Monthly Archives: February 2017

Warren Buffett says low-cost funds founder is my hero

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I know I go on about the cost of active investment management, but I am sure you will agree that Warren Buffett has more clout than me.

In his latest annual letter to his investors he referred to Jack Bogle the founder of Vanguard, which transformed investing forever with the index fund, as a hero for protecting millions of investors from the high cost of active investment.

Warren Buffett has estimated that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade.

Buffett stated: “If a statue is ever erected to honour the person who has done the most for American Investors, the hands down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.”

Buffett saved his most brutal attack for the hedge fund industry, stating that a number of smart people are involved in running hedge funds, but to a great extent their efforts are self-neutralising and their IQ will not overcome the costs they impose on investors. He then went on to say the problem, simply, is that the majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.

He advised investors of all spectrums to make more use of index funds and went on to say: “The bottom line: when trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

Bearing in mind that investment management fees are generally higher in the UK than the US, UK investors are likely to be even better off long-term by following Warren Buffett’s advice. This is why we advocate the use of low-cost funds by using the likes of Vanguard and Dimensional, so that you, as our client, retain more of the investment performance than you would if you invested in actively managed funds.

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2016/17 Year End Planning

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The 2016/17 year end for tax planning purposes is now only a matter of months away with the deadline approaching on 5 April. Effective tax planning is about knowing the personal and business taxes you are liable to pay and acting to legally minimise them. It is also about maximising your net income and creating opportunities to invest and save tax-efficiently for the current and future needs of your business, your family and yourself.

While there is no doubt that the tax system is complex, you should not let complexity deter you from a simple goal: keeping your taxes as low as possible. We have provided some of the key areas you need to consider if applicable to your particular situation.

Personal Allowance

Ensure each spouse uses their full Personal Allowance for Income Tax purposes where possible. Annual income of less than currently £11,000 is not liable to tax. Spouses and registered civil partners should consider the possible transfer of income-producing assets to ensure that Personal Allowances are not wasted.

Personal Allowance for high earners

Your Personal Allowance goes down by £1 for every £2 that your adjusted net income is above £100,000. This means your allowance is zero if your income is £122,000 or above.

Spouse remuneration

If a self-employed person or family company employs a spouse to assist in the running of the business, the spouse could be remunerated fairly to utilise the tax-free Personal Allowance. It is possible to set the earnings at a level whereby no tax or National Insurance Contributions will be due but entitlement to State Retirement Pension and other benefits is protected.

Minor children and teenagers 

Minor children are entitled to Personal Allowances. There are restrictions on the amount of income that a child can derive from a parent, but gifts from other relatives can be considered. Junior Individual Savings Accounts (JISAs) can be funded by parents. Teenaged children can be employed in family businesses providing legal restrictions and national minimum wage issues are taken into account.

Individuals with no taxable income

Pension contributions of up to £3,600 gross per year can be made by individuals with no taxable income. The net contribution after tax relief contributed at source by the UK Government would be just £2,880.

Tax-relievable pension contributions

The Annual Allowance for making tax-relievable pension contributions is £40,000, so consideration should be made to utilising the full Annual Allowance for 2016/17 by 5 April 2017. It is also possible to carry forward unused Annual Allowances from the previous three tax years, so it may be possible to receive tax relief in the current tax year on contributions well in excess of £40,000 with a little planning.

Tax-relievable pension for high earners

For high earners, the Annual Allowance definition is more complicated, but those with an annual ‘adjusted income’ of more than £150,000 will be reduced to as little as £10,000 for 2016/17.

Pension Lifetime Allowance

The pension Lifetime Allowance – the total amount of UK pension savings each individual is allowed to build up in their lifetime – is currently £1m. If you exceed the Lifetime Allowance, you could be facing a 55% tax bill. The ‘flexible drawdown’ pension rules now in place from 6 April 2015 onwards allow individuals the opportunity to plan their affairs to manage the level of the money they take from their pension pot to both minimise annual Income Tax liabilities and keep within the Lifetime Allowance. A review of what you could draw down as income from your pension funds before 6 April 2017 could prove worthwhile.

Tax-favourable investments

If appropriate to your particular situation, the use of tax-favourable investments such as Individual Savings Accounts (ISAs), Enterprise Investment Schemes (EIS), Seed Enterprise Investment Schemes (SEIS) and Venture Capital Trusts (VCT) should be reviewed. Up to £15,240 per person (so up to £30,480 for a married couple) can be invested in an ISA for the 2016/17 year.

Timing of income

Taxable incomes may fluctuate from year to year as a result of one-off payments or changes in circumstances. Consideration should be given to the benefits of accelerating or deferring the taxation point of investment income and employment bonuses, and also to the timing of the payment of dividends paid out by family-owned companies.

Company dividends

From 6 April 2016, company dividends are still treated as the top slice of income but will no longer be grossed up, and will be taxed at 7.5% in the basic rate band, 32.5% in the higher rate band and 38.1% in the additional rate band. However, the first £5,000 of dividends will be tax-free to the recipient, no matter which tax band you fall in.

Capital Gains Tax

It’s important to consider utilising your tax-free Capital Gains Tax Annual Exemption, currently £11,100. Each spouse or registered civil partner is entitled to the exemption each year, so gifts between spouses prior to sales of assets may be tax-effective. It may be worth crystallising capital losses where gains in excess of the Annual Exemption have been made. The deferral of sales until after 5 April may see tax paid at lower rates and provide significant cash flow benefits in terms of when tax needs to be paid.

Inheritance Tax

The use of and the carrying forward of the £3,000 annual exemption should be reviewed, together with other possible exemptions such as those for small gifts of up to £250 per individual, regular gifts out of normal annual income and tax-free gifts in consideration of marriage, which can range between £1,000 and £5,000 depending on the relationship with the person getting married.

Review your Will

A review is due if there has been: a birth or a death; a marriage or a divorce; a move abroad; a significant change in the value of your estate; a new business or the disposal of a previous business; a retirement; or a relevant change in tax law. We can help you to work through changes to keep your estate plan up to date.

Want to explore the options available to you?

We all have to pay our taxes, but within the legal framework there are numerous ways of saving tax and making sure you do not pay more than is absolutely necessary. If you would like to explore the options available to you in preparation for the 2016/17 year end, please contact us sooner rather than later.

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Keep your heart out of investing

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Hello and Happy Valentine’s Day to you all.   Tonight, I will be spending a lovely evening with Nicky, cooking and eating a great meal and employing the kids as waiters or minders to keep our two-year old son out of the way with his football – just long enough for us to have some quality time together.

The thought of the day ahead, as I planned the menu for the evening, got me thinking about whether there was a place for the heart in investment and financial planning. Oh dear, get a life I hear you say…maybe you are right, but here goes!

Emotion and money seldom make good bedfellows and I think we have empathised this many a time together with the view that investment should be boring.

Hot funds or stocks aren’t guaranteed to keep going up and those that have plummeted may not go lower, in fact the opposite is likely to be the case. We get overconfident in our investment ability and put too much into a certain share or our favourite sector, and fail to diversify. We also try to predict the markets, but do we really think that the Sunday paper columnist (if he could predict the future) would be telling everybody how it can be done or would they just keep it to themselves and make their own fortune?

So, unfortunately there should be no emotion in your financial plan. It is a long term document and there will be mishaps along the way, but if you stick to the plan they will iron themselves out.   Hey, wait a minute, isn’t that is a lot like relationships?  They aren’t all plain sailing either. Except that the plan is there to achieve your financial goals and, if they are achieved, then it makes your emotional life far less stressful, so you can both enjoy yourselves without having to think about the money.

If music is the food of love, feel free to play on, but if your heart rules your head in finance, don’t expect to play for too long!

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If I were a rich man…

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We tend to assume that wealth is accumulated over time, often growing fastest in the later working years. Yet, in a broader sense, we are all born with wealth in the form of human capital, which represents the value of the earning potential that we have over our working lifetime.  As younger people have a long time to go before they will need the money, the advice they receive is often that excess earnings should be invested predominantly in equities.  A subtler approach considers the attributes of each person’s human capital which ranges from bond-like to equity-like in nature.  How assets are invested should, ideally, take this into account.  Cash-flow modelling can help those in the accumulation phase of investing to understand the financial impact of changes to their human capital.  Owning sufficient life cover to protect the outstanding human capital should also be an important part of the discussion.

If I were a rich man…

‘No man is an island, Entire of itself, Every man is a piece of the continent, A part of the main.’ John Donne, 1624

We are all born rich

Most of us have held a newly born child – our own perhaps, or that of a relative or a close friend – and in its fragile, dependent state wondered what life has in store for him or her. We perhaps frame these thoughts in terms of the current state of the world and the tough climate for young people struggling to get onto the housing and jobs ladder.  According to the Resolution Foundation[1], the younger generation is the first in living memory to be worse off than their parents.  Yet perhaps we should frame our thoughts in a more positive manner, starting with how rich every child is at birth.

We tend to see wealth as accumulated financial assets, large houses, nice cars and the freedom and time to do the things that are important to us. Yet on the very day we are born we are wealthy in terms of our human capital, or in other words, the present value of all the future earnings that we can accumulate over our working lives.  Part of those future earnings are turned into financial assets, which ultimately deliver income in our retirement.

From a financial perspective, our lives can be divided into three distinct phases:

  • Phase 1 – growing up and getting educated: this phase is of enormous importance to our financial lives; there is plenty of evidence to show that investment in education at a tertiary level can have a big impact on future earnings. Investing in education may well have a far larger impact on wealth than the rate of return achieved if the money spent was invested instead.
  • Phase 2 – working: this phase presents investors with a range of choices, not least how to invest excess earnings and protect their human capital from sickness or even premature death.
  • Phase 3 – retirement: this phase possesses its own challenges, particularly how to invest assets to deliver stable retirement income, without running out of money.

Today, investors must take far more responsibility for their financial assets than ever before and maybe need to think a little more deeply and subtly about how to structure their investment assets.

Today is not like yesterday

Up until the mid-1980s the conversion of human capital into retirement income was far more straight forward and considerably less risky than it is now, as companies offered their employees generous defined benefit pensions, i.e. a percentage of final salary that would be paid monthly on retirement, usually with some form of inflation protection. This income, coupled with the state pension, provided a stable, inflation-proofed, risk-free income for life.  Excess earnings could be squirrelled away into extra savings, paying down debt quicker or the purchase of a second home.  Today, £50,000 of inflation-proofed income, purchased at age 65, would cost over £1.5 million via an annuity.  Rejoice if you have a defined benefit pension!

However, for those still working today – and some more recently retired – such income security does not exist. The demise of defined benefit pensions – a sad story of government and corporate mismanagement – is too long a subject to be explored in this short note.  However, the impact of these changes, including the transfer of income risk from corporations to the individual, combined with a more flexible, fluid and entrepreneurial work environment are worth noting.  These changes have a material impact on the process of turning human capital into financial capital.  How one invests these assets, protects the value of human capital and secures a stable retirement income matter.  These are not easy decisions to make without the help of a good financial planner.

Human capital slowly converts into financial capital across a working life

At the start of a person’s life, human capital represents the major part of his or her total wealth, when wealth is viewed in this broader context. As they progress through their working lives, some of their earnings will be converted into financial assets in the form of payments into defined contribution pensions (by employer and employee), other investments and a family home.  At retirement, human capital is exhausted, unless the retiree does some part time work.  Financial assets then take over the financial burden of delivering income, supplemented by other sources such as a state pension and rental income, if they exist.  The schematic below illustrates this relationship in a generic form.

Figure 1:  Human capital, financial capital and total wealth

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Source: Albion Strategic Consulting

It is interesting to note that in many instances, toward the end of a person’s life, residential property may well be the principle asset, as other financial assets have been depleted.

Careers can be bond or equity-like

When it comes to saving and investing for retirement, i.e. the accumulation phase as it is sometimes known, advice has often been quite generic suggesting that as the investor has a long time horizon, they should invest more in equities to obtain a higher rate of return than holding bonds or cash. In general that makes sense for many.  However, the risks associated with each person’s human capital will vary widely.  This is plain to see looking at three different career paths:

  • Low risk: A tenured professor at a university has great job security and a regular, inflation-linked income that will rise in a predictable manner. Her or his human capital acts like an index linked bond.
  • Higher risk: A salesperson, whose high remuneration is based on commission, and who faces the threat of being fired if targets are not met, has higher earnings risk. His or her human capital acts more like a high yield (lower quality) bond, delivering strong returns when times are good but doing poorly when times get tough.
  • High risk and correlated: An entrepreneur launching an online retail equity trading platform has even more earnings risk. His or her income and rewards are both variable and uncertain and, more importantly, income is likely to be correlated with equity markets. Human capital, in this instance, acts like an equity.

So, if they are all 40 years old and have the same level of financial capital, should they all invest in the same way? Intuitively, the answer is no.  As Burton Malkiel stated in his seminal book A Random Walk Down Wall Street:

‘The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income’

Those with more bond-like human capital could well take on more risk and those with more equity-like human capital should, perhaps, take on less risk with their financial capital. Ironically, it is also possible that those who choose steady, stable jobs may have lower tolerance to losses than the entrepreneur, and vice versa.  One can see the risk of this scenario.  Additionally, two partners may also have different levels of risk in their human capital. Imagine a professor married to an entrepreneur; together they form a balanced portfolio between bonds and equities and their investable portfolio of financial capital should reflect this.

Figure 2: How human capital attributes influence asset allocation

Lower equity content in portfolio Higher equity content in portfolio
Low job and earnings stability High job and earnings stability
Low earning flexibility High earning flexibility
High correlation of earnings to equities Low correlation of earnings to equities
Low earning capability High earning capability (replenish losses quickly)

Source: Albion Strategic Consulting

In effect, investors should invest their financial assets in a way that provides both balance to, and diversification of, their human capital during the accumulation phase. In some extreme circumstances, it might be necessary to adjust an investment portfolio to avoid the specific industry risks that relate to a client’s human capital.

Human capital should be treated like any other asset class; it has its own risk and return properties and its own correlation with other financial asset classes.

Ibbotson, Milevsky, Chen and Zhu (2007)[2]

As an example, one of the saddest outcomes of the Enron collapse in the US in 2001 was the fact that many Enron employees held Enron stock in their pension plans making their human and financial capital highly correlated with devastating consequences.

Protecting human capital risk

As part of a comprehensive financial planning process, two key forms of protection exist that will need to be discussed. The first is protecting human capital using income protection and life insurance.  The second is protecting retirement income through the purchase of annuity.  The astute reader will spot the fact that these are exact opposites; one is a bet on dying early and the other is a bet on living a very long time.

Purchasing life insurance, which is a perfect hedge for human capital risk, needs to be modelled based on the outstanding level of human capital, which reduces with time as human capital is converted into financial capital. Fortunately, when most life insurance is needed (young and with a family), it is relatively cheap to obtain.  In a simple sense, the life insurance cover needs to fill the gap between accumulated financial assets today and the target level of assets at retirement.

Conclusion

The true value of cash-flow modelling by a financial planner is the ability to take both human and financial capital into account and to run severalp scenarios for each. It is difficult to see how a stockbroker or investment manager can structure a portfolio sensibly, particularly where the investor still has substantial human capital, without the insight into, and modelling of, the client’s total asset picture.  No financial portfolio is an island.

so, The next time you hold a baby, remember just how valuable and unique he or she is in so many ways, not least in terms of human capital.

 

 

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]     Resolution Foundation (2016), Millennials facing ‘generational pay penalty’ as their earnings fall £8,000 behind during their 20s, www.resolutionfoundation.org

[2]    Ibbotson, Milevsky, Chen and Zhu (2007), Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, Research Foundation of CFA Institute publication.