contribute up to £4,000 a year and receive a 25% bonus from the Government. That is extra £1 for every £4 saved, a maximum of £1,000 per year. You must be under 40 when opening the account; you will be entitled to the bonus every year up to the age of 50, but only if you have opened an account before 40 (therefore those reaching 40 before 6 April 2017 will miss out). Furthermore, to qualify for the bonus the money must only be used either to save for retirement or to buy a home. If you withdraw cash before the age of 60 and use it for purposes other than buying a home, you will lose the bonus (including any returns on it) and pay a 5% penalty.

The Lifetime ISA is intended as an alternative to pensions for young workers (“many of whom haven’t had such a good deal from the pension system”) and will most likely further develop in the next years. With its home ownership objective it will replace the previously announced Help to Buy ISA, which remains in place until 2019 and can be transferred to the new ISA after April 2017.

Capital Gains Tax Down (Excluding Property)

Shares and other investments sold outside an ISA or pension scheme are subject to Capital Gains Tax when the annual CGT allowance (currently £11,100) is exceeded. As another welcome change to investors, the rates of CGT will drop from 18% to 10% (basic rate) and from 28% to 20% (higher rate).

Importantly, these reductions won’t apply to capital gains from property sales, which will continue to be taxed at the existing rates. This is consistent with the Government’s recent actions against Buy to Let and intended to “ensure that CGT provides an incentive to invest in companies over property”.

Other Changes

The following are some of the other announcements from this year’s Budget speech.

  • From April 2017 there will be two new tax-free allowances (£1,000 each) to support micro-entrepreneurs and the “sharing economy”. The first will apply to property income (such as when renting out your home), the other to trading income (such as when occasionally selling goods and services online).
  • Corporation Tax will decrease further than previously announced, to 17% from April 2020.
  • Contrary to expectations, fuel duty will continue to be frozen for sixth year in a row.
  • From April 2018 there will be a new levy on soft drinks with high sugar content. The proceeds will help finance more PE and sport in schools.
  • Last but not least, Armed Forces veterans in need of social care will be able to keep their war pensions, rather than use them to pay for care.

Conclusion

For the time being, pensions remain the primary way to save for retirement and their tax and other advantages are hard to beat by the alternatives, even with the reduced CGT. Their major downsides are the reduced Lifetime Allowance and Annual Allowance for high earners, effective from 6 April. Of course, further changes may come in the next months and years.

With 25% bonus from the Government, the new Lifetime ISA offers attractive net returns, as long as you meet the conditions. It is only £4,000 per year, but that could add up and compound over time. Even if you are too old to qualify yourself, make sure your children know and take advantage of it when it starts to be available in April 2017.

Lastly, if you are likely to exceed the CGT allowance, consider deferring the sale until 6 April where possible. Not only you will have a new allowance to use, but also CGT rates will be lower by 8 percentage points if you exceed it.