Chapter Five

Investment

Security depends not so much upon how much you have, as upon how much you can do without.

JOSEPH WOOD KURTCH

Successful investing has never been easy but since the financial crisis began, it’s been a bit like journeying into the unknown. Bond yields are at record lows, central banks have never printed quite so much money (quantitative easing) nor have governments been quite so persistently in debt in all of recorded history (Britain has run a deficit for 51 of the last 60 years). With the likelihood of inflation rearing its ugly head again in the future and the markets as uncertain as ever, there’s not much to cheer the average investor. If you’re a short-term trader it’s important to be aware of events around the globe that might move markets, since our world has never been more interconnected. But for those who are more interested in saving for retirement and for the long term, the principles of successful investing remain the same. Keep the costs down, shelter as much money from the taxman as you can, and buy assets when they are cheap and sell when they are expensive.

One thing investors know for certain is that getting (and paying for) good advice is essential if you are to avoid nasty surprises. The Retail Distribution Review (known as the RDR) was introduced in January 2013 for the benefit of everyone who invests and it is one of the few bits of good news that could make your retirement more pleasant than it might have been. RDR has been a fantastic thing for transparency and it is shaking up the industry. But the financial industry doesn’t take threats to its profitability lying down – it always has a cunning plan. What can you do to avoid the issue? Put your money in investment trusts rather than unit trusts, buy individual shares (if you don’t mind doing the research) or buy clean funds via a cheap transparent adviser. (More on this in Chapter 6 – Financial advisers.)

But back to basics: there’s a big difference between ‘saving’ and ‘investing’. Investing is for the long term. It’s money you can put away for your retirement, and in the long run it should grow more rapidly than in a savings account. If you are saving for a shorter-term goal, say you’re going to need it in less than five years, then you’re looking to get the most interest paid on your money. This chapter does not attempt the impossible but where saving and investing is concerned it highlights things to look out for and what to avoid.

Here are some tips for starters:

Thanks to the internet, investors have unprecedented opportunity to access information and advice. Here are some useful websites you could look at:

Since everyone has different financial aims, there is no one-size-fits-all approach to investing. In very simple terms, there are four different types of investment you could consider:

While you were working, you probably had an emergency fund equal to at least three months’ take-home pay. In retirement you may not need such a big fund. Work out what you need to have put away for a rainy day; once you have this sum set aside, you could consider investing for higher potential returns.

Sources of investable funds

If you are looking at investment options from your resources, possible sums of quite significant capital include:

General investment strategy

Investments differ in their aims, their tax treatment and the amount of risk involved. If you are taking the idea of investing seriously, the aim for most people is to acquire a balanced portfolio. This could comprise a mix of investments variously designed to provide some income to supplement your pension and also some capital appreciation to maintain your standard of living in the long term. Except for annuities and National Savings and Investments, which have sections to themselves, the different types of investment are listed by groups, as follows: variable interest accounts, fixed interest securities, equities and long-term lock-ups. As a general strategy, mix and match your investments so they are spread across several groups.

Annuities

This is one of the biggest decisions that most people approaching retirement have to make: cashing in their pension and buying an annuity. When you buy an annuity, you hand over a lump sum (usually your pension fund, although you can withdraw up to 25 per cent of it as a tax-free lump sum first) to an insurance company in return for a regular, guaranteed income for the rest of your life. Under the current rules the earliest age you can do this is 55. This income is taxable if it exceeds your personal allowance. If you are retiring today, low annuity rates probably make you wince. That doesn’t mean you should necessarily ignore them. Once you have bought your annuity, the income you receive is effectively free of investment risk. That has been transferred to your provider. There is little danger of running out of money as your provider has to pay you for as long as you live.

When you approach retirement your pension company will contact you about purchasing an annuity. They will provide you with a quotation, which will tell you the amount of money you have in your ‘pension pot’, the amount of tax free lump sum you are entitled to take, and the level of income you will receive each month (should you convert your pension fund to an annuity with them). Check you are getting the correct allowance and that you have the right tax code. This tells the pension company how much tax to deduct but there is no guarantee that it will be right. For more information, see www.incometaxcalculator.com. Specialist help for older people is available from www.taxvol.org.uk.

You need to do some research to make sure which type of annuity is best for you. You only get one chance to purchase an annuity, and once you have done so there is no going back. The benefit of shopping around is that you could very well receive more money by doing so. Each annuity provider will have different rates dependent on its own underwriting criteria and your own position. Research shows that by shopping around you may be able to increase the amount of income you receive by up to 20 per cent. Choosing an annuity is a decision that should not be taken without the help of a specialist financial adviser, who has experience in this field.

The gender gap closed in December 2012, from which point insurers are no longer allowed to take gender into account when fixing annuity rates. Rates for men will get worse and won’t improve much for women either.

Types of annuities

There are several different kinds of annuities.

The most basic is a level annuity. This pays you a fixed income for the rest of your life. If you die, the income usually stops. And – crucially – it will not change if prices rise. So in an inflationary world, your purchasing power will fall every year. For example, if inflation averages 4 per cent a year, the purchasing power of your annuity income will halve in 18 years.

To avoid this you could buy an increasing annuity. Here the amount of income you receive will rise in line with inflation each year, or by a set percentage. And if you are worried about your insurance company keeping a large chunk of your pension fund should you die after only a few years of retirement, you could buy a guaranteed annuity. So if you bought a five-year guarantee, and you died after two years, your nominated beneficiary (your spouse perhaps) would receive annuity income for another three years.

Another option is a joint-life annuity where your partner can receive some or all of your pension income if you die before them. If you want to take a bit more of a risk, you could choose an investment-linked annuity. Here you start with an initial level of income while your fund is invested in an insurance company’s with-profits-fund. If the fund makes a profit, your income goes up. If it loses money, however, your income goes down.

Your health can also have a significant impact. If you are a smoker or have an illness, you may be eligible for an enhanced annuity or impaired life annuity. These pay a higher annual income than a standard annuity. In short, the annuity provider is betting that you won’t live as long, so it can afford to pay you more.

It pays to shop around

There are a wide range of annuities available and everyone is entitled to shop around for the best one for their circumstances. This is known as the OMO (Open Market Option). In other words you don’t have to take the offer from your existing pension provider – you are free to go to any provider. Figures show that less than half of people shop around. Failing to do so is a huge mistake, particularly since annuity rates have fallen in recent years. The reasons for the fall in rates are due to people living longer. Insurance companies have to keep paying incomes for longer. Second, falling interest rates make it harder to generate a source of funds to pay annuity income. Currently there is a gap of around 20 per cent between the best and the worst annuity rates – so don’t just take the first offer that comes your way.

Other options

If you don’t want to buy an annuity because of low rates, there are a number of strategies you can use. One is known as phased retirement. This is where you set up a series of annuities and drawdowns with 25 per cent tax-free lump sums. You will get a lower starting income but if you think annuity rates are going to rise it might be worth considering.

Another possible option is fixed-term annuities. Here you set up an annuity for a fixed period (say 5 or 10 years). You get paid an income for the fixed term but at the end of the period, you have a guaranteed pot of money to reinvest again. As with phased retirement, your income will be lower than from a standard annuity.

Alternatives to annuities

Income drawdown is an alternative to buying an annuity at retirement. Instead of purchasing a guaranteed income from an insurance company, pension savings remain invested and a percentage can be ‘drawn down’ each year. There are two types: ‘capped’ imposes limits on how much you can withdraw; the other – ‘flexible’ – puts no limits on withdrawals. These products came into force in April 2011, replacing an unsecured pension or an alternatively secured pension, at the same time the government removed the requirement to buy an annuity by age 75. The catch is that you need at least £20,000 in other sources of guaranteed income, such as state pension and annuities, to qualify. Before making a decision financial advice is essential as there are certain risks. One good piece of news is that the income drawdown rules were changed in the April 2013 Budget. The limit has been restored to 120 per cent (previously limited to 100 per cent) of what you would get from the equivalent annuity. This change will attract more pensions to drawdown, experts predict, as one of the advantages is that drawdown can be used to minimize your tax bill in several ways (see ‘How To Choose an Annuity’ by Phil Oakley and Tim Bennett, The Week PROSPERwww.theweek.co.uk).

Tax

It is important in all of the above plans to consider carefully the tax implications. Income tax on optional annuities is relatively low, as part of the income is allowed as a return on capital that is not taxable. Pension-linked annuities are fully taxable.

How to obtain an annuity

The annuity market is large and there is a vast choice of products. A helpful free booklet is Martin Lewis’s Money Saving Expert.com Guide to Annuities sponsored by Annuity Direct Limited (published March 2013). See: Martin Lewis’s website: www.moneysavingexpert.com or Annuity Direct: www.annuitydirect.co.uk.

Other useful websites include:

    Annuity Advisor: www.annuity-advisor.co.uk.

    Annuity Bureau: www.annuity-bureau.co.uk.

    Hargreaves Lansdown: www.h-l.co.uk/pensions.

    Origen Annuities: www.origenfsannuities.co.uk.

    William Burrows: www.williamburrows.com.

You can also buy an annuity direct from an insurance company or via an intermediary, such as an Independent Financial Adviser (IFA). See Chapter 6, Financial advisers, or consult these professional advice websites:

    Unbiased.co.uk: www.unbiased.co.uk.

    The Institute of Financial Planning: www.financialplanning.org.uk.

    Personal Finance Society (PFS): www.findanadviser.org.

    Telegraph Retirement Service: www.telegraph.co.uk/retire.

National Savings & Investments (NS&I)

NS&I Savings Certificates, of which there are two types (fixed interest and index linked), are free of tax. They do not pay much interest but any tax-free investment is worth considering. For non-taxpayers who invest in NS&I products there is no need to complete an HM Revenue & Customs (HMRC) form to receive money in full, as this is automatic. www.nsandi.com.

The main NS&I investments are:

NB The April 2013 Budget revealed that the Treasury will not relaunch index-linked savings certificates, the accounts run by NS&I that pay interest matching inflation, plus a bonus on top, tax-free, for at least a year.

Complaints

If you have a complaint about any NS&I product, you should raise this with the Director of Savings. Should the matter not be resolved to your satisfaction it can be referred to the Financial Ombudsman Service; see website: www.financial-ombudsman.org.uk.

Variable interest accounts

You can save in a wide range of savings accounts with banks, building societies, credit unions and National Savings & Investments (NS&I) – already mentioned. With around 54 million current accounts in the UK, banks and building societies frequently introduce new accounts with introductory bonuses, to attract new customers. Although keeping track may be time consuming, all advertisements for savings products must now quote the annual equivalent rate (AER). AER provides a true comparison taking into account the frequency of interest payments and whether or not interest is compounded.

NB: The over-50s are being advised to show added caution when signing up to a savings account, particularly if it is tailored to their age. By looking only at over-50s products, savers would be ignoring over 93 per cent of the market. There are around 43 different variable-rate bank accounts available for the over-50s in the UK, offered by 22 different providers (The Mature Timeswww.maturetimes.co.uk).

Definition

Other than the interest-bearing current accounts described above, these are all ‘deposit’-based savings accounts of one form or another, arranged with banks, building societies, the National Savings & Investments Bank, and some financial institutions that operate such accounts jointly with banks. The accounts include instant-access accounts, high-interest accounts and fixed-term savings accounts. Some institutions pay interest annually; others – on some or all of their accounts – will pay it monthly. Although you may get a poor return on your money when interest rates drop, your savings will nearly always be safe. Should the bank or building society get into serious financial difficulty, up to £85,000 of your money will be 100 per cent protected under the Financial Services Compensation Scheme. See website: www.fscs.org.uk.

Access

Access to your money depends on the type of account you choose: you may have an ATM card and withdraw your money when you want; you may have to give a week’s notice or slightly longer. If you enter into a term account, you will have to leave your money deposited for the agreed specified period. In general, the longer the period of notice required the better the rate of interest earned.

Sum deposited

You can open a savings account with as little as £1. For certain types of account, the minimum investment could be anything from £500 to about £5,000. The terms tend to vary depending on how keen the institutions are to attract small investors.

Tax

With the exception of tax-free cash ISAs and of the National Savings and Investments Bank, where interest is paid gross, tax is deducted at source. However, you must enter the interest on your tax return and, if you are a higher-rate taxpayer, you will have additional liability. Basic-rate taxpayers pay 20 per cent on their bank and building society interest. Higher-rate taxpayers pay 40 per cent. Non-taxpayers can arrange to have their interest paid in full by completing a certificate (R85, available from HMRC or the bank) that enables the financial institution to pay the interest gross. If you largely rely on your savings income and believe you are or have been paying excess tax, you can reclaim this from HMRC. For further information, see ‘Income tax on savings and investments’ in Chapter 4.

Choosing a savings account

There are two main areas of choice: the type of savings account and where to invest your money.

Instant-access savings account

This attracts a relatively low rate of interest, but it is both easy to set up and very flexible, as you can add small or large savings when you like and can usually withdraw your money without any notice. It is an excellent temporary home for your cash if you are saving short term. However, it is not recommended as a long-term savings plan.

High-interest savings account

Your money earns a higher rate of interest than it would in an ordinary savings account. However, to open a high-interest account you will need to deposit a minimum sum, which could be £500 to £1,000. Although you can always add to this amount, if your balance drops below the required minimum your money will immediately stop earning the higher interest rate. Terms vary between providers. Usually interest is only paid yearly, and you can only withdraw yearly.

Fixed-term savings account

You deposit your money for an agreed period of time, which can vary from a few months to over a year. In return for this commitment, you will normally be paid a superior rate of interest. As with high-interest accounts, there is a minimum investment: roughly £1,500 to £10,000. If you need to withdraw your money before the end of the agreed term, there are usually hefty penalties. If interest rates are still low, your money may be better invested elsewhere.

Equity-linked savings account

This offers a potentially better rate of return, as the interest is calculated in line with the growth in the stock market. Should the market fall, you may lose the interest, but your capital should normally remain protected. The minimum investment varies from about £500 to £5,000 and, depending on the institution; the money may need to remain deposited for perhaps as much as five years.

ISA savings

See later in this chapter, page 93.

Information

For banks, enquire direct at your nearest high street branch. You can also investigate other banks and building societies to see whether they offer better terms. Look at as many as you can since the terms and conditions may vary quite widely. The Building Societies Association offers information and advice on savings and types of accounts and much more. See its website: www.bsa.org.uk.

The safety of your investment

Investors are protected by the legislative framework in which societies operate and, in common with bank customers, their money (up to a stated maximum) is protected under the Financial Services Compensation Scheme. See website: www.fscs.org.uk.

Complaints

If you have a complaint against a bank or building society, you can appeal to the Financial Ombudsman Service (FOS) to investigate the matter, provided the complaint has already been taken through the particular institution’s own internal disputes procedure – or after eight weeks if the problem has not been resolved – and provided the matter is within the scope of the Ombudsman Scheme. Generally speaking, the FOS can investigate complaints about the way a bank or building society has handled some matter relating to its services to customers. See website: www.financial-ombudsman.org.uk.

Fixed interest securities

Fixed interest securities pay interest at a rate that does not change with any external variable. The coupon payments are known in advance. Coupons are almost always all for the same amount and paid at regular intervals, regardless of what happens to interest rates generally. There are two risks with fixed income securities: credit risk and interest rate risk.

Credit risk is one of the main determinants of the price of a bond. The price of a debt security can be explained as the present value of the payments (of interest and repayment of principal) that will be made. Credit risk is an issue for lenders such as banks, ie losses to the bank. So correlation with the bank’s other lending is what matters, not correlation with debt available in the market.

Interest rate risk is simply the risk to which a portfolio or institution is exposed because future interest rates are uncertain. Bond prices are interest rate sensitive so if rates rise, the present value of a bond will fall sharply. This can also be thought of in terms of market rates: if interest rates rise, then the price of a bond will have to fall for the yield to match the new market rates. The longer the duration of a bond, the more sensitive it will be to movements in interest rates.

If you buy when the fixed rate is high and interest rates fall, you will nevertheless continue to be paid interest at the high rate specified in the contract note. However, if interest rates rise above the level when you bought, you will not benefit from the increase. Generally these securities give high income but only modest, if any, capital appreciation. The securities include high interest gilts, permanent interest-bearing shares, local authority bonds and stock exchange loans, debentures and preference shares.

Gilt-edged securities

Definition

Gilts, or gilt-edged securities, are bonds issued by the UK government that offer the investor a fixed interest rate for a predetermined, set time, rather than one that goes up or down with inflation. But the gilt market isn’t what it used to be. The Bank of England used to own no gilts at all. Now, via quantitative easing, it owns £375 billion, more than a quarter of the market. More importantly, it’s nearly half of the £800 billion the government has issued since December 2007. The 10-year gilt yield is now around 2.0 per cent and seemed to bottom out around August 2012. If thinking of buying gilts, diversify your portfolio.

Buying gilts is best done when interest rates are high and look likely to fall. When general interest rates fall, the value of the stock will rise and can be sold profitably. When buying or selling, consideration must be given to the accrued interest that will have to be added to or subtracted from the price quoted. Gilts are complicated by the fact that you can either retain them until their maturity date, in which case the government will return the capital in full, or sell them on the London Stock Exchange at market value.

Yields are low and while bank interest rates remain at current levels things are not likely to improve.

Index-linked gilts

Index-linked gilts are government-issued bonds – glorified IOUs – that you can buy to obtain a guaranteed rate of return over inflation. In previous years they have performed well, but if you are buying them now you will be doing so at a premium and it is likely you will suffer capital losses as their value falls back, even while your income remains above inflation. However, if you are less worried about preserving your capital and require inflation-linked income, then these can still be useful in a balanced portfolio.

Tax

Gilt interest from whatever source is paid gross. Gross payment means that you must allow for a future tax bill before spending the money. Recipients who prefer to receive the money net of tax can ask for this to be arranged. A particular attraction of gilts is that no capital gains tax is charged on any profit you may have made, but equally no relief is allowed for any loss.

How to buy

You can buy gilts through banks, building societies, a stockbroker or a financial intermediary, or you can purchase them through Computershare Investor Services; see website: www.computershare.com. In all cases, you will be charged commission.

Assessment

Gilts normally pay reasonably good interest and offer excellent security, in that they are backed by the government. You can sell at very short notice, and the stock is normally accepted by banks as security for loans, if you want to run an overdraft. Index-linked gilts, which overcome the inflation problem, are generally speaking a better investment for higher-rate taxpayers – not least because the interest paid is very low.

Gilt plans

This is a technique for linking the purchase of gilt-edged securities and with-profit life insurance policies to provide security of capital and income over a 10- to 20-year period. It is a popular investment for the commuted lump sum taken on retirement. These plans are normally obtainable from financial intermediaries.

Permanent interest-bearing shares (PIBS)

These are a form of investment offered by some building societies to financial institutions and private investors as a means of raising share capital. They have several features in common with gilts: they pay a fixed rate of interest that is set at the date of issue; this is likely to be on the high side when interest rates generally are low and on the low side when interest rates are high. The interest is usually paid twice yearly, there is no stamp duty to pay or capital gains tax on profits. Despite the fact that PIBS are issued by building societies, they are very different from normal building society investments. They are generally rated as being in the medium- to high-risk category, so professional advice should be taken first.

Equities

These are all stocks and shares, purchased in different ways and involving varying degrees of risk. They are designed to achieve capital appreciation as well as give you some regular income. Most allow you to get your money out within a week. Millions of people in the UK invest in shares. Equity securities usually provide steady income as dividends but they fluctuate with the ups and downs in the economic cycle. Investing has never been easier with the growing number of internet-based trading facilities. Equities include ordinary shares, unit trusts, OEICs (see below), investment trusts and REITs.

Equities probably provide the greatest potential for income that can beat inflation over the medium to long term. Dividend yields on many equity funds are currently in excess of 3–4 per cent per annum, due to the corporate world’s finances being in a healthier state than those of governments. Most businesses are well placed to continue to pay decent levels of dividends unless there is a protracted period of economic recession.

Unit trusts and OEICs

Definition

Unit trusts and OEICs (Open-Ended Investment Companies, a modern equivalent of unit trusts) are forms of shared investments, or funds, which allow you to pool your money with thousands of other people and invest in world stock markets. The advantages are that it is simple to understand, you get professional management and there are no day-to-day decisions to make. Additionally, every fund is required by law to have a trustee (called a ‘depository’ in the case of OEICs) to protect investors’ interests.

Unit trusts have proved incredibly popular because your money is invested in a broad spread of shares and your risk is reduced, but they are rapidly being replaced by the OEIC (pronounced ‘oik’). The minimum investment in some of the more popular funds can be as little as £25 a month or a £500 lump sum. Investors’ contributions to the fund are divided into units (shares in OEICs) in proportion to the amount they have invested. Unit trusts and OEICs are both open-ended investments. As with ordinary shares, you can sell all or some of your investment by telling the fund manager that you wish to do so. The value of the shares you own in an OEIC, or units in a unit trust, always reflects the value of the fund’s assets. The key differences between the two are:

Investment trusts

Over the past decade investment trusts beat unit trusts in eight of nine key sectors. One of the biggest benefits investment trusts offer is to income investors. While open-ended funds must pay out all the income they receive, investment trusts can hold some back in reserve. This allows them to offer a smoother and more certain return. There are four major advantages an investment trust has over a unit trust:

How to obtain

Units and shares can be purchased from banks, building societies, insurance companies, stockbrokers, specialist investment fund providers and Independent Financial Advisers, directly from the management group and via the internet. Many of the larger firms may use all these methods. For a list of unit trusts, investment trusts and OEICs the Investment Management Association (IMA) website gives information: www.investmentfunds.org.uk. Or you can look at the following:

    www.thisismoney.co.uk/investing;

    www.moneyweek.com;

    www.moneysupermarket.com;

    www.investment-advice.org.uk;

    www.investorschronicle.co.uk.

For further information on investment advice, see Chapter 6, Financial advisers.

Tax

Units and shares invested through an ISA have special advantages (see ‘Individual Savings Account’, below). Otherwise, the tax treatment is identical to that of ordinary shares.

Assessment

Unit trusts and OEICs are an ideal method for smaller investors to buy stocks and shares: less risky and easier. This applies especially to tracker funds, which have the added advantage that charges are normally very low. Some of the more specialist funds are also suitable for those with a significant investment portfolio.

Complaints

Complaints about unit trusts and OEICs are handled by the Financial Ombudsman Service (FOS). It has the power to order awards of up to £100,000. Before approaching the FOS, you must first try to resolve the problem with the management company direct via its internal complaints procedure. If you remain dissatisfied, the company should advise you of your right to refer the matter to the FOS; see website: www.financial-ombudsman.org.uk.

The safety of your investment

Investors are protected by the legislative framework and, in common with bank customers, their money (up to a stated maximum) is protected under the Financial Services Compensation Scheme (FSCS); see website: www.fscs.org.uk.

Ordinary shares listed on the London Stock Exchange

Definition

Public companies issue shares as a way of raising money. When you buy shares and become a shareholder in a company, you own a small part of the business and are entitled to participate in its profits through a dividend, which is normally paid six monthly. It is possible that in a bad year no dividends at all will be paid. However, in good years, dividends can increase very substantially. The money you invest is unsecured. This means that, quite apart from any dividends, your capital could be reduced in value – or if the company goes bankrupt you could lose the lot. The value of a company’s shares is decided by the stock market. The price of a share can fluctuate daily, and this will affect both how much you have to pay if you want to buy and how much you will make (or lose) if you want to sell.

See the London Stock Exchange website: www.londonstockexchange.com, to find a list of brokers in your area that would be willing to deal for you. The securities department of your bank or one of the authorized share shops will place the order for you, or you can do it online. Whichever method you use, you will be charged both commission and stamp duty, which is currently 0.5 per cent. Unless you use a nominee account (see below), you will be issued with a share certificate that you or your financial adviser must keep, as you will have to produce it when you wish to sell all or part of your holding. It is likely, when approaching a stockbroker or other share-dealing service, that you will be asked to deposit money for your investment upfront or advised that you should use a nominee account. This is because of the introduction of several new systems, designed to speed up and streamline the share-dealing process.

There are three types of shares that are potentially suitable for small investors:

Tax

All UK shares pay dividends net of 10 per cent corporation tax. Basic-rate and non-taxpayers have no further liability to income tax. Higher-rate taxpayers must pay further income tax at 22 per cent. Quite apart from income tax, if during the year you make profits by selling shares that in total exceed £10,600 (the annual exempt amount for an individual in 2012/13) you will be liable for capital gains tax, which is now calculated at a flat rate of 28 per cent.

NB: From April 2014 investors in London’s Alternative Investment Market (AIM) will no longer pay 0.5 per cent stamp duty on transactions. In the past AIM shares were deemed risky but there is now a proposal to allow them to be included in a shares ISA, making them free of income and capital gains tax. But investors are advised to be cautious, possibly opting for a professionally managed fund.

Assessment

Although dividend payments generally start low, in good companies they are likely to increase over the years and so provide a first-class hedge against inflation. Good advice is critical, as this is a high-risk, high-reward market.

Individual Savings Account (ISA)

Definition

Despite low interest rates, savers who use cash ISAs can build up their nest eggs three times faster than those who put them in instant access accounts. If you’re looking to get the most interest paid on your savings, a cash ISA is about the best bet. ISAs are very popular forms of investment as all income and gains generated in the account are tax free, and they stay tax free, year after year. It is important to shop around for the best rates and take full advantage of your annual allowance. There are two types of ISA: cash ISAs and stocks and shares ISAs. The ISA allowance is the amount you are allowed to invest in each financial year, set by the Chancellor of the Exchequer in the annual Budget. At 6 April 2013 the limit is £5,760 per year in a cash ISA and up to £11,520 in a stocks and shares ISA. The cash ISA limit is half the value of the stocks and shares ISA limit. The 2013 Budget ignored calls to change the rules on ISAs and let the full £11,580 allowance be held in cash.

It’s up to you to choose the best home for your money. Instant access cash ISAs are perfect for money you may need in the short term. However, if you don’t need it for a long time, notice cash ISAs and fixed-rate cash ISAs offer better interest rates. New ISAs are often introduced with attractive bonus rates, then after 12 months this is quietly removed and your savings are left earning very little. The only way to avoid this is to check your old accounts and then switch.

Self-select stocks and share ISAs are growing in popularity. Rather than opting to buy a fund for your ISA, these let you pick from a wide range of individual investments. First you’ll have to find the best one. Most brokers offer some sort of self-select ISA. Self-select ISAs usually come with an annual management fee. This will be either a fixed amount (normally between £20 and £50 per year) or a percentage of the total investment. There are two types of brokers (execution-only and full service). Execution-only brokers simply provide you with the internet trading platform and charge the lowest fees. Full service or advisory brokers give advice on what to put into your ISA and are consequently more expensive. Given that the whole point of a self-select ISA is to avoid paying too many fees, think carefully before choosing.

The Junior ISA (JISA) replaced the short-lived Child Trust Fund (CTF) scheme. New junior ISAs are a tax-efficient wrapper for your investments. There is no capital gains tax or income tax to be paid but the annual allowance is smaller – £3,720 (2013/2014) and they are available to all children born on or after 3 January 2011, or born before September 2002, or are under 18 and do not have a Child Trust Fund (see below). The fund is locked until the child is 18 when they get control of the money.

Tax

ISAs are completely free of all income tax and capital gains tax. You should be aware that a 20 per cent charge is levied on all interest accruing from non-invested money held in an ISA that is not specifically a cash ISA.

Assessment

ISAs offer a simple, flexible way of starting, or improving, a savings plan. While cash ISAs remain useful, there are fewer advantages to basic-rate taxpayers as a result of the charges and the removal of the dividend tax credit. For further information on the various forms of ISAs, see these websites:

    www.thisismoney.co.uk/investing;

    www.moneyweek.com;

    www.moneyadviceservice.org.uk;

    www.moneysavingexpert.com;

    www.moneysupermarket.com;

    www.investment-advice.org.uk;

    www.investorschronicle.co.uk;

    www.investmentfunds.org.uk.

    www.telegraph.co.uk/isas

NB: The banks are set to agree a new ISA transfer system which should reduce the time (up to three weeks) it can currently take to move from one ISA to another. Bear in mind that you can transfer a cash ISA into a shares ISA but not the other way round. While the current year’s cash ISA must be moved between providers, whole, allowances from previous years can be split between different providers. Remember that once you take money out of any ISA, you can’t put it back in.

Child Trust Funds

Children born after December 2010 are not eligible for a Child Trust Fund. However, accounts set up for eligible children will continue to benefit from tax-free investment growth. Withdrawals will not be possible until the child reaches 18. The child, friends and family will be able to contribute £1,200 per year. It was announced in the April 2013 Budget that for these children there are now moves afoot to enable them to transfer their funds. See website: www.childtrustfund.gov.uk.

Useful reading

How the Stock Market Works by Michael Becket of the Daily Telegraph, published by Kogan Page; see website: www.koganpage.com.

Long-term lock-ups

Certain types of investment, mostly offered by insurance companies, provide fairly high guaranteed growth in exchange for your undertaking to leave a lump sum with them or to pay regular premiums for a fixed period, usually five years or longer. The list includes life assurance policies, investment bonds and some types of National Savings Certificates.

Life assurance policies

Definition

Life assurance can provide you with one of two main benefits: it can either provide your successors with money when you die or it can be used as a savings plan to provide you with a lump sum (or income) on a fixed date. There are three basic types of life assurance: whole-life policies, term policies and endowment policies.

An important feature of endowment policies is that they are linked to death cover. If you die before the policy matures, the remaining payments are excused and your successors will be paid a lump sum on your death. The amount of money you stand to receive, however, can vary hugely, depending on the charges and how generous a bonus the insurance company feels it can afford on the policy’s maturity. Over the past few years, payouts have been considerably lower than their earlier projections might have suggested. Aim to compare at least three policies before choosing.

Both whole-life policies and endowment policies offer two basic options: with profits or without profits:

Premiums can normally be paid monthly or annually, as you prefer. The size of premium varies enormously, depending on the type of policy you choose and the amount of cover you want. As a generalization, higher premiums tend to give better value, as relatively less of your contribution is swallowed up in administrative costs. You may be required to have a medical check if large sums are involved. More usually, you fill in and sign a declaration of health. If you make a claim on your policy and it is subsequently discovered that you gave misleading information, your policy could be declared void and the insurance company could refuse to pay. Many insurance companies offer a better deal if you are a non-smoker. Some also offer more generous terms if you are teetotal. Women generally pay less than men of the same age because of their longer life expectancy.

How to obtain

Policies are usually available through banks, insurance companies, Independent Financial Advisers and building societies. Be careful with the small print: terms and conditions that sound very similar may obscure important differences that could affect your benefit. To be sure of choosing the policy best suited to your requirements, consult an IFA. For help in finding an IFA in your area, see websites: www.unbiased.co.uk; www.financialplanning.org.uk; www.findanadviser.org. See also Chapter 6, Financial advisers.

Disclosure rules

Advisers selling financial products have to abide by a set of disclosure rules, requiring them to give clients certain essential information before a contract is signed. They present potential clients two ‘key facts’ documents: ‘About our services’, describing the range of services and the type of advice on offer; and ‘About the cost of our services’. IFAs must offer clients the choice of paying fees or paying by commission. For further information consult the Association of British Insurers (ABI) website: www.abi.org.uk. See also Chapter 6, Financial advisers.

Tax

Under current legislation, the proceeds of a qualifying policy – whether taken as a lump sum or in regular income payments are free of all tax. If, as applies to many people, you have a life insurance policy written into a trust, there is a possibility that it could be hit by inheritance tax rules affecting trusts if the sum it is expected to pay out is above the (2013/14) £325,000 IHT threshold. The best advice is to check with a solicitor.

Assessment

Life assurance is a sensible investment, whether the aim is to provide death cover or the benefits of a lump sum to boost your retirement income. It has the merit of being very attractive from a tax angle, though you are locked into a long-term commitment. So choosing the right policy is very important. Shop around, take advice and, above all, do not sign anything unless you are absolutely certain that you understand the small print.

Complaints

Complaints about life assurance products, including alleged mis-selling, are handled by the Financial Ombudsman Service (FOS). Before approaching the FOS, you first need to try to resolve a dispute with the company direct. See website: www.financial-ombudsman.org.uk.

The Financial Services Compensation Scheme (FSCS) is the compensation fund of last resort for customers of authorized financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. See website: www.fscs.org.uk.

Alternatives to surrendering a policy

If you wish to terminate an endowment policy before the date of the agreement and avoid the punitive costs, you could sell the policy for a sum that is higher than its surrender value. See the Association of Policy Market Makers website: www.apmm.org. For those looking for investment possibilities, second-hand policies could be worth investigating. Known as traded endowment policies (TEPs), they offer the combination of a low-risk investment with a good potential return. A full list of appropriate financial institutions and authorized dealers that buy and sell mid-term policies is obtainable from the Association of Policy Market Makers. It can also arrange for suitable policies to be valued by member firms, free of charge.

Bonds

Until recently, it was fairly difficult for small investors to access the corporate bond market. But a couple of years ago the London Stock Exchange established a retail bond platform designed to make trading corporate bonds as easy as trading listed shares. It has proved very popular and yields have been quite respectable. Since March 2011 nearly £1.7 billion has been raised by companies in the market. Bonds generally offer less opportunity for capital growth; they tend to be lower risk as they are less exposed to stock market volatility; but they have the advantage of producing a regular guaranteed income. The three main types of bonds are:

Investment bonds

Definition

This is the method of investing a lump sum with an insurance company, in the hope of receiving a much larger sum back at a specific date – normally a few years later. All bonds offer life assurance cover as part of the deal. A particular feature of some bonds is that the managers have wide discretion to invest your money in almost any type of security. The risk/reward ratio is, therefore, very high. They can produce long-term capital growth but can also be used to generate income.

While bonds can achieve significant capital appreciation, you can also lose a high percentage of your investment. An exception is guaranteed equity bonds, which, while linked to the performance of the FTSE 100 or other stock market index, will protect your capital if shares fall. However, while your capital should be returned in full at the end of the fixed term (usually five years), a point not always appreciated is that, should markets fall, far from making any return on your investment you will have lost money in real terms. Your capital will have fallen in value, once inflation is taken into account; and you will have lost out on any interest that your money could have earned had it been on deposit.

All bond proceeds are free of basic rate tax, but higher rate tax is payable. However, higher-rate taxpayers can withdraw up to 5 per cent of their initial investment each year and defer the higher-rate tax liability for 20 years or until the bond is cashed in full, whichever is earlier. Although there is no capital gains tax on redemption of a bond (or on switching between funds), some corporation tax may be payable by the fund itself, which could affect its investment performance. Companies normally charge a front-end fee of around 5 per cent plus a small annual management fee, usually not related to performance.

Tax

Tax treatment is complicated, as it is influenced by your marginal income tax rate in the year of encashment. For this reason, it is generally best to buy a bond when you are working and plan to cash it after retirement.

Offshore bonds

It has been suggested that offshore bonds are the new pensions with a recent surge of interest in offshore bonds from high earners looking for an alternative to pensions for their retirement savings. These can provide significant tax savings for investors because up to 5 per cent of capital can be withdrawn while deferring higher-rate tax for up to 20 years with no immediate tax to pay.

Offshore bonds are an insurance ‘wrapper’ around a portfolio of investments, which receive tax advantages by allowing you to defer the tax on the growth of the investments. Capital growth in an onshore bond is taxed at 20 per cent, whereas offshore bond capital grows tax free. While basic-rate taxpayers have no more tax to pay when they cash in an onshore investment bond, higher-rate taxpayers must pay a further 20 per cent and top-rate taxpayers must pay 30 per cent. With offshore bonds there is no tax to pay until you encash the bond, when higher-rate taxpayers will pay the entire 40 per cent and the top-rate payers will be liable for 50 per cent.

Charges for offshore bonds are high: typically 0.3 to 1 per cent upfront plus £400 to 0.25 per cent a year, depending on how much is invested. Adviser commission on top means the bonds are generally best for investments greater than £100,000 and held for more than five years. In comparison with pensions, these schemes are being increasingly recommended for retirement savings for higher-rate taxpayers who use their ISA and capital gains allowance, and no longer benefit from higher-rate tax relief.

Investor protection

The Financial Services Authority (FSA) the UK’s banking regulator was set up in 1997 as part of the so-called tripartite structure whereby banks, insurers, building societies and other such firms were regulated by the FSA, the Treasury and the Bank of England. The FSA has been abolished and replaced with two successor organizations. The changes mark the end of the system set up by the previous Labour government. Since 1 April 2013, the Prudential Regulation Authority (PRA) ensures the stability of financial services firms and is part of the Bank of England. It regulates around 1,700 financial firms. The Financial Conduct Authority (FCA) is now the City’s behavioural watchdog. The Bank of England has also gained direct supervision for the whole of the banking system through its powerful Financial Policy Committee (FPC), which can instruct the two new regulators. These changes were announced by the Chancellor, George Osborne, back in 2010, aiming to make it clear who is in charge over supervising the financial services sector and avoid a recurrence of failing banks and enormous state-backed bailouts. The regulator changes see the Bank of England gain much more control over the functioning of the financial system and are the biggest changes to the central bank since it was given independence in 1997.

Since January 2012 when the Retail Distribution Review (RDR) came into effect, all financial advisers have to set out their charges explicitly, so you will know how much they cost you (see Chapter 6 Financial advisers).

Investment businesses must adhere to a proper complaints procedure, with provision for customers to receive fair redress, where appropriate. Unsolicited visits and telephone calls to sell investments are for the most part banned. Where these are allowed for packaged products (such as unit trusts and life assurance), should a sale result the customer will have a 14-day cooling-off period (or a seven-day ‘right to withdraw’ period if the packaged product is held within an ISA and the sale follows advice from the firm). The cooling-off period is to give the customer time to explore other options before deciding whether to cancel the contract or not.

A single Ombudsman scheme

The single statutory Financial Ombudsman Service (FOS) provides a ‘one-stop shop’ for dissatisfied consumers and covers complaints across almost the entire range of financial services and products – from banking services, endowment mortgages and personal pensions to household insurance and stocks and shares. The list equally includes unit trusts and OEICs, life assurance, FSAVCs and equity release schemes. A further advantage is that the FOS applies a single set of rules to all complaints. Since April 2007 the Financial Ombudsman Service has also covered – for the first time – the consumer-credit activities of businesses with a consumer-credit licence issued by the Office of Fair Trading. Consumer-credit activities now covered by the Ombudsman range from debt consolidation and consumer hire to debt collecting and pawnbrokers.

For further information on Complaints, scams and how to protect yourself, see Chapter 7.