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.

When Chasing Interest, Don’t Forget Currency Risk

For many years, interest rates have been extremely low in the UK and most other developed countries. If you are living abroad and your new country’s interest rates are much higher than back home, it is natural to think about ways to capitalise on the difference. The right strategy can significantly enhance your returns, but at the same time there are risks which many expats underestimate or completely ignore.
Do You Want to Earn 0.35% or 14.35%?
At present, central bank rates are at 0.5% in the UK and the US, 0.05% in the Eurozone, and negative in several other developed countries including Switzerland, Sweden and Japan. You can get a cheap mortgage, but you also earn close to nothing on your savings. At the same time, the rates are 6% in South Africa, 7.5% in Turkey, 11% in Russia and 14.25% in Brazil, just to name a few.
Why save at 1% or less in a British bank when you can earn multiples of that just by keeping the funds in a different currency? It makes complete sense, particularly when you are living there and big part of your expenses are denominated in that currency anyway.
Interest Rate Differences and Exchange Rate Changes
You have heard it before: There is no free lunch in the markets. To earn considerable returns, you must take considerable risks. In this case, the risk is that the currency you hold will depreciate and the resulting losses will wipe out or exceed any interest gains. This risk is very real. It happens all the time.
Even with the pound’s current weakness, in the last three years the South African rand has lost 38% against the pound, the Turkish lira has lost 34%, the Russian rouble 56% and the Brazilian real 46%. In spite of their high interest rates, you would have lost money on all of them.
According to an economic theory (named uncovered interest rate parity), when there is a difference in interest rates between two currencies, it is expected (other things being equal, which they never are) that the high interest currency will depreciate against the low interest currency, so the total return will be the same on both. For example, if interest rates are at 0.5% in the UK and 14.25% in Brazil, it is reasonable to expect that the BRL will lose approximately 13.75% against the pound in the next 12 months.
Theory and Reality
In reality, other factors come into play. Sometimes the high interest currency does not depreciate that much and you indeed make money holding it. However, other times it loses much more than “expected”, as seen on the examples above.
The risk of disproportionate adverse moves in emerging currencies is particularly high at times of global liquidity shortage and increased risk aversion, such as in the 2008 financial crisis or the 1997 Asian currency crisis, which spilled over and contributed to subsequent problems in Russia, Brazil and Argentina. The problem with these events is that you never see them coming until it’s too late. Furthermore, even an otherwise stable country’s currency can often be affected only due to market sentiment and its emerging status.
What It Means for Your Finances
The above does not mean you should always keep all your savings in GBP or other major currencies. It means that whenever the currency structure of your income, expenses, assets and liabilities is in mismatch, you are exposed to currency risk. For instance, if you are living in Brazil and saving in BRL, but planning to eventually return to the UK or retire elsewhere, you are to a large extent betting your future on the BRL exchange rate.
Make sure you know what you would do in an adverse scenario, such as a currency crisis, however unlikely that might seem at the moment. Keep at least a portion of your savings in a strong and stable currency, even when the returns don’t look that attractive. It is widely known that rich families in places like China or Russia prefer to keep big parts of their wealth in developed countries, giving up the higher returns they would earn at home. They do it for a reason and that reason is safety and stability.
You can allocate some funds to high-yield currencies and riskier investments, but with the core of your assets, like the pension pot, it should be defence first. Don’t bet your future lifestyle.

Possible Brexit Consequences and Your Portfolio

Whether you support Leave or Remain, you may be wondering how leaving the EU (or staying in) can affect your investments. Will British stocks underperform if the UK leaves? Will the pound continue to be under pressure until the June referendum, but recover if people vote to stay in the EU? Is there anything you can do to prepare your portfolio for either outcome?
The Brexit referendum is a typical example of an event with known timing (23 June) but unknown outcome. Plenty of these occur in the markets on a regular basis, including corporate earnings, macroeconomic data or central bank policy announcements. While this one is obviously of extraordinary significance, the underlying principles of market psychology still apply.
One of these principles is that anticipation can result in as much volatility as the event itself (if not more). In other words, when investors know that something is going to happen, or might happen with a certain non-zero probability, the market often “reacts” before the outcome is announced. In line with the Efficient Market Hypothesis, prices immediately reflect all available information.
The pound has weakened by 9% against the dollar and by 11% against the euro in the last 3 months. It seems like big part of the damage has already been done. Will it depreciate further? It is impossible to predict.
When anticipating an event, sometimes the market overshoots and then corrects, making a counterintuitive move when the actual outcome is finally known (like the pound strengthening after the referendum even if Leave wins). The saying “buy the rumour, sell the fact” comes to mind. Sometimes it’s the opposite. Other times it’s completely random. No one can tell before it happens.
With the above being said, there are two things we consider highly likely:
Firstly, until the June referendum we will probably continue to see increased volatility in the pound’s exchange rate (saying nothing about the direction). As the first days have confirmed, the debate will be heated. New questions and new fears will arise. Both camps will achieve small victories and suffer small defeats. The perceived probability of leaving the EU will change as new opinion polls will come out.
Secondly, given the high profile and non-stop media coverage of the matter, the economic significance and consequences of Brexit are probably exaggerated at the moment by both the Remain supporters (doom and gloom if we leave) and the eurosceptics (prosperity guaranteed if we rid ourselves of EU bureaucracy).
Contrary to what it may seem, the world has not come to a standstill, waiting for the UK to decide. There are other events and other factors which will continue to influence the economy, the stock market and the currency, before and after the referendum. Some of them will probably have much greater effects than Britain leaving the EU – possible candidates include oil price (the FTSE is energy heavy), interest rates, slowdown in China or the US, wars (e.g. Ukraine, Syria) getting worse and spilling over, or shocks in the financial sector. This time last year, it was Grexit, not Brexit, dominating the headlines. The fact that no one talks about Greece at the moment does not mean that the sovereign debt problem (in Greece and elsewhere) has been resolved. It can strike back at any time and hurt British banks and the economy even if we are already out of the EU.
The above does not mean that consequences of a possible Leave vote will be negligible or non-existent. However, they are too complex for anyone to understand and forecast. We don’t know the referendum outcome. If it’s Leave, we don’t know how the future arrangement will look (in any case, the UK will not cease to trade with Europe). Most importantly, the global economy and external factors will definitely not remain constant, further complicating any predictions.
Therefore we believe that avoiding panic and sticking to your long-term investment strategy is the best course of action. Remember that trying to outsmart and time the market rarely leads to superior results.

Tax Year End Planning Checklist

The end of the tax year is approaching again; therefore it’s time to think about maximising allowances, minimising taxes and taking all the other steps to ensure your tax position will be as favourable as possible going forward. Although there are still almost two months left, it’s better to start now rather than leave it all to the last days, for some of the necessary steps can take some time to process.

When going through the checklist below, you may find this page useful. It contains all the key thresholds, rates and allowances for 2015-16 as well as 2016-17.

Income Tax and National Insurance

If possible, delaying an invoice (if you are self employed), salary, bonus or dividend payment (if you have a company) until 6 April can save, or defer, a considerable amount of taxes. Company owners should also find the right mix of salary and dividends to minimise taxes. Don’t forget to include all of them when making the decision – personal income tax, both employee’s and employer’s NI, corporation tax and dividend tax.

The key figures are:

  • £5,824 = Lower Earnings Limit – minimum to qualify for State Pension and other benefits
  • £8,060 = Primary Threshold – employee’s NI (12%) kicks in
  • £8,112 = Secondary Threshold – employer’s NI (13.8%) kicks in
  • £10,600 = Personal Allowance – basic rate income tax (20%) kicks in
  • £31,786 = higher rate income tax (40%) kicks in

Many company owners choose to pay themselves a salary equal to the Primary or Secondary Threshold, in order to avoid paying NI, and take the rest in dividends. However, if your company is eligible for the Employment Allowance (first £2,000 of employer’s NI free), it could make sense to pay yourself up to the Personal Allowance (£10,600) in salary. Of course, your other income, family situation and other circumstances could alter the figures and must always be considered.

Pension Contributions

Making pension contributions can save you a lot of money in taxes, as long as you stay within your annual allowance, which is £40,000 for the 2015-16 tax year. At the moment, pension contributions are subject to tax relief at your marginal tax rate, which makes them particularly attractive to higher and additional rate taxpayers.

Normally you need to make the contributions before the tax year end (5 April), but this time it is recommended to act before the Budget Statement, which is due on 16 March.

There is high risk that Chancellor George Osborne will announce important changes which may affect the tax relief. The exact outcome is not known, but experts have been speculating about a flat rate replacing the marginal tax rate (this would effectively reduce or eliminate the tax relief for higher and additional rate taxpayers). The Chancellor has also mentioned the idea of cancelling the pension tax relief altogether and using a completely new mechanism for taxing pensions in the future, perhaps similar to ISAs (after-tax money in and tax-free money out).

It is not clear if this will eventually materialise and when any changes would come into effect. However, pension tax relief has clearly been one of the Chancellor’s primary targets in the effort to reduce the deficit and raise tax revenue. In light of the uncertainty, the safest approach is to make pension contributions before 16 March to avoid potential disappointment.

Note that if you didn’t use your full allowance in the three previous tax years, you might still be able to get that money in, on top of this year’s £40,000. The previous three years’ allowances were £50,000, £50,000 and £40,000, respectively. One condition is that your total contribution must not exceed your earned income for the current tax year. Another thing to watch out for is the lifetime allowance (currently £1.25m, but falling to £1m in April), as exceeding that could be costly when you retire.

NISAs

If you have the cash, you should always use your annual NISA allowance to the maximum. A NISA is a tax wrapper which allows you to build savings and investments without incurring taxes on income and capital gains going forward. The allowance is £15,240 for 2015-16 and it is use it or lose it – if you don’t deposit the money by 5 April, this year’s allowance is gone forever. You may also want to use your partner’s and your children’s allowances (£4,080 per child under the so called “Junior ISA”).

If you have existing cash ISA accounts, now is also a good time to review them and check the interest rates. Banks like to lure savers with attractive rates, only to slash them after 12 months or some other period. In such case you may want to transfer the funds elsewhere. There are two things to keep in mind:

  • Always transfer from ISA to another ISA directly. If you do it via your regular bank account, once you have withdrawn the money, it loses the ISA status (and withdrawals do not increase your annual allowance – that will only change the next tax year).
  • Each tax year you can only deposit money to one cash ISA account and one stocks and shares ISA account.

Capital Gains Tax

You can often save on capital gains tax even outside ISAs. There is an annual CGT allowance, which makes the first £11,100 (for 2015-16) of capital gains tax-free. You need to realise these by the tax year end; otherwise the current year’s allowance is lost forever.

Depending on the investments you are holding, whether there are unrealised gains or losses and whether you want to sell any of them, the decisions to make can become quite complicated, but may save you a lot in taxes. A potentially large CGT bill can be reduced (by crystallising losses) or deferred (if you wait with the sale until 6 April). On the other hand, if you are well within your CGT allowance you can crystallise gains to reduce future taxes.

Always keep in mind that tax issues are an integral part of any investment strategy (and tactics), as taxes can affect net return substantially. At the same time, don’t forget to consider transaction costs.

Inheritance Tax

If your estate is likely to exceed the IHT threshold (£325,000 for individuals or £650,000 for couples), you may want to take steps to reduce it. Estate planning can obviously become very complex, but the easiest thing you can do is make gifts to your beneficiaries. These are subject to annual allowance of £3,000. If you didn’t use the allowance last year, it can still be used now (making it £6,000 in total), but after the tax year end it is lost. As long as you live for seven years after the gift, it is out of your estate.

Other Considerations

The above are the most common points which apply to most people. Depending on your circumstances, there may be other opportunities, further allowances and other things to do before the tax year end. In any case, it is best to discuss your entire financial and tax position with your adviser, as some actions might have unexpected consequences. Don’t forget the key date is 5 April, with the exception of pension contributions where it is safer to act before 16 March this year. Also remember that some actions will require longer time to process and don’t leave everything to the last days.

 

 

 

 

Bear Market Coming? Stick with Your Strategy

Following a multi-year rally, 2015 wasn’t particularly successful in the global markets and, so far, the start of the new year hasn’t been any good either. The UK’s FTSE 100 index is below 6,000, lowest in more than three years. It’s times like this when various doomsday predictions start to appear, warning against events “worse than 2008”, using words such as “crash” and “meltdown”, and pointing to factors such as rising interest rates, growing political tensions, China, rising commodity prices, falling commodity prices and many others.
The truth is that no one really knows what is going to happen. Not the TV pundits, not the highly paid bank strategists and stock analysts, not even the Prime Minister or the Bank of England Governor.
That said, when you have significant part of your retirement pot invested, it is natural to feel uneasy when you hear such predictions, especially if they come from an analyst who got it right last time and correctly predicted some previous market event (he was lucky).
When the markets actually decline and you see your portfolio shrinking in real time, the concerns may become unbearable. Fear and greed get in charge, both at the same time. It is tempting to think about selling here and buying the stocks back when they are 20% lower a few months from now. Easy money, so it would seem. Nevertheless, that would be speculating, not investing. The problem with the financial industry (and the media) is that these two are confused all the time.
Time in the Market, Not Timing the Market
While some people have made money speculating, academic research as well as experiences of millions of investors have shown that it is a poor way to save for retirement. When a large number of people take different actions in the markets, some of them will be lucky and get it right purely due to statistics (luck). However, it is extremely difficult to repeat such success and consistently predict the market’s direction with any accuracy.
In the long run, the single thing which has the greatest effect on your return is time, not your ability to pick tops and bottoms. The longer you stay invested in the market, the more your wealth will grow. You just need the patience and ability to withstand the periods when markets fall, because eventually they will recover and exceed their previous highs.
Time Horizon and Risk Tolerance
The key decision to make is your risk tolerance – how volatile you allow your portfolio to be, which will determine your asset allocation. While personality and other personal specifics come into play, the main factor to determine your risk tolerance is your investment horizon. The longer it is, the more risk you can afford and the more volatility your portfolio can sustain. If you are in your 40’s and unlikely to need the money in the next 20 years, you should have most of your retirement pot in equities. If you are older and closer to retirement, your portfolio should probably be more conservative, because you might not have the time to wait until the markets recover from a possible crash. It is important to get the risk tolerance and the asset allocation right (an adviser can help with that) and stick with it.
How to Protect Your Portfolio from Yourself
Because the above is easier said than done, here are a few practical tips how to protect your retirement pot from your emotions and trading temptations:
1. Have a written, long-term investment plan. It is human nature to consider written rules somehow harder to break than those you just keep in your head. It is even better if you involve your adviser to help you create the plan. Not only is an adviser better qualified and more experienced in the investment process, but another person knowing your rules makes them even harder to break.
2. Do not check fund prices and the value of your portfolio every day. This doesn’t mean that you shouldn’t review your investments regularly. But the key is to make these revisions planned and controlled, rather than emotion-based. You will be less likely to make impulsive decisions, which more often than not are losing decisions.
3. Maintain an adequate cash reserve. This should be enough to meet any planned short-term expenditure and also provide a reserve for unexpected expenses. It will help you avoid the need to encash investments at a time when investment values are low.

Would you like to discuss this article with an adviser?

The Seven Roles of an Advisor

What is a financial advisor for? One view is that advisors have unique insights into market direction that give their clients an advantage. But of the many roles a professional advisor should play, soothsayer is not one of them.

The truth is that no-one knows what will happen next in investment markets. And if anyone really did have a working crystal ball, it is unlikely they would be plying their trade as an advisor, a broker, an analyst or a financial journalist.

Some folk may still think an advisor’s role is to deliver them market-beating returns year after year. Generally, those are the same people who believe good advice equates to making accurate forecasts.

But in reality, the value a professional advisor brings is not dependent on the state of markets. Indeed, their value can be even more evident when volatility, and emotions, are running high.

The best of this new breed play multiple and nuanced roles with their clients, beginning with the needs, risk appetites and circumstances of each individual and irrespective of what is going on in the world.

None of these roles involves making forecasts about markets or economies. Instead, the roles combine technical expertise with an understanding of how money issues intersect with the rest of people’s complex lives.

Indeed, there are at least seven hats an advisor can wear to help clients without ever once having to look into a crystal ball:

The expert: Now, more than ever, investors need advisors who can provide client-centred expertise in assessing the state of their finances and developing risk-aware strategies to help them meet their goals.

The independent voice: The global financial turmoil of recent years demonstrated the value of an independent and objective voice in a world full of product pushers and salespeople.

The listener: The emotions triggered by financial uncertainty are real. A good advisor will listen to clients’ fears, tease out the issues driving those feelings and provide practical long-term answers.

The teacher: Getting beyond the fear-and-flight phase often is just a matter of teaching investors about risk and return, diversification, the role of asset allocation and the virtue of discipline.

The architect: Once these lessons are understood, the advisor becomes an architect, building a long-term wealth management strategy that matches each person’s risk appetites and lifetime goals.

The coach: Even when the strategy is in place, doubts and fears inevitably will arise. The advisor at this point becomes a coach, reinforcing first principles and keeping the client on track.

The guardian: Beyond these experiences is a long-term role for the advisor as a kind of lighthouse keeper, scanning the horizon for issues that may affect the client and keeping them informed.
These are just seven valuable roles an advisor can play in understanding and responding to clients’ whole-of-life needs that are a world away from the old notions of selling product off the shelf or making forecasts.

For instance, a person may first seek out an advisor purely because of their role as an expert. But once those credentials are established, the main value of the advisor in the client’s eyes may be as an independent voice.

Knowing the advisor is independent—and not plugging product—can lead the client to trust the advisor as a listener or a sounding board, as someone to whom they can share their greatest hopes and fears.

From this point, the listener can become the teacher, the architect, the coach and ultimately the guardian. Just as people’s needs and circumstances change over time, so the nature of the advice service evolves.

These are all valuable roles in their own right and none is dependent on forces outside the control of the advisor or client, such as the state of the investment markets or the point of the economic cycle.

However you characterise these various roles, good financial advice ultimately is defined by the patient building of a long-term relationship founded on the values of trust and independence and knowledge of each individual.

Now, how can you put a price on that?

Gravel Road Investing

Owners of all-purpose motor vehicles often appreciate their cars most when they leave smooth city freeways for rough gravel country roads. In investment, highly diversified portfolios can provide similar reassurance.

In blue skies and open highways, flimsy city sedans might cruise along just as well as sturdier sports utility vehicles. But the real test of the vehicle occurs when the road and weather conditions deteriorate.

That’s why people who travel through different terrains often invest in a SUV that can accommodate a range of environments, but without sacrificing too much in fuel economy, efficiency and performance.

Structuring an appropriate portfolio involves similar decisions. You need an allocation that can withstand a range of investment climates while being mindful of fees and taxes.

When certain sectors or stocks are performing strongly, it can be tempting to chase returns in one area. But if the underlying conditions deteriorate, you can end up like a motorist with a flat on a desert road and without a spare.

Likewise, when the market performs badly, the temptation might be to hunker down completely. But if the investment skies brighten and the roads improve, you can risk missing out on better returns elsewhere.

One common solution is to shift strategies according to the climate. But this is a tough, and potentially costly, challenge. It is the equivalent of keeping two cars in the garage when you only need one. You’re paying double the insurance, double the registration and double the upkeep costs.

An alternative is to build a single diversified portfolio. That means spreading risk in a way that helps ensure your portfolio captures what global markets have to offer while reducing unnecessary risks. In any one period, some parts of the portfolio will do well. Others will do poorly. You can’t predict which. But that is the point of diversification.

Now, it is important to remember that you can never completely remove risk in any investment. Even a well-diversified portfolio is not bulletproof. We saw that in 2008-09 when there were broad losses in markets.

But you can still work to minimise risks you don’t need to take. These include exposing your portfolio unduly to the influences of individual stocks or sectors or countries or relying on the luck of the draw.

An example is those people who made big bets on mining stocks in recent years or on technology stocks in the late 1990s. These concentrated bets might pay off for a little while, but it is hard to build a consistent strategy out of them. And those fads aren’t free. It’s hard to get your timing right and it can be costly if you’re buying and selling in a hurry.

By contrast, owning a diversified portfolio is like having an all-weather, all-roads, fuel-efficient vehicle in your garage. This way you’re smoothing out some of the bumps in the road and taking out the guesswork.

Because you can never be sure which markets will outperform from year to year, diversification increases the reliability of the outcomes and helps you capture what the global markets have to offer.

Add discipline and efficient implementation to the mix and you get a structured solution that is both low-cost and tax-efficient.

Just as expert engineers can design fuel-efficient vehicles for all conditions, astute financial advisors know how to construct globally diversified portfolios to help you capture what the markets offer in an efficient way while reducing the influence of random forces.

There will be rough roads ahead, for sure. But with the right investment vehicle, the ride will be a more comfortable one.

Article by

Jim Parker, Vice President, Dimensional Fund Advisers

Top 10 Investment Guidelines

The media would have you believe that a successful investment experience comes from picking stocks, timing your entry and exit points, making accurate predictions and outguessing the market. Is there a better way?

It’s true that some people do get lucky by making bets on certain stocks and sectors or getting in or out at the right time or correctly guessing movements in interest rates or currencies. But depending on luck is simply not a sustainable strategy.

The alternative approach to investment may not sound as exciting, but is also a lot less work. It essentially means reducing as far as possible the influence of fortune, taking a long-term view and starting with your own needs and risk appetite.

Of course, risk can never be completely eliminated and there are no guarantees about anything in life. But you can increase your chances of a successful investment experience if you keep these 10 guidelines in mind:

Let the market work for you. Prices of securities in competitive financial markets represent the collective judgment of millions of investors based on current information. So, instead of second guessing the market, work with it.

Investment is not speculation. What is promoted in the media as investment is often just speculation. It’s about making short-term and concentrated bets. Few people succeed this way, particularly after you take fees into account.

Take a long-term view. Over time, capital markets provide a positive rate of return. As an investor risking your capital, you have a right to the share of that wealth. But keep in mind, the return is not there every day, month or year.

Consider the drivers of returns. Differences in returns are explained by certain dimensions identified by academic research as pervasive, persistent and robust. So it makes sense to build portfolios around these.

Practise smart diversification. A sound portfolio doesn’t just capture reliable sources of expected return. It reduces unnecessary risks like holding too few stocks, sectors or countries. Diversification helps to overcome that.

Avoid market timing. You never know which markets will be the best performers from year to year. Being well diversified means you’re positioned to capture the returns whenever and wherever they appear.

Manage your emotions. People who let their emotions dictate their decisions can end up buying at the top when greed is dominant and selling at the bottom when fear takes over. The alternative is to remain realistic.

Look beyond the headlines. The media is by necessity focused on the short term. This can give you a distorted impression of the market. Keep up with the news by all means, but you don’t have to act on it.

Keep costs low. Day to day moves in the market are temporary, but costs are permanent. Over time, they can put a real dent in your wealth plans. That’s why it makes sense to be mindful of fees and expenses.

Focus on what you can control. You have no control over the markets, but in consultation with advisor acting in your interests you can create a low-cost, diversified portfolio that matches your needs and risk tolerance.

That’s the whole story in a nutshell. Investment is really not that complicated. In fact, the more complicated that people make it sound the more you should be sceptical.

The truth is markets are so competitive that you can save yourself much time, trouble and expense by letting them work for you. That means structuring a portfolio across the broad dimensions of return, being mindful of cost and focusing on your own needs and circumstances, not what the media is trying to sell you.

Business owners to profit from pension flexibility

Business owners to profit from pension flexibility
Business owners looking to extract surplus profits from their business will be looking forward to April’s new pension income flexibility. Not only will pension funding remain the most tax efficient way to extract profits, but those funds will also become far more accessible than ever before.

Allowable contributions have the double benefit of reducing the profits subject to corporation tax, without incurring an employer National Insurance liability. Extraction by salary or bonus will reduce profits before tax, but will not side step NI.

The only previous downside for business owners was that pension funds were not as readily accessible as cash. But all that will change from April if the owner of the business is over age 55. This could lead to business owners seeking advice on how to maximise their contributions.

How much can be paid?
Potentially if someone has not paid anything into their pension for some time they can pay up to £230,000 now. This would be done in two stages. First, by using carry-forward from the 3 previous tax years. This amounts to £150,000 using allowances from 2013/14, 2012/13 & 2011/12. Plus, in order to carry-forward they would also have to pay the maximum £40,000 for the current year. Potentially they may also be able to pay a further £40,000 towards next year’s allowance now if their current input period ends in the 2015/16 tax year.

Unlike paying pension contributions personally, company contributions are not limited by the business owner’s earned income. Instead, the company just has to be able demonstrate that the contributions were ‘wholly and exclusively for the purpose of trade’. However, the company would typically need to have enough profits in the accounting year to get the full benefit of corporation tax relief.

The financial dangers of hoarding cash
There may also be a spin off benefit of paying surplus profits to a pension instead of capitalising it:

Inheritance tax
Shares in unquoted trading companies normally attract IHT business property relief (BPR). But cash built up in the company bank account or investments held within the company could be regarded as an ‘excepted asset’ and not qualify for BPR. To qualify for relief; cash has to have been used in the business in the past two years or earmarked for a specific future business purpose. Clients should always obtain professional advice to get clarity on their particular situation.

With many companies still stockpiling cash following the credit crunch, some business owners could be unwittingly storing up an IHT charge. Amounts over and above their company’s usual working capital could be included within their estate.

Paying into their pension could help ease this. There is typically no IHT payable on pension death benefits provided the contributions weren’t made when they were in ill health. Extracting the cash from the business in the form of a pension contribution could result in an immediate reduction in the business owner’s estate.

Capital Gains Tax
Holding excess cash in the business could cause similar issues when shares in the company are sold. Entrepreneurs’ relief is valuable to business owners as it can reduce the rate of CGT payable on the disposal of qualifying shareholdings to just 10%. To qualify the shares must be in a trading a company. A trading company for this purpose is one which does not include substantial non-trading activities.

While cash reserves are not looked at in isolation, holding substantial cash and other investments could contribute to a company losing its ‘trading’ status. And unlike BPR, entrepreneurs relief is all or nothing. If cash and investments trigger a loss in relief it affects the full value of the business disposed of; not just the non-trading assets.

CGT will not be an issue if they intend to pass their shares on death to other family members. But it could have huge implications for business owners approaching retirement and planning to sell their business as part of their exit strategy. Extracting surplus cash through pension planning to ensure entrepreneurs’ relief is secured on sale of the business will be an important consideration.

The cost of delay
Each year clients delay, the maximum amount they can pay using carry-forward will diminish. The annual allowance cut from £50,000 to £40,000 in 2014/15 will reduce the amount that can be carried forward by £10,000 for each of the next 3 years. By 2017/18 the maximum carry-forward will have dropped from £190k to £160k.

What difference could this make to your retirement pot? Well, if your planned retirement was in 10 years, a net annual growth rate of 4% after charges on £190k would provide a pot of over £281K. By contrast, waiting three years and investing £160k, the accumulated pot would be £210k – almost £71k less.

Time to act
With the main rate of corporation tax set to fall by 1% from 1 April it makes sense to bring forward pension funding to maximise relief. Paying contributions in the current accounting period will see a reduction in the profits chargeable at a higher rate of corporation tax.

All in all, there are many compelling reasons to use pensions to extract profits which aren’t required for future business use. And the longer they leave it the greater the danger of missing out on valuable reliefs.