Category Archives: Financial Planning

Negative Interest Rates – a Thought Experiment

In recent weeks the Bank of England (BoE) wrote a letter to major UK banks to verify how ready they would be if the Bank of England base rate moved from 0.1% into negative territory.

They stated that for negative rates to be effective, the financial sector must be ready to implement them in a way that doesn’t negatively affect its safety or soundness of firms.

Whilst it’s generally accepted that negative interest rates won’t be entered into, it’s interesting to explore what the consequences would be if they were.

Even prior to the coronavirus pandemic, the UK economy’s growth was comparatively weak, so when restrictions were brought in to address the spread of Covid-19 the Bank of England had to act to help support the economy. They did this by reducing interest rates and via quantitative easing strategies.

Very simply, these policies are designed to help keep money in the economy and to kick-start spending. The intention is to get money flowing out of banks and into the economy in the form of loans and mortgages.

Despite actions taken earlier in the year, the prospect of increasing unemployment and its resultant effect on economic prosperity mean that the Bank of England are having to plan for further stimulus. As I write, the UK base rate is historically low at 0.1%, any further cuts suggest rates may turn negative.

If interest rates are cut to fall below zero, the theory outlined above should still apply to encourage borrowing and discourage saving. However, negative interest rates can result in some bizarre outcomes.

Have negative interest rates worked in the past?

Evidence from negative rates in Europe is mixed but does not really support the argument that they encourage greater lending activity.

Negative rates mean that banks are charged for holding cash reserves with the central bank, rather than being paid. This in turn reduces profit margins and means banks have to look at measures to recoup that cost.

The theory suggests that banks pass on the cost to savers by charging them to hold cash.  However, banks have been reluctant to do this. Some have increased banking fees or charges but others haven’t been able to, which means they have reduced lending, which is contrary to the policy’s intention is to stimulate the economy.

How would negative rates affect my mortgage?

In theory, in this scenario, lenders would actually pay the borrower. In some European countries, mortgages are at sub-zero rates. In practical terms, negative rates have reduced outstanding capital balances which means borrowers repay their mortgage more quickly.

This seems like such a perverse outcome for a lender but a negative return may still be a better return relative to other returns a bank could receive on its capital.

 

Could UK mortgage rates really go negative?

Many believe this is highly unlikely. From a practical perspective, most people in the UK take out Fixed Rate mortgages. Borrowers would need to wait for that Fixed Rate to expire before being able to benefit from negative interest rates, which suggests a negative interest rate policy would need to be around for a prolonged period of time before negative mortgage rates become common place. Anyone with a tracker mortgage may have signed up to terms preventing their rate going negative.

Will I have to pay my bank to hold my cash?

It is possible that the costs of holding cash on deposit increase. In countries that have already implemented negative rates we have tended to see interest rates at zero, but the majority of people have not had to pay the bank!

That said, German savers have experienced negative rates on deposits. However, it’s mainly large institutions and savers with large sums on deposit that have been affected.

Impact on bond markets

Government and corporate bonds are traditionally considered a lower risk asset which provide investors with an income.

They are debt instruments which, on issue, allow governments and large corporations to raise finance to fund their expenditure / investment obligations.#

Debt is issued with a fixed rate of interest paid over a fixed period of time and on maturity investors receive their capital back. The bonds can be traded after issue and the value of that bond is dependent on the strength of the issuer (this determines how safe the capital may be) and the relative value of the income it delivers (this can be influenced by interest rates and expectations for future interest rates).

Interest rate cuts encourage capital values of bonds sold on the secondary market to increase and this reduces the yield (income) that can be achieved by holding this type of asset.

This effectively pushes investors to look for alternative assets to deliver the income they require. Often this means investors take on additional investment risk.

Impact on stock markets?

Lower interest rates increase the relative value of future earnings that companies make which tends to lead to an increase in the value of their shares.

Summary

It is generally accepted that the Bank of England are highly unlikely to reduce interest rates to zero. The risks of negative consequences to key actors within the economy are high and for that reason we may instead see extensions or variations of Quantitative Easing measures.

 

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Office of Tax Simplification Publishes First Stage of Capital Gains Tax Review

It should come as no surprise that in light of increased public spending, the government are looking at potential ways to reform the tax system.

The Office of Tax Simplification (OTS) has issued one of two reports on the Capital Gains Tax system which are written for the treasury to help inform them on how they can raise taxes to help sure up the country’s finances. Their initial recommendations would lead to significant changes if implemented as suggested.

Capital Gains Tax is a tax applied on profit when you sell or dispose of something (an ‘asset’) that’s increased in value.

As things stand the full gain after deduction of the annual exempt amount (with no adjustment for inflation) is added on top of income to determine the rate of tax which will apply. For gains made on non-residential assets falling within the basic rate threshold, a rate of 10% will apply. For gains falling into higher rate thresholds, a rate of 20% will apply. The rate of tax applying to residential property assets is higher for both basic rate and higher rate taxpayers and is charged at 18% and 28% respectively.

Some of the recommendations and policy considerations are discussed below.

  1. Annual Allowance

Currently the annual exemption allows chargeable gains up to £12,300 each year to be taken free of tax. This has the effect of taking many individuals with relatively modest gains out of the need to report or pay tax on them.

It is also a very effective way of limiting the gains payable on an investment portfolio by ensuring sufficient gains are realised each year to utilise the allowance. This is currently worth up to £2,460 a year for a higher rate taxpayer and £1,230 for a basic rate taxpayer. If the exercise is repeated each tax year, the tax savings can have a significant impact on the net investment return.

The OTS considers this allowance to be too generous after review of initial policy intentions and have suggested that the treasury reduce the allowance significantly.

  1. Rate of Capital Gains Tax

The OTS suggest that the multiple capital gains tax rates should be simplified and that Capital Gains Tax rates should align more closely with income tax rates.

If the latter is implemented, the OTS suggest the government should consider reintroducing a mechanism to relieve inflationary gains.

  1. Interaction with lifetime gifts and IHT

Inheritance tax (IHT) and CGT are linked. On death if one of these taxes is chargeable then generally the other does not apply.

The OTS looked at this interaction last year in their review of IHT. They concluded it was complex and could affect decision making particularly around how and when to pass on assets to future generations.

They also flagged that where assets benefit from business property relief (BPR), agricultural property relief (APR) or the spousal exemption, then neither IHT nor CGT would be payable.

When someone dies, there’s no CGT charged on the assets they own, just IHT. The beneficiaries of the estate will acquire assets at market value at the date of death. This is commonly known as ‘market uplift’.

The OTS recommended that where IHT relief is applied there should be no CGT market uplift. This would mean there’s still no charge on death but, instead, assets would be transferred on a ‘no gain, no loss’ basis meaning that beneficiaries will acquire the assets at the cost to the deceased.

They have also suggested that consideration is given to applying this principle more widely so that the Capital Gains Tax uplift on death is replaced with the base cost.

  1. Exemptions & Reliefs

The OTS are also investigating a range of exemptions and reliefs available to determine if they continue to meet their policy objective and aren’t distorting behaviours. Business Asset Disposal Relief and Gift Holdover relief are discussed below.

Entrepreneurs Relief (now known as Business Asset Disposal Relief) is under the spotlight. If you’re entitled to Entrepreneurs’ Relief, qualifying gains up to the lifetime limit applying at the time you make your disposal, will be charged to CGT at the rate of 10%. In his last Budget the Chancellor cut the lifetime limit on the amount of relief from £10m to £1m.

The OTS suggests the Government should consider replacing Business Asset Disposal Relief with a relief more focused on retirement; and abolish investors’ relief.

Gift Holdover Relief allows the donor to make gifts without triggering a disposal for CGT and any gain is deferred until the recipient of the gift disposes of the asset. The relief currently applies to gifts of business assets, including unquoted shares, and also where any asset is gifted to a ‘relevant property trust’ (i.e. discretionary trust). The OTS has suggested that the government consider extending Gift Holdover Relief to a broader range of assets.

In the 2017-18 tax year £8.3 billion of Capital Gains Tax was paid and £55.4 billion of net gains (after deduction of losses) reported by a total of 265,000 individual UK tax payers. Whilst not an insignificant amount, this compares with £180 billion of Income Tax paid in the same tax year by 31.2m individual taxpayers. Clearly, CGT has been identified as one area where tax collections could be increased substantially. It would therefore be fair to expect some – if not all – of the above recommendations to be brought in by the government in the not too distant future.

NB. The Financial Conduct Authority (FCA) does not regulate tax advice.

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Redundancy Lump Sum Payments – What are the Wider Financial Implications?

Unfortunately, the Covid-19 pandemic has already and will further see redundancies becoming more common place as businesses look to streamline costs. It is important for those in such circumstances to understand how a lump sum redundancy payment could impact their wider financial position.

The tax due on a termination payment is usually accounted for through the PAYE system, but it’s still important to understand how that payment is taxed and the impact on tax related allowances and benefits.

Statutory and enhanced redundancy payments for loss of office are received free of tax and National Insurance (NI) up to a limit of £30,000. The excess amount is subject to income tax. Employees do not pay national insurance on the excess amount but employers pay NI at 13.8%.

Redundancy packages also commonly account for salary, holiday pay, payment in lieu of notice and payment for periods of restriction, all of which are generally fully taxable and no part is tax free even if the full £30,000 tax amount available to statuary redundancy pay has not been used.

Statutory redundancy payments are treated as received when the employee becomes entitled to the payment, meaning it is not possible to spread the payment over two or more tax years.

Receiving a large lump sum redundancy payment in one tax year can push individuals into higher tax bands, and result in lost allowances and benefits, increasing the effective rate of tax for that year. Taxation consequences include:

  1. Higher tax rates

Whilst the first £30,000 of the redundancy payment is tax free, the taxable elements often fall into higher or additional tax brackets, especially if redundancy occurs late in the tax year when a large proportion of the annual salary has already been received.

This can have a knock on effect by pushing savings income, dividends and Capital Gains into higher rates of tax.

  1. Loss of personal savings allowance

The personal savings allowance might also be reduced from £1,000 to £500, or lost altogether if total income exceeds £150,000.

  1. Loss of personal allowance

Redundancy can often result in the loss of personal allowance. The personal allowance allows individuals to receive up to £12,500 per annum without any liability to income tax. However, for every £2 of adjusted net income over the income limit of £100,000, £1 of personal allowance will be lost. In the tax year 2020/21, the personal allowance is wiped out when adjusted net income exceeds £125,000.

If this happens, an individual may have further tax to pay at the end of the year as the amount deducted via PAYE is unlikely to account for the lost personal allowance.

  1. Loss of child benefit   

Child benefit is reduced if adjusted net income exceeds £50,000 and is totally lost if it exceeds £60,000. The amount of child benefit is dependent on the size of the family – for example, a family of 3 children could lose around £2,500 a year.

  1. Reduced pension annual allowance

The standard annual allowance for pension contributions is £40,000 but can be tapered down to a minimum of £4,000 for high earners. Individuals previously unaffected could be caught due to the size of their redundancy package. For this tax year, if an individual’s threshold income is more than £200,000 and their adjusted income is more than £240,000, their annual allowance will be reduced. The reduction is £1 for each £2 of adjusted income over £240,000.

What options are available to mitigate these costs?

It might seem illogical to make a pension contribution at a time when cash flow is a priority, however pension contributions may help better an individual’s financial position. The following points provide details of how pension contributions can help.

  1. Pension tax relief

A higher rate tax payer currently benefits from income tax relief of 40%. This means that a £10,000 addition to pension savings comes at a net cost of £6,000 for a higher rate taxpayer.

If a pension contribution helps to restore other allowances, the effective rate of relief can be as high as 60%.

  1. Reducing tax rates and reinstating allowances

Making a pension contribution, whether as a personal contribution or an employer contribution through salary sacrifice, can reduce tax rates paid on total income, either from 45% to 40% or from 40% to 20%. ‘Adjusted net income’ (ANI) is also reduced. This can help to reinstate personal allowances (worth £5,000 to a higher rate taxpayer) or child benefit.

  1. Pension funding by salary sacrifice (or not)

Individuals may be able to sacrifice part of a redundancy payment in favour of an employer pension contribution.  Employer pension contributions are not normally subject to NI at 13.8% but statutory redundancy payments in excess of £30,000 are. This means employers will make savings from the sacrifice agreement, which they may be willing to pass on to the individual. Care should be taken to ensure that the sacrifice is made from parts of the redundancy package that are subject to employers NI in the first place.

High earners should take further care here as this option can cause the pensions annual allowance to be tapered. This restricts the amount that can be paid into pension without incurring a pensions annual allowance tax charge. For these individuals, a personal pension may be more appropriate.

The thought of redundancy is scary and unsettling. However, it can be a welcome cash injection that could mean retirement plans can be brought forward or savings boosted if new employment is found quickly. The silver lining may indeed mean that with careful planning, retirement and savings plans could be progressed more quickly.

 

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The Great Emergency Fund

Many people – through no fault of their own – have found themselves in a position where they have had a reduced level of income over recent months. From self-employed people who have been unable to work, through to retirees who have reduced income to avoid drawing down from depleted funds, and a great many different scenarios in between, you don’t need to look very far to find someone whose financial security has suddenly and unexpectedly come under threat.

No-one could have predicted this pandemic a year ago; if we could, many people may have done lots of things very differently. But this just goes to demonstrate the point that we never know what’s around the corner and being prepared financially can provide great peace of mind in the event of the unexpected.

As the past few months have amplified, relatively few people in the population at large have a ‘rainy day fund’ to fall back upon should they need it. Statistics1 indicate that a third Brits have less than £600 in savings with 1 in 10 having no savings at all. A further worrying statistic is that 40.93% of Brits don’t have enough savings to live for a month without income.

One of the key fundamental elements when we begin putting a financial plan in place with a client is an ‘emergency fund’. Although the exact amount varies from person to person depending on circumstances and preferences, the general consensus is that this should be somewhere in the region of 6 months to a year’s worth of income.

One comment we have heard from clients time and time again during the course of this difficult period has been ‘at least I have savings to fall back on’ – or words to this effect.

Here are five tips to building up your own emergency fund…

Look for day to day savings

With so many parts of our lives having been restricted during lockdown, it’s possible that the period highlighted some of the areas where savings in day to day spending could be made. For example, not being able to eat out, buy coffees or have regular hair or beauty treatments.

Although many people will find themselves with less income as a result of the Coronavirus crisis, conversely, there are some individuals and families who may find that they have been able to accumulate savings due to not being able spend in the normal way. In fact, some surveys have found that 70% of people have actually managed to save during lockdown. Whether it’s saving on the cost of commuting, days out or buying coffees and snacks, these mount up on a week by week and month by month basis. Rather than simply reverting to old ways as more of these options become available, it could be a good time to rethink what you spend and try and divert more everyday costs into savings.

Be disciplined

There’s no doubt about it, saving up takes discipline. We would all like to be able to afford to buy anything we want to as well as having money set aside for a rainy day or as part of our plans for the future, but for most of us, this simply isn’t possible. Regardless of your income and how much you can afford to save or invest, any sort of financial planning involves making a plan and sticking to it. There will almost always be some sacrifices and choices to make, but try to remember the end goal and what you’re saving towards.

Get to grips with your finances

Being able to save effectively requires a good understanding of your financial situation, and how much money you have available to set aside for your future. Most people get paid every month, so listing your monthly income and expenditure is a good place to start. It is also worth bearing in mind that you will have some larger annual costs – such as some insurance premiums or annual subscriptions. Taking all of this into account, you should be able to work out a rough amount that you have that is surplus to your spending requirements on a monthly basis. From here, it is up to you to decide how much you are comfortable or willing to set aside each month or year. As above, it may be worth looking at what items are ‘essential’ in your spending and what are ‘optional’, and how you may be able to utilise more of your optional expenditure into savings, whilst remembering that the things you spend money on today come at the additional cost of what you will have available to spend in the future.

Use technology

Making a conscious decision to set up an ISA and make payments into it isn’t something that everybody has the resources to do. But the good news is that technology has evolved rapidly over recent years and there are numerous online tools and apps aimed at helping people build up savings in small increments. For example, there are apps that round up everyday spending to the nearest pound, setting the money into a pot for investing or saving. Although you’re unlikely to be able to sail away into the sunset using this approach, it’s a great place to start for those with little ‘disposable’ income.

Pay yourself first

Move money into savings accounts on payday so it’s not tempting to spend your ‘future fund.’ When trying to build up savings, it can be easier to build the process of saving into your monthly expenditure plan, even automating the process by way of a direct debit or standing order. Taking the manual process out of the equation means that saving can take place without you having to think about it.

Equally, making monthly contributions can, for some, make saving and indeed investing more manageable. When investing on a monthly basis you also benefit from ‘pound cost averaging,’ which helps to mitigate risks relating to market timing.

Although these tips are written with the idea of building up an emergency fund in mind, in fact, they apply to anyone at any stage of the financial planning journey. An emergency can hit anyone at any stage as the Covid-19 pandemic has demonstrated.

For more information on any of the above points or to discuss starting your own journey into savings and investments, please get in touch with one of our financial advisers.

 

Resources:

1 – https://www.finder.com/uk/saving-statistics

 

 

 

 

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Lessons from Covid-19 – Being Prepared for the Unexpected

Five months ago, if someone had told you that there would be an outbreak of a virus that would effectively bring the world to a standstill, would you have believed it? Even now, at times it’s hard to think that any of this has happened; it’s almost as if you’ll wake up one day and it will have been one, long, bad dream.

Covid-19 is likely to be the biggest global health pandemic many of us will ever experience in our lives. A crisis such as this hasn’t been seen since 1918 and according to many experts, viruses such as this are a once in a century occurrence. Perhaps the most shocking thing is the speed at which the outbreak and subsequent restrictions progressed; catching the vast majority of us completely off guard.

Unfortunately, other health scares and concerns on an individual level are not so unlikely. We have all read the statistics around cancer; 1 in 2 UK people will be diagnosed with cancer in their lifetime according to Cancer Research UK. Similarly, we will all know someone who has been affected by a serious accident – on the roads, at work or even in the home.

Yet even in light of this knowledge, we, on the whole, fail to protect ourselves and our loved ones financially via the numerous insurance policies available.

Income Protection Assurance is just one such insurance. It provides an income if an individual is ill long term. Usually speaking, it pays a maximum of 60% of income, tax free.

Critical illness Cover is another type of policy that provides a lump sum payment upon diagnosis of serious illnesses.

Life assurance provides a fixed one off payment upon the death of a named policy holder to help provide financial security to remaining loved ones.

The fact of the matter is that life is unpredictable. None of us want to think about the bad things that may happen to us or our family members, and it seems that our aversion to morbid thinking takes precedence over taking the sensible and usually straightforward precaution of putting policies in place. Yet for a relatively small sum per month, it can be possible to have the peace of mind that should you – or any member of your close family – encounter one of life’s nasty ‘surprises’, financial support will be payable.

Covid-19 has brought many things into focus across a variety of aspects of our lives. It’s made us appreciate the things we have and are able to do; the freedoms we ordinarily enjoy and the people we love.

If events over the past few months have prompted you to think about the ways in which you can protect yourself and your family in the future, please contact us to discuss the range of insurance policies available. As Chartered Financial planners, Gresham Wealth Management’s advisers are qualified to advise on life and wealth protection products.

 

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