Unit 1
Introduction to the financial services environment and products
After studying this unit, you will be able to demonstrate an understanding of:
• the purpose and structure of the UK financial services industry;
• the main financial asset classes and their characteristics, covering past performance, risk and return;
• the main financial services product types and their functions;
• the main financial advice areas;
• the process of giving financial advice, including the importance of regular reviews of the consumer’s circumstances;
• the basic legal concepts relevant to financial advice;
• the UK taxation and social security systems and how they affect personal financial circumstances;
• the impact of inflation, interest rate volatility and other relevant socio-economic factors on personal financial plans.
The UK financial services industry
Introduction
Section 1 begins by providing a broad introduction to the functions of the financial services industry and to the institutions that make up the industry.
The impact of the government on the development of financial services is now greater than it has ever been: some aspects of the involvement of government are considered in this section (ie taxation and social security). Regulation of the industry is considered in Unit 2.
Section 1 covers parts 1 and 7 of the syllabus for Unit 1, ie the purpose and structure of the industry and the taxation and social security systems.
1.1 The functions of the financial services industry
The existence of money is taken for granted in all advanced societies today – so much so that most people are unaware of the enormous contribution that the concept of money, and the industry that has developed to manage it, have made to the development of our present way of life.
In earlier civilisations, the process of bartering was adequate for exchanging goods and services: a poultry farmer could exchange eggs or chickens for carrots and cabbages grown by a gardener. In modern society, people still produce goods or provide services that they could, in theory, trade with others for the things they need. The complexity of life, however, and the sheer size of some transactions make it virtually impossible for people today to match what they have to offer against what others can supply to them.
What is needed is a separate commodity that people will accept in exchange for any product, which forms a common denominator against which the value of all products can be measured. These two important functions (defined technically as being a medium of exchange and a unit of account respectively) are carried out by the commodity we call money. In order to be acceptable as a medium of exchange, money must have certain properties. In particular it must be:
• sufficient in quantity;
• generally acceptable to all parties in all transactions;
• divisible into small units, so that transactions of all sizes can be precisely carried out;
• portable.
Money also acts as a store of value. In other words, it can be saved because it can be used to separate transactions in time: money received today as payment for work done or for goods sold can be stored in the knowledge that it can be exchanged for goods or services later when required. To fulfil this function, money must retain its exchange value or purchasing power and the effect of inflation can, of course, adversely affect this function.
Notes and coins are legal tender, ie they have the backing of the government and the central bank, but money comprises much more than cash. It includes amounts held in current accounts and deposit accounts, and other forms of investments.
The financial services industry exists largely to facilitate the use of money to carry out these main functions. It ‘oils the wheels’ of commerce and government by channelling money from those who have a surplus, and wish to lend it for a profit, to those who wish to borrow it, and are willing to pay for the privilege (this is described in more detail in Section 1.1.1). Of course, the financial organisations want to make a profit by providing this service and, in the process of so doing, they provide the public with products and services that offer, among other things, convenience (eg current accounts), means of achieving otherwise difficult objectives (eg mortgages) and protection from risk (eg insurance).
In any economy there are surplus and deficit sectors. The surplus sector comprises those individuals and firms that are cash-rich, ie they own more liquid funds than they currently wish to spend. These want to lend out their surplus funds to earn money. The deficit sector comprises those who own less liquid funds than they wish to spend. These are prepared to pay money to anyone who will lend to them.
In this context, a financial intermediary is an institution that borrows money from the surplus sector of the economy and lends it to the deficit sector, paying a lower rate of interest to the person with the surplus and charging a higher rate of interest to the person with the deficit. Banks and building societies are the best-known examples. An intermediary’s profit margin is the difference between the two interest rates.
But why do the surplus and deficit sectors need the services of a financial intermediary? Why can they not just find each other and cut out the middleman's profit? Actually, there are some cases where this does happen and this is known as disintermediation, eg when a company raises funds from the general public by issuing shares.
There are, however, several reasons why both individuals and companies need the services of the intermediaries. The four main reasons relate to the following factors.
• Geographic location: firstly, there is the physical problem that individual lenders and borrowers would have to locate each other and would probably be restricted to their own area or circle of contacts. An individual potential borrower in Surrey is unlikely to be aware of a person in Edinburgh with money to lend, but each may have easy access to a branch of a high-street bank.
• Aggregation: even if a potential borrower could locate a potential lender, the latter might not have enough money available to satisfy his requirements. The majority of retail deposits are relatively small, averaging under £1,000, while loans are typically larger, with many mortgages being for £50,000 and above. But intermediaries can overcome this size mismatch by aggregating small deposits.
• Maturity transformation: even supposing that a borrower could find a lender who had the amount he or she wanted, there is a further problem. The borrower may need the funds for a longer period of time than that for which the lender is prepared to part with them. The majority of deposits are very short term (eg instant access accounts), whereas most loans are required for longer periods (personal loans are often for two or three years, while companies often borrow for five or more years and typical mortgages are for 20 or 25 years). Intermediaries are able to overcome this maturity mismatch by offering a wide range of deposit accounts to a wide range of depositors, thus helping to ensure that not all of the depositors' funds are withdrawn at the same time.
• Risk transformation: individual depositors are generally reluctant to lend all their savings to another individual or company, principally because of the risk of default or fraud. But intermediaries enable lenders to spread this risk over a wide variety of borrowers so that, if a few fail to repay, the intermediary can absorb the loss.
Another way of mitigating risk is offered by insurance, which has been defined as ‘a means of shifting the burden of risk by pooling to minimise financial loss’. Individuals effectively get together to contribute to a fund from which the losses of the few who suffer in certain specified circumstances are covered. Without the services of a central organisation – the insurance company – individuals would struggle to find a convenient way of sharing their risks in this manner. The companies therefore provide another form of intermediation.
1.1.3 ‘Product sales’ intermediaries
There is a further type of intermediation, slightly different in nature from those defined above. This is the intermediation that ‘oils the wheels’ of the financial services industry itself by bringing together the product providers (such as banks and insurance companies) and the potential customers who wish to purchase the providers’ products and services. These intermediaries include financial advisers, insurance brokers and mortgage advisers.
This section will briefly describe some of the types of financial institution that make up the financial services industry in the UK. Regulatory organisations are not included here because they are described in more detail in Unit 2.
Prior to the 1980s, there were more clearly defined boundaries between different kinds of financial organisations: some were retail banks, some wholesale banks; others were life assurance companies or general insurance companies, although a few offered both types of insurance and were known as composite insurers; yet others were investment companies. Today, many of the distinctions have become blurred, if they have not disappeared altogether. Increasing numbers of mergers and takeovers have taken place across the boundaries and now even the term bancassurance, which was coined to describe banks that owned insurance companies (or vice versa), is inadequate to describe the complex nature of modern financial management groups. For example, one major UK ‘bank’ offers the following range of services:
• retail banking services;
• mortgage services through a subsidiary that is a former building society;
• credit card services, split into: UK customers; international customers; corporate chargecards; and merchant services;
• wealth management services, for high net worth individuals;
• financial asset management (fund management) for institutional customers;
• investment banking, including financing, risk management and corporate finance advice;
• insurance services, by acting as an independent intermediary in relation to general insurance and as an appointed representative in relation to life assurance, pensions and income protection.
The Bank of England (often referred to simply as ‘the Bank’) was founded by a group of wealthy London merchants in 1694 and later granted a Royal Charter by William III. It developed a unique relationship with the Crown and Parliament, which was formalised in 1946 when it was nationalised and became the UK's central bank. A central bank is an organisation that acts as banker to the government, supervises the economy and regulates the supply of money. In the United States, for example, these tasks are the responsibility of the US central bank, which is known as the Federal Reserve. Within the eurozone of the European Union, the European Central Bank (ECB) acts as central bank for those states that have accepted monetary union.
The Bank of England has a number of important roles within the UK economy. Its main functions are as follows.
• Issuer of banknotes: the Bank of England is the central note-issuing authority and is charged with the duty of ensuring that an adequate supply of notes is in circulation.
• Banker to the government: the government's own account is held at the Bank of England. The Bank provides finance to cover any deficit by making an automatic loan to the government. If there is a surplus, the Bank may lend it out as part of its general debt management policy.
• Banker to the banks: all the major banks have accounts with the Bank of England for depositing or obtaining cash, settling clearing, and other transactions. In this capacity, the Bank can wield considerable influence over the rates of interest in various money markets, by changing the rate of interest it charges to banks that borrow or the rate it gives to banks that deposit.
• Adviser to the government: the Bank of England, having built up a specialised knowledge of the UK economy over many years, is able to advise the government and help it to formulate its monetary policy. The Bank's role in this regard has been significantly enhanced since May 1997, with full responsibility for setting interest rates in the UK having been given to the Bank's Monetary Policy Committee (MPC). This committee meets once a month and its mandate in setting the base rate is to ensure that the government's inflation target is met.
• Foreign exchange market: the Bank of England manages the UK's official reserves of gold and foreign currencies on behalf of the Treasury.
• Lender of last resort: the Bank of England traditionally makes funds available when the banking system is short of liquidity, in order to maintain confidence in the system.
The Bank of England was also formerly responsible for managing new issues of gilt-edged securities. This function has now been transferred to the Debt Management Office within the Treasury, in order to avoid conflicts of interest that might arise from the Bank's responsibility for setting interest rates. Gilt-edged securities, also known as gilts, are loans to the government. There are a wide variety of loans on different terms and for varying periods, including some with no fixed redemption date. These securities are called gilt-edged because the government guarantees their income and redemption amounts.
In addition to the functions described above, the Bank of England was previously charged with responsibility for the supervision and regulation of those institutions that make up the banking sector in the UK. This responsibility was transferred to the Financial Services Authority with effect from 1 June 1998. The Bank, however, retains its traditional responsibility for maintaining the stability of the financial system as a whole.
1.2.2 Proprietary and mutual organisations
We have already mentioned that the boundaries between different types of financial organisation have become blurred. One distinction that still exists, albeit to a reduced extent, is the split between proprietary and mutual organisations.
Proprietary organisations, which account for the great majority of the large financial institutions, are those that are limited companies. They are owned by their shareholders, who have the right to share in the distribution of the company’s profits in the form of dividends and who can contribute to decisions about how the company is run by voting at shareholders’ meetings.
By contrast, a mutual organisation is one that is not constituted as a company and does not therefore have shareholders. The most common types of mutual organisation are building societies and friendly societies, each of which is mutual by definition, and life assurance companies, of which only a small proportion are mutual.
A mutual organisation is, in effect, owned by its members, who can determine how the organisation is managed through general meetings similar to those attended by shareholders of a company. In the case of a building society, the members comprise its depositors and borrowers; for a life company, they are the with-profit policyholders.
Since the Building Societies Act 1986, a building society has been able to demutualise – in other words, to convert to a bank (with its status changed to that of a public limited company). Such a change requires the approval of its members, but this approval has in practice generally been readily given, not least because of the windfall of free shares to which the members have been entitled following conversion to a company.
The possibility of a windfall on conversion has led to a spate of carpetbagging. This refers to the practice of opening an account at a building society that it is believed will soon convert, purely to obtain the subsequent allocation of shares. Societies considering conversion have, in response, sought to protect the interests of their long-term members by placing restrictions on the opening of new accounts.
In recent years, some mutual life assurance companies, including Norwich Union, have also elected to de-mutualise. In May 2006, at a special general meeting, it was decided that Standard Life, the largest mutual life assurer in the UK, would demutualise.
The concepts of retail and wholesale are most obvious in the world of banking. The main distinction between retail and wholesale transactions is one of size, wholesale transactions being generally much larger than retail ones. Because of this, the end-users of retail services are normally individuals and small businesses, whereas wholesale services are provided to large companies, the government and to other financial institutions.
Retail banking is primarily concerned with the more common services provided to personal and corporate customers, such as deposits, loans and payment systems. It is largely the province of high-street banks and building societies that deliver their products through traditional branch networks, call centres, or the Internet.
These institutions are, as described in Section 1.1.1, acting as intermediaries between people who wish to borrow money and people who have money that they are prepared to deposit. The price of borrowing and the reward for investing is, of course, interest.
With the widespread replacement of cheques by credit and debit cards, the traditional suppliers of retail banking are experiencing increasing competition from major stores, such as Tesco and Sainsbury, which are offering their own banking facilities, credit cards and other financial services.
Wholesale banking refers to the process of raising money through the wholesale money markets in which financial institutions and other large companies buy and sell financial assets.
This is the method normally used by finance houses, but the main retail banks are also heavily involved in wholesale banking in order to top up deposits from their branch networks as necessary. For example, if a bank has the opportunity to make a substantial profitable loan but does not have adequate deposits, it can raise the money very quickly on the interbank market. This is a very large market encompassing over 400 banking institutions, which serves to recycle surplus cash held by banks, either directly between banks or more usually through the services of specialist money brokers.
The rate of interest charged in the interbank market is the London interbank offered rate (LIBOR). It acts as a reference rate for the majority of corporate lending, for which the rate is quoted as ‘LIBOR plus a specified margin’. LIBOR rates are fixed daily and vary in maturity from overnight through to one year.
Building societies are also permitted to raise funds on the wholesale markets: up to 50% of their liabilities.
The distinction between ‘retail’ and ‘wholesale’ in financial services is much less obvious than it used to be, however, with many institutions operating in both areas. These words are not part of the day-to-day terminology in other financial areas such as life assurance, pensions and unit trusts, but the concepts are present in the background:
• some organisations are clearly based at the wholesale end of the market, notably product providers such as life assurance companies and unit trust managers;
• other organisations and individuals, such as insurance brokers and financial advisers, are purely retailers of the products and services offered by the providers;
• product providers that sell direct to the public or through their own dedicated sales forces are, in effect, operating in both wholesale and retail capacities.
1.3.1 The influence of the European Union
The UK has been a member of the European Union – as it is now known – since 1973, although it remains outside the eurozone, having chosen not to adopt the euro when the single currency was introduced in 1999.
In spite of the UK retaining – at least for the time being – its own currency and control over its own monetary policy, the financial services industry is hugely influenced by the European Union’s policies and laws. Few people realise that large portions of the UK’s regulatory regime for financial individuals and for companies are closely determined by European laws. This includes regulation relating to banking, investment, life assurance, general insurance, operating as a financial adviser, compensation for losses, money laundering, data protection and many other areas.
The European Parliament and the Council of Ministers share the power to adopt European laws, often acting on suggestions from the European Commission. These laws can take a number of forms, of which the two most common are regulations and directives:
• regulations have general application and are binding in their entirety and directly applicable in all member states (unless particular states have specific dispensation);
• directives are binding as to the result to be achieved upon each member state to which they are addressed. In other words, the objectives of the directive must be achieved within a specified timescale (typically two years) but exactly how they are achieved is left to national authorities in each state.
Many of the regulatory requirements that affect UK financial services organisations can be seen to mirror closely the details found in related European directives.
Regulation of the financial services industry in the UK is, broadly speaking, a five-tier process.
• First level: European legislation that impacts on the UK financial industry. The two main types of European legislation are regulations and directives (see Section 1.3.1).
• Second level: the Acts of Parliament that set out what can and cannot be done. Whenever reference is made to Acts of Parliament, it should be borne in mind that the effects of the laws are often achieved through subsidiary legislation – known as statutory instruments – which are made pursuant to the Act. Examples of legislation that directly affect the industry are the Financial Services and Markets Act 2000, the Banking Act 1987 and the Building Societies Act 1997.
• Third level: the regulatory bodies that monitor the regulations and issue rules about how the requirements of the legislation are to be met in practice. The main regulatory body is now the Financial Services Authority (FSA), which has taken over the regulatory responsibilities of a number of other bodies, including the Bank of England, which previously regulated the banking sector, and the Building Societies Commission.
• Fourth level: the policies and practices of the financial institutions themselves and the internal departments that ensure they operate legally and competently, eg the compliance department of a life assurance company.
• Fifth level: the arbitration schemes to which consumers' complaints can be referred. For most cases, this will now be the Financial Ombudsman Service, which has taken over the responsibilities of a number of earlier ombudsman bureaux and arbitration schemes.
The current regulatory regime is described in more detail in Unit 2.
Governments use taxation not only for the basic process of raising revenue but as a means of controlling the money supply. Here we will consider briefly how the manipulation of the taxation regime can have an impact on the financial services marketplace, before we review the main UK taxes. This section will give an overview of the main UK taxes, together with some detail, but it is not intended to equip its readers to give professional taxation advice.
Changes in taxation affect the market for financial services and products in two main ways:
• increased general taxation reduces the amount of money available for investment or to fund loan repayments;
• tightening of the taxation regime for particular products makes them less attractive to investors. An example of this is the government's decision, in 1998, to remove the right of pension fund managers to reclaim tax deducted from dividends received. The effect of this step is that pension funds are now taxed on a large proportion of their income, whereas previously they were effectively tax-free. Although this move was clearly made in order to bring in more tax revenue, it seems to be in conflict with the government's acknowledged need to persuade individuals to contribute more toward their own pension provision.
It is worth mentioning that, with many of the more popular investment schemes, such as unit trusts and investment trusts, there are two possible levels at which taxation can occur: the fund managers can be taxed and the investor can be taxed. It is essential to view both aspects when assessing the tax position of an investment.
1.3.3.1 Domicile and residence
Whether or not a person is liable to pay income tax, capital gains tax and inheritance tax will depend on the taxpayer's residence or domicile according to UK law.
Residence mainly affects income tax and capital gains tax. Any person who is present in the UK for at least 183 days in a given tax year is regarded as a UK resident for tax purposes. A person who is not a UK resident in a particular tax year may, however, be defined as ordinarily resident if they normally live in the UK.
A person who is resident or ordinarily resident in the UK should be subject to UK income tax on his or her worldwide earned and unearned income, whether or not such income is brought into the UK. Similarly, capital gains tax is charged on the realisation of gains anywhere in the world. The UK, however, has double taxation agreements with many other countries, the purposes of which are to ensure that individuals are not taxed twice on the same income or gains.
Domicile is best described as the country that an individual treats as his or her home, even if he or she were to live for a time in another country. Everyone acquires a domicile of origin at birth. This is the domicile of their father on the date of their birth (or the domicile of the mother if the parents are not married).
A person can change to a different domicile (known as domicile of choice) by going to live in a different country, intending to stay there permanently and showing that intent by generally ‘putting down roots’ in the new country and severing connections with the former country. There is no specific process for this.
Domicile mainly affects liability to inheritance tax. If a person is domiciled in the UK, inheritance tax is chargeable on assets anywhere in the world, whereas for persons not domiciled in the UK, tax is due only on assets in the UK. Persons who are not UK domiciled but who have lived in the UK for at least 17 of the previous 20 years are, however, deemed to be UK domiciled for inheritance tax purposes.
Income tax is one of the main sources of government revenue. Liability for income tax is based on income received in a tax year or fiscal year that, in the UK, runs from 6 April in one calendar year to 5 April in the next.
Each year, following delivery of the Budget, a Finance Bill is published containing the taxation proposals made in the Budget. When the Bill is approved by Parliament and later becomes law, the new tax measures take effect at dates provided in the legislation.
The new Act (a Bill that has gone through Parliament and has received Royal Assent) becomes a part of the substantial body of legislation that forms the basis of the rules relating to income tax and other taxes.
The main statute is the Income and Corporation Taxes Act 1988 but there are other sources of tax law, both by way of statute and case law.
Tax is due from individuals on their income from employment (including benefits in kind, such as company cars) and also on interest, dividends and other income they receive from investment. All UK residents, including children, may be subject to income tax, depending on the type and amount of income they receive.
All residents, both children and adults, who are not income taxpayers, are entitled to make a declaration (on form R85) that they do not pay tax. They are then able to receive interest from certain deposits gross, without deduction of tax at source.
The income of a child that arises from a settlement or arrangement made by the parents, will normally be treated as the parents’ income for tax purposes. If treated as the parents’ income, a child’s unused allowances cannot be set against this income.
Not all of the income that an individual receives is taxable. Examples of types of income that are taxable, and of those that are not are given below.
Income assessable to tax includes:
• salary/wages from employment, including bonuses and commissions, and taxable benefits in kind;
• pensions and retirement annuities, including state pension benefits;
• profits from a trade or profession;
• inventor’s income from a copyright or patent;
• tips;
• interest on bank and building society deposits;
• dividends from companies;
• income from government stocks and local authority stocks;
• income from trusts;
• rents and other income from land and property;
• the value of benefits in kind, such as company cars or medical insurance (if total income, including the value of benefits in kind, exceeds £8,500).
The taxable benefit for company cars is based on the car’s carbon dioxide emission rating and is equal to a percentage of the car’s list price. The percentage varies between 15% for emissions of up to 155 grams/km and 35% for emissions over 255 grams/km. The list price is the car’s UK list price at date of first registration, including taxes and VAT but excluding the road fund licence. It also includes delivery charges and accessories.
If fuel is also provided by the employer, a further taxable benefit applies. This is equal to a percentage of a specified figure (£14,400 in 2006/07). The percentages are 15% for engine sizes up to 1400cc, 25% between 1400cc and 2000cc, and 35% over 2000cc.
In the case of both car benefits and fuel benefits, the percentages are increased by 3% for diesel vehicles, subject to an overall maximum of 35%.
Income not assessable to tax includes:
• redundancy payments and other compensation for loss of office (if total receipts exceed £30,000, then the excess over £30,000 is assessable);
• interest on National Savings Certificates;
• income from ISAs and PEPs;
• certain covenanted or Gift Aid payments;
• proceeds of a qualifying life assurance policy (in most circumstances);
• casual gambling profits (eg pools, etc);
• lottery prizes;
• wedding presents and certain other presents from an employer that are not given in return for one’s services as an employee;
• certain retirement gratuities and redundancy monies paid by an employer (within limits);
• any scholarship or other educational grant that is received if one is a full-time student at school, college, etc;
• certain grants received from an employer solely because an individual has passed an examination or obtained a degree or diploma;
• war widows’ pensions;
• certain Social Security benefits;
• housing grants paid by local authorities;
• the capital part of a purchased life annuity (but not the interest portion);
• interest on a tax rebate.
In addition, all UK residents, including children from the day of their birth, have a personal allowance, ie an amount of income that can be received each year before income tax begins to be charged. In the 2006/07 tax year, this allowance is £5,035, rising to £7,280 for people aged 65 and over, and to £7,420 at age 75. Personal allowances cannot be transferred to a spouse or any other person, even where an individual has insufficient income to use the full allowance.
For persons over age 65 whose annual income exceeds a certain figure (£20,100 in 2006/07), the increased personal allowance is reduced, on a scale of £1 reduction for every £2 of income above the threshold. It cannot be reduced below the level of the basic under-65 allowance.
The Blind Person’s Allowance (£1,660 in 2006/07) is available to those registered with a local authority as blind. If it cannot be used by the blind person, it can be transferred to the spouse, even if the spouse is not blind.
Prior to April 2000, married couples were entitled to receive an additional allowance, but this has now been withdrawn, except that it continues to be available to couples where at least one spouse was born before 6 April 1935.
In addition to these allowances, taxpayers are permitted to make certain deductions from their gross income before their tax liability is calculated. These include:
• pensions contributions (within specified limits) either to a scheme set up by an employer or to a personal pension or stakeholder pension;
• allowable expenses, such as costs incurred in carrying out one's employment. For self-employed persons, these must be incurred ‘wholly and exclusively for the purpose of trade’, while for employed persons they must be incurred ‘wholly, exclusively and necessarily’ while doing the job.
When all the relevant deductions have been made from a person's gross income, what remains is his or her taxable income. This is the amount to which the appropriate tax rate or rates is applied in order to calculate the tax due.
Income tax rates and the bands of income to which they apply are reviewed by the government each year. Any changes are announced in the Budget and included in the subsequent Finance Act. In the 2006/07 tax year, the lowest rate of tax (applying to taxable income up to £2,150) is 10%; the basic rate (on taxable earned income from £2,151 to £33,300) is 22% and the higher rate (on taxable income above £33,300) is 40%.
A different basic rate (20%) is applied to income from investments, eg the interest on bank and building society deposit accounts.
For most forms of investment income, tax is normally deducted at source. This applies, for example, to interest on bank and building society deposit accounts and to ordinary shares. In the case of deposit accounts, non-taxpayers can choose to receive their interest without deduction of tax by signing an appropriate declaration. Since many depositors pay basic rate income tax, interest rates are often quoted net, ie after deduction of 20% tax. The true gross rate can be calculated by dividing the net rate by 0.8, so, for example a net rate of 3% is equivalent to a gross rate of 3.75%. Higher rate taxpayers will have to pay a further 20% of the grossed-up interest through their tax returns or tax coding.
A different system applies to share dividends, which are received net of a nominal 10% tax. This is deemed to satisfy the income tax payable by lower rate taxpayers and also basic rate taxpayers, who have no more to pay. In this case, the gross dividend can be calculated by dividing the net dividend by 0.9, so that if a shareholder receives a net dividend of £100, say, the equivalent gross dividend is £111.11. In this case, a higher rate taxpayer has to pay a further 22.5% of the grossed-up dividend, making an unusual total higher rate of 32.5% on share dividends. Sadly, in the case of share dividends, non-taxpayers are not able to reclaim the 10% tax deducted at source.
The method of collection of income tax from employment depends on the nature of a person's work, as follows.
Employees pay income tax under the pay-as-you-earn (PAYE) system, under which the amount of tax due is calculated by their employers using tables supplied by HM Revenue and Customs (HMRC), deducted from their wages or salary and passed on by their employers to HMRC. In order to deduct the right amount of tax, the employer is supplied with a tax code number for each employee: the tax code is related to the amount of ‘free’ pay for the employee, including allowances, exemptions and adjustments for fringe benefits and for amounts overpaid or underpaid from previous years.
A P60 is issued to each employee by the employer in April each year. This shows, for the previous tax year, total tax deducted, National Insurance Contributions and the final tax code.
On leaving an employer, an employee should be provided with a form P45 showing:
• name;
• district reference;
• code number;
• week or month of last entries on the employee’s deductions working sheet;
• total gross pay to date;
• total tax due to date.
A copy is sent to HM Revenue and Customs. The P45 provides the new employer with all the information they require to complete a new tax deductions working sheet for the employee.
Self-employed persons (including partners in a business partnership) pay income tax directly to HM Revenue and Customs (HMRC) on the basis of a declaration of net profits calculated from their accounts. Net profits for a self-employed person are broadly the equivalent of the gross income of an employee, ie they are the amount on which income tax is based. They are calculated by taking the total turnover of the business and deducting allowable business expenses and capital allowances.
Under the current self-assessment rules, taxpayers are expected to calculate their own liability and submit their figures to the tax authorities for approval (although tax-payers who submit their returns promptly can ask HMRC to do the calculation for them). Many self-employed people engage an accountant to prepare their accounts for them and to deal with HMRC on their behalf.
1.3.3.2.4 Classification of types of income
Different types of income used to be classified under Schedules A, D, E, and F. These schedules have now been abolished for income tax purposes and replaced by a new regime established under two recent pieces of legislation:
• Income Tax (Earnings and Pensions) Act 2003. This covers income that previously fell under Schedule E – income from employment, pensions and taxable social security benefits.
• Income Tax (Trading and Other Income) Act 2005. This covers income that previously fell under the other schedules, in particular:
– Part 2: Trading income, ie income from self-employment that previously fell under Schedule D Cases I and II;
– Part 3: Income from property (previously Schedule A);
– Part 4: Income from savings and investment, including interest, previously under Schedule D Case III, and dividends, previously under Schedule F.
Although the legislative source of the rules has changed, the way in which tax is calculated is unchanged.
1.3.3.2.5 Income taxed at source
Whenever possible, HM Revenue and Customs collects income tax at source, ie from the person who makes the payment not the recipient. Tax is usually deducted at the basic rate and any further liability at the higher rate will be collected by direct assessment on the taxpayer.
An example of where tax is deducted at source is PAYE (see Section 1.3.3.2.2). Employers deduct tax weekly or monthly (as appropriate) from wages and salaries, which are then paid to the employee net of tax. (This does not take account of other deductions that are also made, ie National Insurance contributions.)
1.3.3.2.6 Tax-paid investment income
Where investment income has been taxed at source, the recipient normally has no further tax to pay, unless he is a higher rate taxpayer. Higher rate taxpayers are liable for the difference between the higher rate and the rate of tax deducted at source.
Examples of investments that have income tax deducted at source include:
• interest on fixed-interest loans to companies (eg loan stocks and debentures);
• distributions from unit trusts;
• dividends from UK companies (dividends are not subject to deduction of income tax and are dealt with by the use of tax credits, but the result to the taxpayer is the same);
• the interest from building society and bank deposits;
• the interest element of certain life annuities;
• interest from certain finance company deposits;
• income from trusts and settlements.
In most cases, non-taxpayers can reclaim the tax deducted at source by completing a tax return.
1.3.3.2.7 Taxation of proceeds from a life assurance policy
An investor’s premiums paid into a company’s life fund are invested in different assets such as property, gilts, shares etc. It is necessary to be aware of how the taxation of the life fund itself impacts on the investor.
In effect, the fund pays sufficient tax to satisfy the basic rate tax liability on income such as dividends, gilt interest or rental income. When the fund sells any of its assets at a profit, it incurs 20% tax on the capital gain.
The net result for the investor is that all benefits coming out of a life fund are deemed to have already borne tax at 20% and for the basic rate payer there is no further liability. There may, however, be a tax liability for a higher rate taxpayer, amounting to 20% of the gain (ie higher rate tax of 40% less the 20% already paid).
This additional tax liability can only arise if the policy is non-qualifying. Qualifying policies do not suffer any additional tax. Broadly speaking, in order to be a qualifying policy, a policy must meet the following rules:
• premiums must be payable annually, half-yearly, quarterly or monthly for at least ten years;
– If premiums cease within ten years, or three-quarters of the original term if less, the policy becomes non-qualifying;
• premiums in any one year must not exceed twice the premiums in any other year or one-eighth of the total premiums payable;
• the sum payable on death must be at least equal to 75% of the total premiums payable.
1.3.3.2.8 Taxation of proceeds from a unit trust
The investments within a unit trust will generate income in the form of dividends on shares and gilt interest. Dividends from UK shares are received net of tax; when passed on to unitholders, there is no liability to basic rate tax. There may, however, be a liability for higher rate tax.
Gilt interest and dividends on foreign shares however, will not have paid UK tax. The unit trust in this instance will pay corporation tax on foreign dividends and basic rate tax on gilt interest. Unit trusts are exempt from capital gains tax (CGT) but unitholders may have a liability if they sell units at a profit.
1.3.3.2.9 Calculation of income tax liability
The calculation of personal liability to income tax is broadly speaking a four-stage process as follows.
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Example 1 A married man aged 30 earns £20,000 pa in the 2006/07 tax year. He is employed and has a personal allowance of £5,035. Gross income £20,000 Personal allowance £5,035 Taxable income £14,965 Income tax due £2,150 at 10% = £215.00 £12,815 at 22% = £2,819.30 Total tax due £3,034.30 |
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Example 2 A single woman aged 40 earns £50,000 pa in the 2006/07 tax year. She is employed and has a personal allowance of £5,035. Gross income £50,000 Personal allowance £5,035 Taxable income £44,965 Income tax due £2,150 at 10% = £215.00 £31,150 at 22% = £6,853.00 £11,665 at 40% = £4,666.00 Total tax due £11,734.00 |
If a person’s income comes from several different sources, there is an order of priority in which different forms of income are taxed: earned income is taxed first, then interest, and, finally, dividends. This may make a difference because the tax calculation for dividends, for instance, is different from that for interest.
National Insurance contributions are a form of taxation in everything but name. They are in effect a tax on earned income and are payable in different ways according to whether the earner is employed or self-employed.
They are classified as follows.
Class 1: these are paid by employees at 11% on earnings between certain levels known as the primary threshold (£97 per week in 2006/07) and the upper earnings limit (£645 per week in 2006/07), with a reduced level of 1% payable on earnings above the upper limit. They are also paid by employers at 12.8% on employees' earnings above a lower limit called the secondary threshold (£97 per week in 2006/07) – but with no upper limit. Reduced contributions apply if employees are contracted out of the state second pension (S2P).
Class 2: these are flat-rate contributions paid by the self-employed if their annual profits exceed a specified lower threshold (£4,465 pa for 2006/07). They are quoted as a weekly amount (£2.10 per week in 2006/07) but are normally paid monthly by direct debit. Many self-employed people also pay Class 4 contributions.
Class 3: these are voluntary contributions that can be paid by people who would not otherwise be entitled to the full basic pension or sickness benefits. This can occur because a person has, for instance, taken a career break or spent some time working overseas. They are flat-rate contributions (£7.55 per week in 2006/07).
Class 4: these are additional contributions payable by self-employed persons on their annual profits between specified minimum and maximum levels, with a reduced rate payable above the upper limit, as for Class 1. They are paid to HMRC in half-yearly instalments along with income tax. The rate for 2006/07 is 8% of profits between £5,035 and £33,540, plus 1% of profits above £33,540.
Capital gains tax (CGT) is payable on the net gain made on the disposal of certain physical assets and the realisation of many financial assets, including shares and unit trusts. Most disposals relate to the sale of an asset but the full definition of a disposal also includes transferring or giving an asset, or receiving compensation for its loss or destruction.
There are some circumstances under which CGT is not due – in particular, it is not payable when property changes hands as the result of a death (although there may be inheritance tax – see Section 1.3.3.5). There is a ‘deemed disposal’ of assets on death, when the assets are deemed to be acquired by the personal representatives at their market value at the time of death. This is to establish the cost of acquisition, should it be necessary at some time in the future to calculate capital gains.
Similarly, there are certain assets that are exempt from CGT, including:
• main private residence;
• ordinary private motor vehicles;
• personal belongings, antiques, jewellery and other tangible movable objects (referred to as ‘chattels’), provided each object is valued at £6,000 or less;
• gifts of items of national, historic or scientific interest to the nation;
• foreign currency for personal expenditure;
• British government stocks (gilts);
• National Savings Certificates and Save As You Earn schemes;
• premium bonds winnings and lottery winnings;
• gains on qualifying life assurance policies disposed of by the owners;
• individual savings accounts and personal equity plans.
If an individual makes a loss on disposal of an asset, this can be offset against gains made elsewhere. It must be offset first against gains in the year the loss occurred. Residual losses may then be carried forward to future years. A capital loss cannot, however, be carried back to a previous year.
Tax is payable on net gains made in the tax year, after deducting any allowable capital losses that were made in the same year or carried forward from previous years. Each individual also has an annual CGT allowance (£8,800 in 2006/07): rather like the personal income tax allowances, this is the level of gains that can be made in the tax year before CGT starts to be payable. This figure also applies to trustees of a mentally disabled person and to personal representatives; half the amount (£4,400 in 2006/07) applies to most other trustees. The annual allowance cannot be carried forward to subsequent years if it is unused in the year to which it applies.
Given that capital losses can be carried forward but the annual exemption cannot, capital losses brought forward are used only to the extent necessary to reduce gains to the level of the annual exemption. Residual losses are then carried forward.
The calculation of the amount of a taxable gain is governed by a number of rules that make it more complex than merely a simple subtraction of purchase price from sale price:
• costs of purchase can be added to the purchase price and selling costs can be deducted from the sale price;
• the cost of improvements to an asset can be treated as part of its purchase price (but costs of maintenance and repair cannot);
• capital gains made prior to 31 March 1982 are not taxed so, for an asset acquired before that date, its value on that date can be substituted for the actual purchase price;
• the purchase price (or value at 31 March 1982, as appropriate) can also be increased in line with the increase in the retail price index (RPI) between the acquisition date (or March 1982) and April 1998. This benefit, known as indexation, is allowed because the government seeks to tax only those gains that are above and beyond the increase in an asset's value due to inflation.
When the amount of the gain has been calculated as described above, it is reduced on a sliding scale according to the length of time that the asset has been held. This is known as taper relief – not to be confused with tapering relief, which applies to inheritance tax (see Section 1.3.3.5). The amount of chargeable gain is reduced by taper relief; the amount of the reduction depends on the length of time the asset has been held (since 5 April 1998) up to a maximum of ten years.
|
Number of complete |
Percentage of gain chargeable |
||
|
years asset held for |
Business assets % |
Non-business % |
|
|
0 |
100 |
100 |
|
|
1 |
50 |
100 |
|
|
2 |
25 |
100 |
|
|
3 |
25 |
95 |
|
|
4 |
25 |
90 |
|
|
5 |
25 |
85 |
|
|
6 |
25 |
80 |
|
|
7 |
25 |
75 |
|
|
8 |
25 |
70 |
|
|
9 |
25 |
65 |
|
|
10 or more |
25 |
60 |
|
From the table above, it is obvious that business assets get preferential treatment as far as capital gains tax is concerned. The definition of business assets includes:
• an asset used for the purposes of a trade either by an individual or a qualifying company;
• an asset held for the purpose of a qualifying office or employment to which the individual devoted most of their time;
• shares in a qualifying company held by an individual;
• all shareholdings held by employees in trading companies (whether quoted or unquoted);
• shareholdings in quoted trading companies where the holder is not an employee but can exercise at least 5% of the voting rights;
• a shareholding by an employee in a non-trading company, as long as the employee does not have a material interest in the company (for example, they cannot control more than 10% of the voting rights).
In general terms, this means that, from 6 April 2001, all shares held by employees in their employer company will be treated as business assets as long as the employee does not have a material interest in the company.
Where an asset was held before 6 April 1998 but disposed of after that date, the process to calculate the gain is as follows:
• apply indexation for the period of ownership up to and including 5 April 1998;
• apply taper relief for the period of ownership after 5 April 1998.
Where an asset was owned prior to 17 March 1998, an extra year can be taken account of when using the above table to calculate the taper relief applicable to non-business assets.
It should also be noted that income tax personal allowances cannot be used to reduce the amount of CGT due.
For most trusts and for personal representatives, the rate of capital gains tax is 40%.
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Example Vanessa bought unit trusts for £50,000 in May 2002 and sold them for £80,000 in June 2006. As they were bought after April 1998, indexation is not applied to the purchase price but taper relief will apply. • The gain of £30,000 can be reduced to 90% (the taper relief amount for assets held for four complete years), giving a figure of £27,000. • This can be further reduced by the annual exemption amount of £8,800 (the 2006/07 allowance) leaving a taxable amount of £18,200. • This amount of £18,200 is treated as an addition to John’s income for 2006/07. If his other taxable income in that year is £28,300 (ie £5,000 below the higher rate tax threshold – see Section 1.3.3.2), then £5,000 of his taxable gain will fall in his ordinary rate band and the remaining £13,200 in his higher rate band. • Total CGT is therefore £5,000 at 20% (= £1,000) plus £13,200 at 40% (= £5,280) giving a total of £6,280. |
One constant source of complaint about the capital gains tax regime is that CGT is due on the whole gain in the year in which the gain is realised, even where that gain has actually been made over a longer period. This means that only one annual exemption can be set against what may be many years' worth of gain. In the past, some holders of shares and unit trusts sought to minimise the effect of this by selling their holding each year and repurchasing it the following day, thus realising a smaller gain that could be covered by that year's exemption. This was known as bed and breakfasting, but the government effectively outlawed the process in the 1998 Budget. Since then, any shares and unit trusts that are sold and repurchased within a 30-day period are treated, for CGT purposes, as if those two related transactions had not taken place.
Business assets are chargeable to CGT. If the assets disposed of are replaced by other business assets, however, roll-over relief may be claimed on all chargeable gains realised by individuals and certain trustees. This means that, instead of CGT falling due on the original disposal, it is deferred until a final disposal is made.
The replacement asset must be bought within a period of one year before and three years after the sale of the original asset.
Relief can be claimed up to the lower of either the gain or the amount reinvested.
Similarly, CGT on any gain arising on the gift of certain assets can normally be deferred until the recipient disposes of it.
Gains may be wholly or partly passed on to the recipient in the case of gifts (or sale at under value) of the following broad categories of assets:
• assets used by the donor in his trade or the trade of his family company or group;
• shares in the transferor’s personal company or in an unlisted trading company;
• agricultural property that would attract relief from inheritance tax;
• assets on which there is an immediate charge to inheritance tax.
CGT is charged on gains arising from disposals in the period 6 April to 5 April in the following year.
CGT is normally payable on 31 January following the end of the tax year in which the gain is realised. For example, CGT for 2005/06 will normally be payable on 31 January 2007.
Details of chargeable assets disposed of during the tax year must be included in an individual’s tax return.
Inheritance tax, as its name suggests, is levied mainly on the estates of deceased persons. The tax is charged at 40% of the amount by which the value of the estate exceeds the nil-rate band, which is up to £285,000 in 2006/07. In order to prevent avoidance of tax by ‘death-bed’ gifts or transfers, the figure on which tax is based includes not only the amount of the estate on death but also the value of any money or assets that have been given away in the seven years prior to death.
Inheritance tax (IHT) is also payable in certain circumstances when assets are transferred from a person's estate during their lifetime (usually in the form of gifts). Most gifts made during a person's lifetime are potentially exempt transfers (PETs) and are not subject to tax at the time of the transfer. If the donor survives for seven years after making the gift, these transactions become fully exempt and no tax is payable. If the donor dies within seven years of making the gift, the tax becomes due (although the amount is scaled down by tapering relief over the final four years of the seven – to 80%, 60%, 40% and 20% of the maximum tax in the fourth, fifth, sixth and seventh years respectively).
Some lifetime gifts – notably those to companies, other organisations and certain trusts – are not PETs but chargeable lifetime transfers, on which tax at a reduced rate of 20% is immediately due. As with PETs, the full tax is due if the donor dies within seven years (subject to the same tapering relief) and any excess over the 20% already paid then becomes payable.
There are a number of important exemptions from inheritance tax:
• transfers between spouses and between same-sex couples registered under the Civil Partnership Act both during their lifetime and on death;
• small gifts of up to £250 (cash or value) per recipient in each tax year;
• donations to charity, to political parties, and to the nation;
• wedding gifts of up to £1,000 (increased to £5,000 for gifts from parents or £2,500 from grandparents);
• gifts that are made on a regular basis out of income and which do not affect the donor's standard of living;
• Up to £3,000 per tax year for gifts not covered by other exemptions. Any part of this £3,000 that is not used in a given tax year can be carried forward for one year, but no further.
Value added tax (VAT) is an indirect tax levied on the sale of most goods and the supply of most services in the UK. The current rate is 17.5%.
Some goods and services are exempt from VAT, including certain financial transactions such as loans and insurance. The supply of financial advice is not exempt and advisers who charge a fee for their service are subject to VAT in the same way as solicitors or accountants.
The supply of health and education services is exempt and a number of related goods and services are currently zero-rated. This is not technically the same as being exempt: zero-rated goods and services are theoretically subject to VAT but the rate of tax applied is currently 0% (although this could change). Zero-rated items include food, books, children's clothes, domestic water supply and medicines. Domestic heating is charged at a reduced rate (currently 5%).
Businesses, including the self-employed, are required to register for VAT if their annual turnover (not profit) is above a certain figure (£61,000 in 2006/07). Firms with turnover below this figure can choose to register for VAT if they wish, but are not obliged to. An advantage of registering is that VAT paid out on business expenses can be reclaimed; two disadvantages are (i) the fact that the firm's goods or services are more expensive to customers (by the amount of the VAT that the firm must charge) and (ii) the additional administration involved in collecting, accounting for and paying VAT.
Stamp duty is a form of tax, payable by the purchaser in respect of certain transactions, notably purchases of securities and of land. It is a tax imposed on the documents that give effect to the transaction (eg conveyances of property or stock transfer forms) and is calculated as a percentage of the purchase price.
It is important to ensure that the documents are stamped within the permitted time period. Failure to do so means, for instance, that the conveyance of the land cannot be registered or that share transfers will not be accepted for registration.
• Stamp Duty Reserve Tax: the rate of stamp duty on securities is 1.5% of the market value for bearer instruments and 0.5% of market value for shares.
• Stamp Duty Land Tax: the rate of stamp duty on property depends on the purchase price:
– there is no stamp duty on purchases of up to £125,000 (or £150,000 in certain designated disadvantaged areas);
– between £125,001 and £250,000, stamp duty is 1% of the whole purchase price;
– between £250,001 and £500,000, it is 3% of the whole purchase price;
– above £500,000, it is 4% of the whole purchase price.
1.3.4 Economic and monetary policy
At this point, it is useful to consider briefly the long-term objectives that the economic policies of most governments try to achieve. These are known as macroeconomic objectives because they concern economic aggregates, ie totals that give us a picture of the economy as a whole, as opposed to microeconomic objectives that concern individual firms or consumers.
• Price stability, ie a low and controlled rate of inflation. This inflation is popularly defined as a rise in the level of prices. In more formal economic terminology, it can be defined as a situation where the rate of growth of the money supply is greater than the rate of growth of real goods and services; in more common terms, ‘too much money chasing too few goods’, which, of course, results in prices rising. Price stability does not mean, however, that zero inflation is desirable and there is a body of economic opinion that believes that moderate inflation can stimulate investment, which is good for the economy.
• Low unemployment, ie to expand the economy so that there is more demand for labour, land and capital.
• Balance of payments equilibrium, ie a situation where expenditure and receipts of foreign currencies are equal. The aim should be to achieve a balance (ie neither a deficit nor a surplus) over the medium term. The UK has, for some years, experienced a deficit on its balance of payments current account with a deficit on manufacturing and on money transfers partly compensated for by a surplus on services and on income from investments. The exchange rate of the country's currency is linked to the balance of payments and most governments aim to keep the price of currency stable at a level that is not so high that exports will be discouraged but not so low as to increase inflation.
• Satisfactory economic growth, meaning that the output of the economy is growing in real terms over time and that standards of living are getting higher. The UK economy, like that of other industrialised countries, grew quite fast in the years up to 2000 but this has fallen off with the onset of recession, which has affected the US and European economies. The accounts published in the third quarter of 2005 showed annual growth of gross domestic product (GDP) in the UK at 1.7%; GDP is a measure of the value of the goods and services produced within the country over a specified period of time.
In practice, it has proven impossible to achieve all of these objectives simultaneously, as the history of the British economy shows. If a government tries to reduce the rate of unemployment by means of expansionary measures such as lower interest rates and lower taxation, demand is boosted and inflation begins to rise. At the same time, people buy more imports and the balance of payments suffers, although the economy will probably grow.
The four objectives given above tend to fall into two pairs: policies to reduce unemployment will also boost growth; measures to reduce inflation will also help to improve the balance of payments. Governments generally have to ‘trade off’ objectives against each other, eg they want price stability but know that the price of getting rid of inflation altogether would be very high unemployment, so they accept a low inflation rate to avoid pushing the economy into recession.
Economic policy in the UK, from the beginning of the 1960s until fairly recently, was of the ‘stop-go’ variety, within which governments accelerate and decelerate the economy in turn. This leads to a situation where periods of fast growth, high employment and high inflation are followed by a slowing-down into high unemployment and lower inflation. The current approach in both the UK and Europe aims at growth via price stability.
The current overall long-term objective aimed at by the UK government is to keep inflation steady at a low rate in the hope that price stability will lead to a long period of sustained economic growth. It aims to keep aggregate demand in line with the productive capacity of the economy.
In order to achieve this objective, the government has set an official direct target, which is to keep inflation as measured by the consumer price index (CPI) – at an average annual rate of 2%, with a maximum divergence either side of 1%. This measure is derived in the same way as the harmonised index of consumer prices (HICP) used within the eurozone and has replaced the retail price index (RPI) that was previously used in the UK for this purpose (although the RPI is still used for some other purposes).
To achieve their objectives, the monetary authorities have a range of instruments at their disposal. The main instrument of monetary policy used to keep inflation in check in the UK is the rate of interest, which is manipulated by the Bank of England Monetary Policy Committee according to economic circumstances.
There are two major types of policy used by modern governments in their attempts to achieve long-term economic objectives:
• monetary policy, which acts on the money supply and on interest rates;
• fiscal policy, which acts on public sector spending, revenue and borrowing or saving.
Both types of policy try to influence the level of aggregate demand in the economy and therefore the level of output, unemployment and prices.
Several decades ago, monetary policy generally took second place to fiscal policy because governments believed that fiscal policy was the best way of making large adjustments to demand. Monetary policy was felt to be suitable only for fine-tuning.
Since 1979, however, and mainly due to the monetarist policies of successive Conservative governments, monetary policy has become the most important means of controlling the economy. The present Labour government has continued to use it, although it has made some changes in its targets and in the methods used.
Monetary policy is based on the ideas of the monetarist school and particularly on those of Professor Milton Friedman of Chicago University. Monetary economists believe that inflation is caused by an increase in the money supply. Broadly speaking, they conclude that, since most of the growth in the money supply is caused by an increase in credit creation by banks, a government that wants to control the growth of the money supply must control the amount of credit creation carried out by banks. A common way to do this is by manipulating interest rates, which in turn influence the demand for credit by customers.
Other methods can be used and have been used in the past. For example, banks can be restricted on the amount they can lend or borrowers can be required to provide a minimum cash deposit when borrowing to make a purchase. None of these is currently in use in the UK, where the favoured method is the manipulation of interest rates. The Monetary Policy Committee (MPC) of the Bank of England decides on the rate of interest at which the Bank of England will lend to banks and other financial institutions (the repo rate, commonly known as the base rate), and it is this official rate that determines all the other interest rates charged to borrowers and paid to lenders.
The MPC meets every month to decide whether or not to change interest rates and, if so, in what direction and by how much. It announces its decision immediately after the meeting and publishes the minutes of the meeting two weeks later. The Treasury retains the right to give instructions to the Bank of England regarding its monetary policy in ‘extreme economic circumstances’; otherwise the Bank acts independently of the government.
1.3.4.1.1 The impact of interest rate changes
When the MPC decides to change its interest rate, the effect is that all banks and similar deposit-takers have to follow suit and alter the interest rates at which they lend and borrow by something close to the same amount. The mechanism by which this is achieved is not covered in this text.
This means that banks’ base rates are inevitably variable rates because they follow the Bank of England’s rate, which is adjusted as necessary to put into operation the monetary policy used to control the economy of the UK.
Until fairly recently, most loan interest rates, including mortgage rates, were variable rates. A major disadvantage of variable rates, particularly in relation to a large transaction such as a mortgage, is that it is difficult for the borrower, whose income does not vary in the same way, to budget for likely future expenses. Sudden large rate increases can lead to borrowers being unable to make their mortgage repayments and, in the worst cases, some borrowers may even lose their homes if the lender has to take possession.
With the development of a large and active wholesale money market, it is now possible for lenders to obtain large amounts of money at fixed rates, which they can in turn lend out to their mortgage borrowers and others. Fixed-rate mortgages in the UK still tend to be fixed only for a short initial period, with the rate reverting to the variable rate for the remainder of the term. Longer-term fixed rates are available in many other European countries and it has been suggested that a greater use of long-term fixed rates in the UK would assist in stabilising the sometimes very volatile British housing market. Fixed-rate mortgages do have their own disadvantages, however, not least of which is the danger that a borrower will lose out if the variable rate falls and they are locked into a higher fixed rate. There is normally a penalty for paying off the mortgage within the fixed-rate period, in order to protect the lender. There may also be an arrangement fee, charged by the lender for reserving sufficient funds at the fixed rate.
Fiscal policy (which is sometimes called budgetary policy) involves influencing the money supply and the overall level of economic activity, including consumption and investment, by manipulating the finances of the public sector (which comprises the central government, local authorities and public corporations).
The public sector has a responsibility to provide certain services that are of national or regional importance, such as education, healthcare and transport. To pay for these services, the government must raise funds from the private sector, ie from individuals and firms, in the form of direct and indirect taxes.
Because the public sector is responsible for taking a large amount of money from the private sector and for making large amounts of expenditure on its behalf, any changes in either side of the account and thus in the balance have a significant effect on the economy as a whole. There are three general outcomes:
• a balanced budget: the effect on the economy is neutral because the amount taken away in taxation is put back into public spending;
• a budget surplus, where the amount of money taken away is more than that put back: the effect is ‘contractionary’ in terms of employment and deflationary in terms of the money supply;
• a budget deficit, where the amount of money put back is more than that taken out (the difference being the amount borrowed): the overall effect is expansionary in terms of employment and also inflationary in terms of the money supply.
A government that has a deficit must borrow to finance it. The Public Sector Net Cash Requirement (PSNCR) is a cash measure of the public sector's short-term net financing requirement.
The central economic goal of the UK government is to achieve high and sustainable levels of growth and employment. Fiscal policy is directed towards maintaining sound public finances over the medium term, based on strict rules, and towards supporting monetary policy where possible over the economic cycle. The government has specified two key fiscal rules:
• the so-called golden rule: over the economic cycle, the government will borrow only to invest and not to fund current spending (there has been some speculation about whether the Chancellor of the Exchequer will have to break this rule to fund current spending);
• the sustainable investment rule: public sector net debt as a proportion of gross domestic product will be held over the economic cycle at a stable and prudent level.
The government outlines its fiscal policy in the annual Budget statement made by the Chancellor of the Exchequer normally in March. The statement includes revenue plans (including taxation of individuals and companies) and the government's planned expenditure. At least three months prior to the Budget, the government publishes a Pre-Budget Report that allows it to consult the public on specific policy initiatives.
Monetary policy acts on the economy as a whole currently through changes in the general level of interest rates. Although fiscal policy can also have an overall macroeconomic effect on the level of activity in the economy, it has microeconomic effects and can be targeted to particular areas of the economy. For example, tax incentives can be given to manufacturing industries to boost employment in what is a declining sector or government grants can be given to firms that move to relatively underdeveloped geographical areas.
In practice, however, fiscal policy and monetary policy are not applied in isolation but are closely linked, and governments generally use a combination of the two.
In the UK, the government plays a vital role in providing assistance to people in need. Although the ‘welfare state’ has had its critics in recent years – largely because it is increasingly expensive to run – it still remains the envy of many other nations.
State benefits can affect financial planning in two main ways.
(i) Social Security benefits can affect the need for protection.
The amount of additional cover needed by a client can be quantified as the difference between the level of income or capital required and the level of cover already existing. Existing provision includes not only any private insurances that the client already has, but also any state benefits to which they or their dependants would be entitled.
(ii) Financial circumstances can affect entitlement to benefits.
Certain benefits are ‘means-tested’ – in other words, the amount of benefit is reduced if the individual’s (or sometimes the family’s) income or savings exceed specified levels. This might mean, for example, that a financial plan that increased a person’s income might be less attractive than it seemed at first sight, if it also had the effect of reducing entitlement to, for instance, Income Support.
There is a wide range of Social Security benefits covering many different circumstances. Many of them, however, are small in amount and can do little more than prevent people from suffering extreme poverty. The whole Social Security benefit structure is very complex and it is not possible to cover every detail here. The main benefits are described in the remainder of this section, together with some information about them that is relevant to the work of financial advisers.
The Department for Work and Pensions (DWP) publishes a wide range of booklets that provide detailed descriptions of the various benefits. These are available from DWP offices, most post offices or by visiting its website at www.dwp.gov.uk.
1.3.5.1 Support for people on low incomes
The two main benefits for those on low income, or no income at all, are the Working Tax Credit and Income Support.
This was introduced in April 2003 and is for people who are employed or self-employed and who work for at least 16 hours per week. They must also be:
• aged 16 or over and responsible for at least one child; or
• aged 16 or over and disabled; or
• aged 25 or over and work for at least 30 hours per week.
A couple must make a joint application and the Working Tax Credit is paid to the one who is working at least 16 hours per week. If both are working 16 hours or more per week, then the couple must choose which of the two is to receive the Tax Credit.
The overall purpose of the Working Tax Credit is to ‘make work pay’ for those on a low income. It is not a benefit as such and is included in the claimant’s wage or salary. Self-employed claimants have their Working Tax Credit paid directly into a bank account.
Income Support is a tax-free benefit designed to help people aged 16 or over whose income is below a certain level and who are working less than 16 hours per week (or where the partner works for less than 24 hours on average per week). It can be claimed by people with no income at all or can be used to top up other benefits or part-time earnings.
Eligibility for Income Support is not dependent on the claimant having paid NICs. It is, however, means-tested on both income and savings:
• if both the claimant and his or her partner are aged under 60, Income Support will be reduced if savings exceed £3,000 and the claimant will be ineligible if savings exceed £8,000;
• if either the claimant and their partner are aged over 60, Income Support will be reduced if savings exceed £6,000 and the claimant will be ineligible if savings exceed £12,000;
• if the claimant lives in a residential care home, Income Support will be reduced if savings exceed £10,000 and the claimant will be ineligible if savings exceed £16,000.
The rules relating to Income Support are complex, and only a brief outline of them can be given here. The range of people who can claim Income Support includes those who are: aged 60 or over; single parents; sick or disabled; looking after a disabled or elderly person; unemployed; only able to work part-time.
1.3.5.1.2.1 Income Support payments
The exact amount of Income Support payments depends on a number of factors, including: claimant’s age; income and savings levels; and whether the claimant has a partner and/or children (and their ages).
Payments are made up of three main parts:
• personal allowances (not to be confused with the tax allowances of the same name), which are meant to cover the day-to-day living expenses of the claimant, partner and dependent children;
• premiums (nothing to do with life policies), which are additional payments given to people who have extra needs, such as one-parent families or people with disabilities;
• other additions, which may include payments for mortgage interest and certain other housing costs.
1.3.5.1.3 Jobseeker’s Allowance (JSA)
Jobseeker’s Allowance (JSA) is a benefit for people who are unemployed and are actively seeking work.
There are two forms of JSA: contribution-based and income-based.
Contribution-based JSA depends on having paid sufficient Class 1 National Insurance contributions and is payable for a maximum of six months. It is paid at a fixed rate irrespective of savings or partner’s earnings, but no additional benefits are paid for dependants. Contribution-based JSA is paid gross but is taxable.
People who do not qualify for contributions-based JSA may be able to get income-based JSA, which is, to all intents and purposes, Income Support under another name.
Claimants for JSA must satisfy a number of strict requirements, including the following:
• they must be ‘capable of, actively seeking, and available for’ work, normally for at least 40 hours per week;
• they must be out of work or working less than 16 hours per week;
• they must normally be 18 or over but below pensionable age;
• they must not be in full-time education;
• they must have signed a Jobseeker’s Agreement, which sets out the steps they must take to look for work.
Claimants are usually credited with National Insurance contributions (NICs) for every week when they receive JSA.
1.3.5.2 Support for bringing up children
Benefits related to bringing up children fall into two categories: benefits payable during pregnancy and benefits payable as the children are growing up.
1.3.5.2.1 Statutory Maternity Pay (SMP)
Women who become pregnant while they are in employment may be able to get Statutory Maternity Pay (SMP) from their employer. The requirements that a woman must meet in order to receive SMP are:
• she must have worked for the same employer, without a break, for at least 26 weeks including (and ending with) the 15th week before the baby is due – known as the qualifying week;
• her average weekly earnings in the eight weeks up to the qualifying week must not be less than the lower earnings limit, the level at which NICs start to be payable;
• she must have paid at least a specified minimum level of Class 1 NICs.
SMP is payable for a maximum of 26 weeks. The earliest it can begin is 11 weeks before the baby is due and the latest is when the baby is born.
There are two rates of SMP: for the first six weeks, the amount paid is equal to 90% of average weekly earnings; after that, the remaining payments are at a flat rate.
SMP is taxable and NICs are due on the amount paid.
Some working mothers who become pregnant are not able to claim SMP. These will include those who are self-employed or who have recently changed jobs. They may be able to claim an alternative benefit called Maternity Allowance. This is paid by the Department of Work and Pensions (DWP) and not by employers.
Maternity Allowance is paid at a lower rate than SMP but, unlike SMP, it is not subject to tax or NICs on the amount paid.
A standard rate of Maternity Allowance is payable to those whose earnings exceed the lower earnings limit. For those who earn less than the limit but above the minimum threshold for a claim to be made, an amount equal to 90% of average earnings will be paid.
Contrary to popular belief, Maternity Allowance is not a benefit available to all women who become pregnant, whether or not they have been working. There are restrictions on who can claim.
Like SMP, Maternity Allowance is payable for a maximum of 26 weeks. The earliest it can begin is 11 weeks before the baby is due and the latest is when the baby is born.
Child Benefit is a tax-free benefit available to parents and others who are responsible for bringing up a child. It is not means-tested and does not depend on having paid NICs. It is not affected by receipt of any other benefits.
Child Benefit is available for each child under age 16. It can continue up to and including age 18 (19 from April 2006) if the child is in full-time education (or, from April 2006, on an unwaged work-based training programme). A higher rate is paid in respect of the eldest child and a lower rate in respect of every other child.
Child Tax Credit is designed mainly to help parents on low incomes but people earning as much as £66,000 per year can be eligible. It brings together the child elements of Income Support, Jobseeker’s Allowance and the Disabled Person’s Tax Credit and is payable in addition to the entitlement to Child Benefit. The parent does not have to be working to claim Child Tax Credit.
Child Tax Credit is paid directly to the person who is mainly responsible for caring for the child. Payment is made in respect of each child until 1 September following his or her 16th birthday or up to the 20th birthday (from April 2006) if the child is:
• in full-time education (or, from April 2006, on an unwaged work-based training programme);
• not claiming Income Support or any tax credit;
• not serving a custodial sentence of four months or more.
1.3.5.3 Support for people who are ill or disabled
There is a wide range of benefits for people who are sick, injured or disabled, or who need constant care.
1.3.5.3.1 Statutory Sick Pay (SSP)
Statutory Sick Pay (SSP) is paid by employers to employees who are off work due to sickness or disability for four days or longer.
SSP is paid for up to a maximum of 28 weeks in any spell of sickness, and spells of sickness with less than eight weeks between them count as one spell. It is payable to employed people whose average weekly earnings are above the level at which NICs are payable.
Amounts paid as SSP are subject to tax and to NI deductions, just as normal earnings would be.
People who are still sick after 28 weeks may be able to claim short-term Incapacity Benefit.
Incapacity Benefit is a benefit for people who are unable to work due to illness or disability. It can be claimed by those who cannot get SSP because they are self-employed or because the SSP payment period has expired.
The right to receive Incapacity Benefit depends on having paid sufficient Class 1 or Class 2 NICs. Those who have not paid sufficient NICs may be able to get Income Support.
Incapacity Benefit has three different levels of benefit, which apply in different circumstances. The lowest rate is not subject to income tax, but the two higher rates are taxable. The rates are:
• short-term lower rate, which is payable for up to 28 weeks to people who cannot get SSP;
• short-term higher rate, which is payable from 29 weeks to 52 weeks;
• long-term rate, which is the highest rate of Incapacity Benefit and is payable to people who are still sick after a year. People who are terminally ill can get Incapacity Benefit at the highest rate from 28 weeks onwards.
1.3.5.3.3 Attendance Allowance
This is a benefit for people aged 65 or above needing help with personal care as a result of sickness or disability.
Attendance Allowance is not means-tested and it does not depend on having paid NICs.
There are two levels of benefit: a lower rate for people who need help with personal care by day or by night and a higher rate for those who need help both by day and at night.
1.3.5.3.4 Disability Living Allowance (DLA)
This is a tax-free benefit for people who need help with personal care and/or need help getting around. It can only be received by people whose disability claim began before age 65 but, once granted, it can continue beyond age 65.
To be eligible for Disability Living Allowance (DLA), a person must have needed help for a qualifying period of three months and must be expected to need help for a further six months. The qualifying period is waived for people who are not expected to live for six months.
There are two components to DLA and claimants may receive either or both:
• care component: this component is for people who need help in carrying out daily tasks such as washing, dressing, using the toilet or cooking a meal;
• mobility component: this component applies if a person has difficulty in walking or cannot walk at all.
The government recognises that support is also needed for carers, ie people who give up a large part of their time – and possibly their jobs – in order to look after someone who is seriously ill or severely disabled. Carer’s Allowance (CA) is a benefit for people who are caring for a severely disabled person; they do not have to be a relative of the patient in order to qualify.
The right to receive CA does not depend on having paid NICs. The benefit is a flat rate, with possible additions for a partner or children. It is taxable and must be declared on tax returns.
The following criteria must be met.
• The carer must:
– be aged between 16 and 65;
– spend at least 35 hours per week as a carer;
– be earning no more than a certain amount each week;
– not be in full-time education (defined as 21 hours or more a week of supervised study).
• The person being cared for must:
– be receiving Disability Living Allowance or Attendance Allowance or Constant Attendance Allowance;
– not be in hospital or in residential care.
1.3.5.4 Support for people in hospital or receiving residential/nursing care
When people are in hospital, some of the needs normally met by benefits or pensions are instead met by the National Health Service. In the past, therefore, some benefits have been reduced or suspended while a claimant is in hospital. In the 2005 budget, however, it was announced that these reductions will no longer be made.
For those in a residential care or nursing home provided by a local council, who cannot afford the minimum charges, Income Support may be available. For those in residential or nursing care in a private establishment, Income Support may be available provided that savings do not exceed £16,000. Income Support amounts are worked out by adding together the fees for the home and any meals that have to be paid for separately, subject to a maximum benefit amount depending on the type of care received.
1.3.5.5 Support for people in retirement
The government first introduced pension provision in 1908 but state pensions first appeared in something like their current form after the Second World War when the National Insurance Act 1946 provided for pensions to be payable to employed people on retirement at age 65 (men) or 60 (women). These ages still apply today but, by 2020, state retirement age will have been equalised at 65 for both men and women.
This flat-rate pension, now known as the basic state pension, was not related to an employee's earnings. It was later extended to include self-employed people and others who have made sufficient National Insurance contributions – which basically means that they have contributed for 90% of their working life (with benefits being scaled down pro rata for lower contribution levels).
The National Insurance Act 1959 first introduced a second tier of state pensions, in which benefits were earnings-related. This was known as the graduated pension scheme and operated from 1961 until it was replaced by the state earning-related pension scheme (SERPS), which came into operation in 1978. SERPS was itself replaced in 2002 by the State Second Pension (S2P).
The basic state pension always was – and still is today – designed to provide little more than a subsistence-level standard of living. It is set at approximately 25% of the national average earnings level. In 2006/07, the single person’s basic state pension is £84.25 per week and the married couple’s rate is £134.75 per week.
The pension is administered on a pay-as-you-go basis, with current National Insurance contributions from the working population being immediately paid out as current pensions to those entitled to receive them. It is readily apparent that, with the number of pensioners increasing and the numbers in employment decreasing, there is little scope for increasing state pensions by anything more than the rate of inflation.
1.3.5.5.2 Additional state pension
The objective of the state earnings-related pension scheme (SERPS) was originally to boost pension provision from 25% of national average earnings (ie the basic pension) to a level around 50%. Like the basic pension, it is funded on a pay-as-you-go basis, a system that is coming under increasing cost pressures. This has resulted in a scaling-down of prospective benefits, which are determined by a complex formula, and there is every likelihood of further reductions in the future.
SERPS was replaced by the State Second Pension (S2P) in 2002. Although initially offered on an earnings-related basis, it will change to a full flat-rate basis at a later date (as yet unspecified). New contributions are to S2P but previously purchased SERPS benefits are retained.
Unlike the basic pension, S2P is available only to employed persons who are paying Class 1 National Insurance contributions. Self-employed people cannot currently be members of S2P, although the 2002 Pensions Green Paper proposed that they should be permitted to contract in to S2P in the future. Employed people are in fact obliged to be in S2P unless they contract out or are contracted out by their employer on the basis of membership of the employer's pension scheme. Contracting out is permitted only if the employer, or the individual, provides acceptable alternative pension provision. If an employer runs a contracted-out pension scheme, the employer and employees who are members pay a reduced level of National Insurance contributions. If an employee contracts out individually, full contributions are still paid but a rebate is given in the form of a transfer to his or her alternative pension arrangement.
The Pension Credit is a benefit designed to ensure that all people of retirement age have a total income of a specified minimum amount. In 2006/07, Pension Credit guarantees a minimum income of £114.05 per week to a single person and £174.05 to a couple. Like the state pensions, this amount is expected to increase each year to take account of inflation.
Test your knowledge and understanding with these questions
Take a break before using these questions to assess your learning across Section 1. Review the text if necessary.
Answers can be found at the end of this unit.
1. What are the four main elements of financial intermediation, as practised by banks and building societies?
2. How does a mutual organisation differ from a proprietary organisation?
3. Who issues UK banknotes?
(a) The Bank of England.
(b) The Treasury.
(c) The Royal Mint.
4. What is the effect on UK law of European Union directives?
5. Karen was born in the United States while her mother, Laura, (born and bred in England) was working there on a two-year assignment. Her father was American but he and Laura never married, and she returned to England with Karen. What is Karen’s domicile?
6. Which of the following is not subject to income tax?
(a) Income from a trust.
(b) A waiter’s tips.
(c) Educational scholarships.
7. What classes of National Insurance contributions are paid by self-employed persons?
8. What rate of inheritance tax is payable on chargeable lifetime transfers?
9. How much Stamp Duty Land Tax is payable by a woman who sells her house for £395,000?
10. It is possible to influence a nation’s level of economic activity by manipulating the amount of tax revenue and the amount of spending by the government, local authorities and public bodies. What is the name for this kind of economic policy?
11. What is the maximum term for which Maternity Allowance can be paid?
12. What is the minimum period per week that must be spent as a carer before Carer’s Allowance can be claimed?
(a) 25 hours.
(b) 30 hours.
(c) 35 hours.
Answers
1. Geographic location; aggregation; maturity transformation; risk transformation.
2. Mutual organisations have no shareholders but are owned by their members.
3. (a) The Bank of England.
4. The objectives of the directive must be implemented in each state, including the UK, within a specified timescale, typically two years. The choice of exactly how they are implemented is left to national authorities in each state.
5. Her domicile of origin is the domicile of her mother at the date of her birth (not the domicile of the father, since they were not married). This is probably UK domicile, although we don’t know for certain without knowing more about Laura’s parents.
6. (c) Educational scholarships.
7. Subject to specified minimum profits levels, Class 2 and Class 4.
8. 20%.
9. None. Stamp Duty Land Tax (like all forms of stamp duty) is paid by the purchaser.
10. Fiscal policy.
11. 26 weeks.
12. (c) 35 hours.
Financial assets
Introduction
Few people today hold their financial wealth in cash. While we still sometimes read of people with large quantities of notes and coins stored in their homes, this is increasingly rare. At the very least they generally keep their money mainly in bank and building society accounts. Many people have wealth stored in the form of property, such as houses or works of art.
When people have more money than they need to spend immediately, they lend to invest it with a view to making a profit, thus becoming part of the chain of intermediation described in Section 1.1.1.
Section 2 looks at a range of what might be described as direct investments, as distinct from indirect investments in financial assets (eg collective investments such as unit trusts), which are covered in Section 3.
Section 2 covers part 2 of the syllabus for Unit 1. The assets covered in Section 2 are deposit-type investments, fixed-interest securities such as gilts and corporate bonds, shares (and other forms of corporate financing) and property. We describe the nature of each type of asset, with its features and benefits, its advantages and drawbacks, and how it is affected by taxation of income and capital gains.
Deposit-based investments are those in which the capital element is fixed but the income from the investment may vary.
Investors place money in deposit-based savings accounts for a number of reasons. Some consider their capital to be secure. In one respect this is true, ie the amount of capital invested remains intact, but inflation reduces the value of capital and, in times of high inflation, the value of their deposits can quickly be eroded in real terms.
There is also the risk of loss of capital if the institution becomes insolvent. This is rare with banks and building societies, but is not unknown. In the event of insolvency, investors may be able to reclaim some of their funds through the Financial Services Compensation Scheme.
The convenience of the ready accessibility of banks and building societies is a strong reason for investors to deposit money with them; it is believed that, to some extent, inertia inhibits an investor’s search for a more rewarding home for their deposits.
If the reason for saving or investing money is for a short-term purpose (next year’s holiday or a new car, perhaps) then few would argue that a deposit-based savings account is a sensible place in which to invest the money. It is prudent to have a part of an investment portfolio that is easily accessible in, for example, a no-notice deposit account; this is often referred to as money put by for a ‘rainy day’. Institutional investors maintain a part of each of their funds in readily accessible form.
In general, banks offer three types of interest-bearing account:
• deposit accounts;
• money-market deposit accounts;
• interest-bearing current accounts.
These are among the most straightforward types of account that banks offer. Depositors (whether individuals or corporate bodies) can invest from as little as £1 with no maximum, and receive a return on their investment in the form of interest.
Interest is normally variable and is usually linked to the bank’s base lending rate. It is calculated daily and added to the account on a periodic basis (ie quarterly, half-yearly or yearly).
Some deposit accounts offer higher interest rates provided that a certain minimum investment is made. Deposits can be subject to notice of withdrawal, with the typical notice period being seven days. Often the requirement for notice will be waived subject to a penalty, which is normally equal to the amount of interest that could be earned over the notice period.
Deposit accounts may be considered as an investment of funds kept for an emergency or otherwise in case of need. Over the longer term, however, they have proved to be unattractive when compared with asset-backed investments.
2.1.1.2 Money-market deposit accounts
These accounts usually attract a higher rate of interest than ordinary deposit accounts. The rate of interest reflects current money-market interest rates and may vary according to the amount invested. There are two basic types of money-market account: fixed accounts and notice accounts.
• Fixed accounts are term deposit accounts, where a sum of money is invested for a fixed period during which time it cannot normally be withdrawn. This period can vary from overnight to five years. The rate of interest is normally fixed for the whole period.
• Notice accounts have no fixed term but, as the name implies, there is a requirement of the investor to give an agreed period of notice of withdrawal. Similarly, the bank must normally give the investor the same period of notice of a change in interest rate. A typical period of notice could be anything from seven days to six months, although 12-month notice periods are available.
Money-market deposit accounts may be suitable for individuals with very large amounts of cash to place on short-term deposit until they commit the cash to other purposes.
2.1.1.3 Interest-bearing current accounts
Interest-bearing current accounts provide an investor with immediate access to his funds without loss of interest. These accounts provide a range of services such as a cheque book and guarantee card, cashpoint facilities and overdrafts.
Interest-bearing current accounts for the mass market are a relatively recent phenomenon and have developed as a result of increased competition between the banks and building societies. Interest rates on current accounts are generally very low although higher rates may be available on accounts processed through telephone call centres or the Internet.
Many banks have for several years, offered high-interest cheque accounts. As the name implies, higher rates of interest are available with these accounts that, as a consequence, have higher minimum levels of investment, typically from £1,000 to £10,000. These accounts are normally free of charges subject to the minimum balance being maintained. Some accounts, however, allow only a limited number of cheques to be drawn in a given period without charge.
Interest paid on bank deposit accounts has tax deducted at a rate of 20%. If the gross interest rate is, for example 4%, the actual net rate received is 3.2%. Lower and basic rate taxpayers have no further liability. Higher rate taxpayers will be liable for an additional 20%.
Interest can be paid gross if the depositor declares that he is a non-taxpayer by completing form R85. Alternatively, non-taxpayers can reclaim any tax deducted and 10% taxpayers can reclaim the additional 10%.
2.1.2 Building society accounts
Building society accounts have long been the home for investors’ surplus funds. They have offered competitive rates of interest in various types of account such as ordinary share accounts, high-interest-bearing accounts and term accounts. The main difference between a bank and a building society is in their legal structure. Building societies are mutual organisations and are owned by their members (investors with share accounts and borrowers), whereas banks are limited companies owned by their shareholders.
• Ordinary share accounts offer instant access without penalty but pay a lower interest rate than notice accounts.
• Notice accounts offer access to money within 7, 30, 60 or 90 days. Societies may allow immediate access to these accounts but will usually charge a penalty equal to the interest earned over the notice period.
Tiered interest rates are often available on building society accounts. Basically, the larger the investment, the higher the rate paid, but should the investment level fall into a lower tier, the interest rate will be reduced.
In addition, building societies may offer monthly income facilities on all their accounts. For this facility, it is a usual requirement to have a higher minimum level of investment.
Building societies, along with banks, provide the appropriate investment for those investors who have short-term investment needs but also require immediate access to their funds.
Currently, all building society deposit accounts subject to tax are taxed the same way as bank deposit accounts (see Section 2.1.1.4).
The term ‘offshore’ is usually applied to any investment medium, whether bank or building society account or other form of investment, which is based outside the UK in countries that offer a more advantageous taxation of investments. Such countries, sometimes referred to as tax havens, include the Channel Islands, Luxembourg and the Cayman Islands.
Offshore investment can potentially expose the investor to greater risk than a similar onshore investment. Firstly, the account may not be denominated in sterling and will therefore be at risk of adverse currency movements if the investment is to be converted back to sterling at some point. Secondly, not all offshore accounts are protected by investor protection schemes. Investors should check what protection is available through local regulatory regimes.
Offshore investments may be useful to an investor who needs money to be available outside the UK, eg someone who owns a property abroad or who plans to move abroad in the future.
The interest on an offshore deposit will be paid gross. A UK resident must declare the income to HM Revenue and Customs. A person who is UK resident when they invest their money can avoid paying tax on their overseas investments if they let the returns roll up and withdraw the money at a point in the future when they have become non-resident. An example of this might be someone who retires and goes to live abroad.
There are specific rules governing whether or not an individual is resident or non-resident as far as his liability to UK taxation is concerned (see Section 1.3.3.1). Care should be taken to determine an investor’s residential status.
Individual savings accounts (ISAs) are a form of tax-efficient personal savings scheme. ISAs can take a number of forms, which are described in Section 3.2.4.
One form of ISA is the cash ISA: it is basically a means of obtaining tax-free interest on a bank or building society deposit account, subject to certain limits and regulations. National Savings and Investments also offer a cash ISA.
The maximum investment in a cash ISA is currently £3,000 per tax year. For further details, see Section 3.2.4.
2.1.5 National Savings and Investments
National Savings and Investments (NS&I) offer a range of saving and investment products on behalf of the government. The risk associated with the products is very low because all products guarantee the return of any capital invested.
There are NS&I products to suit most types of investors, with different terms, interest rates and taxation. Full details of the range of deposit-based savings and investments offered can be obtained from the Post Office or by visiting the National Savings and Investments website at www.nsandi.co.uk.
A brief summary of the main products is included below.
2.1.5.1 Easy access savings account
This is a ‘card and PIN’ based account. It has a tiered interest-rate structure and interest is paid gross but is taxable. It is available to anyone aged 11 or over, subject to a minimum balance of £100.
This account may be opened by anyone over the age of seven and, for those under this age, a parent or legal guardian may open the account.
The account pays a variable rate of interest at rates that are tiered in seven levels, from under £500 to £50,000 and beyond. The interest is paid gross but is liable to income tax.
Income bonds offer regular monthly income. The income bond has no term and capital can be withdrawn at any time, but subject to three months’ notice or loss of interest in lieu.
The interest rates are variable and are tiered according to the amount of money invested. Interest is paid gross but is liable to income tax and must be declared.
This is a lump-sum investment on which the interest rate is guaranteed for one, two or five years at a time. The bonds offer a monthly income that is paid gross but which is liable to tax. They are available to men and women over the age of 60.
The capital bond is a lump-sum investment with a five-year term.
Interest is added to the capital at rates guaranteed at the time of the initial investment. The interest rates increase over the five years so, in order to obtain the maximum guaranteed rate, it is necessary to hold the bond for the full five years.
Interest is paid gross but is taxable and should be declared each year on the investor’s tax return. The investor is liable for income tax on the interest each during those years that the bond is not cashed in.
These bonds carry a fixed rate of interest over a choice of terms: currently one, three or five years.
The interest rate is guaranteed for the term chosen at the outset and will then be reset at the end of the term; the investor can choose whether to withdraw their money or leave it invested for a further term. Interest is paid net of basic rate tax at 20%. Higher rate taxpayers will have to pay an additional 20% tax.
Savings certificates are of two main types: fixed-interest and index-linked. The fixed-interest certificates pay a fixed rate of interest throughout the chosen term of two years or five years. The index-linked certificates (currently available in three-year and five-year terms) differ in that their value increases with inflation as well as offering interest.
The certificates are available for investments of between £100 and £15,000.
Interest is paid gross and carries no liability to personal income or capital gains tax. Certificates are therefore particularly attractive to higher rate taxpayers. At the current interest rate on fixed-interest certificates, ie 2.95%, the equivalent gross rate to a basic rate taxpayer is 3.69%, and 4.92% to a higher rate taxpayer.
Premium bonds provide investors with a regular draw for tax-free prizes, while they retain the right to cash in the bond.
The minimum purchase price is £100 and the maximum is £30,000 per person. Prizes are drawn each month and can be worth up to £1 million. Winnings from premium bonds are tax-free.
The bonds can be encashed at any time, subject to eight working days’ notice.
2.1.5.9 Children’s bonus bonds
The children’s bonus bond is a single premium investment intended to be retained for at least five years. Anyone over 16 may purchase a bond for anyone under 16. The bond should be encashed no later than the child’s 21st birthday because no interest is payable after that age.
The interest rate is fixed for the first five years and a bonus is added on the fifth anniversary. A final bonus is added on the child’s 21st birthday.
Gilt-edged securities (commonly known as gilts) are British government securities and represent borrowing by the government. Gilts are safe investments because the government will not default on interest or capital repayments.
A gilt is categorised primarily according to the length of time left to run until its redemption. The redemption date is the date on which the government must buy back the gilt at its original issue value or par value, normally quoted as a nominal £100. Each gilt pays interest on the par value at a fixed interest rate known as the coupon.
Most gilts have a specific redemption date; some have two dates between which there will be redemption on a date selected by the government, at its discretion.
The categories are as follows:
• short-dated gilts: also known as shorts, these are gilts with less than five years to run before redemption;
• medium-dated gilts: also known as mediums, these are gilts with between 5 and 15 years to run before redemption;
• long-dated gilts: also known as longs, these are gilts with over 15 years to run before redemption;
• undated gilts: gilts with no redemption date at all are redeemable at any time subject to the government’s discretion. The government is, however, under no obligation ever to redeem them.
Index-linked gilts are gilts where the interest payments and the capital value move in line with inflation. The redemption value and the interest paid are therefore index-linked. For the investor this means that the purchasing power of his capital and interest received will remain constant, unlike all other fixed-interest stock where inflation erodes the purchasing power of fixed-interest payments.
A gilt-edged stock with a coupon of 5% and a redemption date in 2021 might be designated as ‘Treasury 5% 2021’.
Interest on gilts is normally paid half-yearly, so the holder of £10,000 nominal of Treasury 5% 2021 would receive £250 in interest every six months. The interest is paid gross, but is subject to income tax at the investor’s highest rate.
Gilts cannot be redeemed by investors prior to the redemption date but can be sold to other investors. The price at which they are sold depends on a number of factors: the level of market rates of interest; nearness to the redemption date; supply and demand.
Gilt prices are quoted either cum dividend or ex dividend. If a stock is bought cum dividend, the buyer acquires the stock itself and the entitlement to the next interest payment. If, however, the stock is bought ex dividend, then while the buyer acquires the stock itself, the forthcoming interest payment will be payable to the previous owner of the stock (ie the seller).
Any capital gains made on the sale of gilts are entirely free of capital gains tax (CGT).
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Example An higher rate taxpayer buys £100,000 par value of Treasury 5% 2019 at a price of 80.0, ie he pays £80,000 for the stock. He receives annual interest of £5,000 (actually £2,500 per half year), which represents a yield of 6.25% on his investment of £80,000. The interest is paid gross but he must pay interest of 40% on it, leaving him with net annual interest of £3,000. Later he sells the stock for £90,000. There is no capital gains tax to pay on his gain of £10,000. |
Like the government, local authorities can borrow money by issuing stocks or bonds, which are fixed-term, fixed-interest securities. They are secured on local authority assets and offer a guaranteed rate of interest, paid half-yearly. The interest is paid net of the basic rate of income tax (20%). Higher rate taxpayers are liable for a further 20% tax and non-taxpayers can reclaim any tax paid. The bonds are not negotiable and have a fixed return at maturity.
Return of capital on maturity is guaranteed but these are not quite as secure as gilts since there is no government guarantee.
2.2.3 Permanent interest-bearing shares
Permanent interest-bearing shares (PIBS) are issued by building societies to raise capital. They pay a fixed rate of interest on a half-yearly basis.
Interest is paid net of 20% tax. Basic and lower rate taxpayers have no further liability; higher rate taxpayers are liable for an additional 20%; non-taxpayers can reclaim.
PIBS are irredeemable and are bought and sold on the Stock Exchange. It is possible for investors to make capital gains and losses and there is no certainty that investors will get all their capital back. There is no capital gains tax payable on any gains made.
Investors should also note that PIBS rank below ordinary accounts in priority of payment, should a society become insolvent.
Corporate bonds are similar in nature to gilt-edged stocks, but they represent loans to commercial organisations rather than to the government. They normally have a fixed redemption date, a specified redemption value and a fixed interest rate, and – like gilts – they can be bought and sold at prices that reflect market rates of interest.
They are considered higher risk than gilts because they do not have government backing, and they therefore tend to offer higher yields.
2.3 Equities and other company finance
When companies need to raise money in order to commence or to expand their business, there are various ways in which this can be done. Section 2.2.4 above introduced corporate bonds, which are one way of borrowing money for a fixed period at a fixed rate of interest. Other types of loan, either secured or unsecured, can also be used and the most common way for companies to be funded is through the issue of shares. These methods of company financing are described in the following sections.
Ordinary shares, also known as equities, are the most important type of security that UK companies issue. They can be, and are, bought by private investors, but by far the largest proportion of transactions in equities are made by institutions and by life and pension funds.
Holders of ordinary shares (shareholders) are in effect the owners of the company. The two main rights that they have are:
• to receive a share of the distributed profits of the company in the form of dividends;
• to participate in decisions about how the company is run, by voting at shareholders’ meetings.
The rights attaching to shares of the same class can sometimes differ from company to company, even though the shares normally have the same major characteristics. It is therefore prudent for investors to find out precisely what rights attach to a particular share. These rights are given in the company’s Articles of Association, which is a public document and can be examined at the registered office of the company or at Companies House.
Direct investment in shares is considered to be high risk because the failure of the company can result in the loss of all the capital invested. This risk can be mitigated by investing across a range of shares and the products available to facilitate this (such as unit trusts and investment trusts) are described in Section 3.2.
The prices at which shares are traded depend on a range of factors, including:
• the profitability of the individual company;
• the strength of the market sector in which it operates;
• the strength of the UK and worldwide economies;
• supply and demand for shares and other investments.
In the short term, share prices can fluctuate both up and down – sometimes quite spectacularly – but in the long term, investment in equities and equity-linked markets has outpaced inflation and has provided higher growth than deposit-type investments.
2.3.1.1 Buying and selling shares
The Stock Exchange has been London’s market for stocks and shares for hundreds of years. Government stock, share capital and loan capital, overseas shares and options are all traded on this market.
There are two markets for shares: the main market (for which full listing is required) and the Alternative Investment Market.
The main market allows companies to be quoted on the Exchange if they conform to the stringent requirements of the Listing Rules laid down by the FSA, acting in its capacity as the UK Listing Authority (UKLA).
For a full listing (ie a listing of the main market), a considerable amount of financial and other information is required to be disclosed accurately. In addition:
• the applicant company must have been trading for at least three years;
• at least 25% of its issued share capital must be in the hands of the public.
2.3.1.1.2 Alternative Investment Market (AIM)
The Alternative Investment Market, which started in 1995, is an additional, separate market on the London Stock Exchange. It is mainly intended for new, small companies with the potential for growth.
Its purpose is to enable suitable companies to raise capital by issuing shares and it allows those shares to be traded. In addition to the benefit of access to public finance, companies will enjoy a wider public audience and enhance their profiles by joining the AIM.
Rules for joining the AIM are fewer and less rigorous than those necessary to join the official list (the main market) and were designed with smaller companies in mind.
Shareholders in a limited liability company do not have a liability for the debts of the company. The company has a separate legal identity and is itself liable for its debts. Shareholders do, however, run the risk that the value of their investment in the company could go down or even, in the event of a liquidation, be lost altogether. In line with the broad rules of risk and return, therefore, it might be expected that the potential for high returns would also be a feature of the share market. It is certainly true that, on average and over the longer term, equity markets have far outpaced the returns available on secure deposit-based investments.
2.3.1.2.2 Assessment of financial returns
The financial returns that shareholders hope to receive from their shares are of two forms: the growth in the share price (capital growth) and the dividends they receive as their share of the company’s distributable profits (income). There are a number of measures that can be used to assess the success of investment in a company’s shares and to predict future performance. Some of these measures are as follows.
• Earnings per share: this is equal to the company's net profit divided by the number of shares, but it is not normally the amount of dividend to which a shareholder is entitled on each of his or her shares. This is because a company may choose not to distribute all of its profits: some profits may be retained in the business to finance expansion, for instance. This in turn leads to the concept of dividend cover.
• Dividend cover: this factor indicates how much of a company's profits are paid out as dividends in a particular distribution. If, for example, 50% of the profits are paid in dividends, the dividend is said to be covered twice. Cover of 2.0 or more is generally considered to be acceptable by investors, whereas a figure below 1.0 indicates that a company is paying part of its dividend out of retained surpluses from previous years.
• Price/earnings ratio: as its name suggests, the P/E ratio, as it is commonly known, is calculated as the share price divided by the earnings per share. It is generally considered to be a useful guide to a share's growth prospects: a ratio of 20 or more, for example, indicates that a share is doing well and can be expected to increase in value in the future. Such a share is likely, as a result, to be relatively more expensive than others within the same market sector. A low ratio – less than about 4 – indicates that the market feels that the share has poor prospects of growth.
Dividends are received by shareholders net of 10%, with a tax credit equal to the amount deducted. Non-taxpayers cannot reclaim this deduction; lower rate and basic rate taxpayers have no further liability, but higher rate taxpayers have to pay sufficient additional tax to bring their tax paid up to the special higher rate applicable to dividends (32.5% of the grossed-up dividend).
This extraordinary system was introduced to smooth out the effect of the abolition of advance corporation tax (ACT) from 6 April 1999.
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Example • An investor who is a higher rate taxpayer receives a net dividend of £900 from shares in a UK company. • The grossed-up dividend is £1000. • She must pay a further 22.5% of the gross dividend, ie a further £225. |
Gains realised on the sale of shares are subject to capital gains tax (CGT), although investors may be able to offset the gain against their annual CGT exemption allowance.
Dividends are usually paid half-yearly. Because of the administration involved in ensuring that all shareholders receive their dividends on time, the payment process has to begin some weeks before the dividend dates. A ‘snapshot’ of the list of shareholders is made at that point, and anyone who purchases shares between then and the dividend date will not receive the next dividend (which will be paid to the previous owner of the shares). During that period, the shares are said to be ex-dividend (or xd). The share price would normally be expected to fall by approximately the dividend amount on the day it becomes xd.
The Stock Exchange Daily Official List gives the closing prices of all listed securities on the previous day. The Financial Times produces daily lists of the share prices of most companies, making it easy to check up-to-date share prices.
It is possible to measure the overall performance of shares by using one or more of the various indices that are produced. These include, among others:
• Financial Times Ordinary Share Index (FT Index): this is an index of 30 major industrial companies’ shares, which represent around one-quarter of the market value of UK equities;
• FTSE 100 Index (commonly known as the ‘Footsie’): this is an index of the top 100 companies in capitalisation terms. Each company is weighted according to its market value;
• FTSE Actuaries All-Share Index: this is an index of around 900 shares, split into sectors. It measures price movements and shows a variety of yields and ratios as well as a total return on the shares.
2.3.1.6 Rights issues and scrip issues
• Rights issue: Stock Exchange rules require that, when an existing company that already has shareholders wishes to raise further capital by issuing more shares, those shares must first be offered to the existing shareholders. This is done by means of a rights issue offering, for example, one new share per three shares already held, generally at a discount to the price at which the new shares are expected to commence trading. Shareholders who do not wish to take up this right can sell the right to someone else, in which case the sale proceeds from selling the rights compensate for any fall in value of their existing shares (due to the dilution of their holding as a proportion of the total shareholding).
• Scrip issue: also known as a bonus issue or a capitalisation issue, this is an issue of additional shares, free of charge, to existing shareholders. No additional capital is raised by this action – it is achieved by transferring reserves into the company's share account. The effect is to increase the number of shares and to reduce the share price proportionately.
2.3.1.7 Preference shares and other shares
• Preference shares: like ordinary shares, holders of preference shares are entitled to dividends payable from the company's profits. Preference dividends are generally at a fixed rate; in the payment hierarchy, they rank after loan interest but ahead of ordinary share dividends. Many preference shares are cumulative preference shares, which means that if dividends are not paid, entitlement to dividends is accumulated until such a time as they can be paid. Preference shares do not normally carry voting rights but, in some cases, holders may acquire voting rights if their dividends have been delayed.
In the event of winding up a company, preference shares rank behind loans but ahead of ordinary shareholders' claims.
• Convertibles: these are securities, issued by companies to raise capital, which carry the right to be converted at some later date to ordinary shares of the issuing company. Traditionally they were issued in a form that effectively made them a loan (with a lower rate of interest than conventional debt because of the right to convert to equity) but, in recent years, they have been increasingly issued as convertible preference shares.
As well as issuing shares, companies can seek loans for use in their business. They can borrow from banks or other lenders. They can also issue what are known as loan stocks and debentures. These types of borrowing are usually over the longer term, which helps the company to make long-term business plans. Loan stocks and debentures are issued on specified terms, including the rate of interest payable by the issuing company (and when that interest is payable) and the redemption date. They are usually issued at a fixed rate of interest.
Loan stocks and debentures are essentially the same, that is, borrowings by the company on certain terms, but, as is the case with shares, it is important to ascertain the precise rights and obligations of a particular borrowing. Broadly speaking, loans that are secured in some way – perhaps on the company’s property – are normally referred to as debentures, while those that are not are simply called loan stocks.
Some loan stocks are issued that give the holder the right to convert the loan into ordinary shares of the issuing company. There is no obligation to do so and if the option is not exercised the loan continues unchanged.
Interest rather than dividends is payable on both types of debt and normally should be payable whether or not sufficient profit has been made by the company. The holders of these types of debt are creditors of the issuing company and so, in a winding-up, take priority over the shareholders. On the other hand, the loan stock and debenture holders do not have the right to vote at company meetings.
The interest on stock is paid net of 20% tax. Basic and lower rate taxpayers have no further liability; higher rate taxpayers are liable for a further 20%; and non-taxpayers can reclaim.
The risk inherent in these types of debt is related to the viability of the issuing company, its prospects and strength. Loan stocks have a greater level of risk than debentures because they do not have the backing of security.
In broad terms, investment in property falls into three categories:
• residential;
• agricultural;
• commercial and industrial.
The vast majority of investors will only ever be involved in residential property. For most people this does not extend beyond the purchase of their own home, although an increasing number of people are buying residential properties specifically as an investment.
Property investment has a number of benefits and advantages, including:
• property is a very acceptable form of security for borrowing purposes;
• the UK property market is highly developed and operates efficiently and professionally;
• rents (and therefore capital values) tend to move with money values and consequently provide a good hedge against inflation;
• professional property management services are readily available.
On the other hand, there are a number of pitfalls and disadvantages of which inexperienced investors in particular should be made aware, including:
• the risk of being unable to find suitable tenants or that tenants will prove to be unsuitable;
• location is of paramount importance and a badly-sited development may prove a problem;
• the property market is affected by overall economic conditions – in times of recession, lettings may be difficult and property prices may fall;
• property is less readily marketable than most other forms of investment;
• investment costs tend to be high – including management fees, legal charges and stamp duty.
As with direct investment in shares, direct investment in property can be a risky business for the small investor, although the advent of buy-to-let mortgages (see Section 2.4.2 below) has made it easier. For smaller amounts of capital and for those who wish to spread the risk, there are property bonds where the underlying fund is invested in a range of properties and shares in property companies.
Income from property, after deduction of allowable expenses, is subject to income tax. It is treated as earned income for tax purposes, ie the basic rate of tax is 22%. On the disposal of investment property, any gain will be liable to capital gains tax (CGT); but any capital expenditure on enhancement of the property’s value can be offset against taxable gains.
Despite some dramatic falls from time to time, the overall trend in UK house prices over the last 30 years has been strongly upwards. The early 2000s saw dramatic rises in the price of property in the UK. One unfortunate consequence of this is that young people and other first-time buyers now find it difficult to afford to purchase a property, especially in the South-East of England, which has seen significant increases. In times of economic downturn, this effect is worsened by an uncertain job market that makes it difficult for people to commit to large mortgages.
The situation can be eased if there is a reasonable supply of good quality properties to rent but, traditionally, the UK has had a shortage of private rental property – much less than in most other European countries, for instance. There are a number of reasons for this, not least of which are:
• historically, lenders viewed loans to buy property to let as being commercial rather than residential loans – even if the property was to be let for residential purposes. This meant higher rates of interest than for standard mortgage loans on owner-occupied property;
• rental income was traditionally excluded from a borrower's income when assessing his or her ability to make the mortgage repayments.
Buy-to-let is an initiative designed to stimulate growth in the private sector of the rental market. The aim is to encourage private investors to borrow at competitive interest rates with a view to investing in rental property that should give them a reasonable expectation of sustained income and capital growth. Lenders involved in this scheme will now take potential rental income into account and will charge interest rates broadly in line with those for owner-occupation mortgages.
The scheme is the result of a joint initiative by the Association of Residential Letting Agents (ARLA) and mortgage lenders. Alliance and Leicester, Halifax and NatWest were instrumental in the early stages, although many more banks and building societies now offer buy-to-let mortgages.
This change in policy results from the knowledge that a buy-to-let scheme will be professionally managed. For many schemes, it is a requirement that an agent who is a member of ARLA should be involved in:
• selecting suitable properties;
• selecting suitable tenants;
• arranging appropriate tenancy agreements (normally Assured Shorthold Tenancies);
• managing the properties.
Gross rents for buy-to-let properties are typically 150% of the monthly mortgage payments. There are of course other costs, such as agents' commission/fees, insurance and maintenance costs.
Rental income is subject to income tax but the cost of insurance, agents’ fees, maintenance etc, can be offset as a deduction against tax. The initial cost of furniture, fixtures and fittings cannot be deducted, but a wear and tear allowance of 10% per year may be allowed.
Investment in commercial property covers almost anything that is not defined as wholly ‘residential’. This includes:
• individual retail shops;
• shopping arcades and shopping centres;
• offices;
• industrial units, ie factories, workshops and storage units;
• hotels and leisure resorts;
• mixed-use property – shops/offices, perhaps including a residential element.
Commercial property tends to provide reasonably high rental income together with, in general, steady growth in capital value.
The main advantages are:
• regular rent reviews, with typically no more than five years between each;
• longer leases than for residential property;
• more stable and longer-term tenants;
• typically lower initial refurbishment costs;
Drawbacks may include the following:
• the higher average value means that spreading the risk is more difficult;
• commercial property does not generally show the spectacular growth in value that can sometimes be achieved in residential property;
• if the investment is to be funded by borrowing, interest rates may be higher than for residential loans.
Lenders often carry out detailed investigations before lending for the purchase of commercial property, checking on:
• the quality of the land and property;
• the reputation of builders, architects and other professionals involved;
• the suitability of likely tenants.
Test your knowledge and understanding with these questions
Take a break before using these questions to assess your learning across Section 2. Review the text if necessary.
Answers can be found at the end of this unit.
1. To what extent can deposit accounts be said to be ‘secure’?
2. What rate of interest, if any, is normally deducted at source from building society accounts?
(a) None.
(b) 10%.
(c) 20%.
3. Give two reasons why offshore investments may be more risky than similar onshore products.
4. What is the minimum age at which a man can take out a National Savings and Investments pensioners’ bond?
(a) 50.
(b) 55.
(c) 60.
5. What is the difference between the taxation of interest on government stocks and on that of local authority stocks?
6. The price/earnings (P/E) ratio of a share indicates the relationship between the share’s current price and the most recently declared dividend. True or false?
7. How can a company raise additional finance for expansion without borrowing?
8. What is the normal distinction between debentures and other loan stocks?
9. What change of attitude by lenders led to the establishment of the buy-to-let market?
10. What type of tenancy agreement would normally be used for a buy-to-let property?
Answers
1. Apart from the small chance of a bank or building society failing, the capital is secure, but the real value of the capital will be eroded by inflation. The amount of interest could fall on variable interest accounts.
2. (c) 20%.
3. If not denominated in sterling, the value of capital and income will be subject to currency fluctuations. The local regulatory regime may not be as strong as that of the FSA in the UK.
4. (c) 60.
5. Interest on government stocks is normally paid gross (but it is taxable), whereas that on local authority stocks is paid net of 20% tax.
6. False. It relates price to the earnings (net profits) per share. Profits are not necessarily all distributed as dividends.
7. By a rights issue of new shares to existing shareholders.
8. Debentures are normally secured on company assets.
9. Lenders began to treat buy-to-let business as residential rather than commercial, applying different underwriting principles and lower interest rates.
10. Assured Shorthold Tenancy.
Financial products
Introduction
This section contains a review of the main products designed to help customers to solve their financial problems and to meet their financial needs and objectives.
Here we concentrate on ‘packaged’ products supplied by product providers such as banks, insurance companies and investment managers. The products considered include collective investments, derivatives, life assurance, general insurance, mortgages and other loans, and pension policies.
Section 3 covers the topics listed in part 3 of the syllabus for Unit 1, ie the main financial services product types and their functions.
The main forms of direct investment, ie cash, current and deposit accounts, fixed interest stocks, shares and property, are described in Section 2.
Collective or pooled investments are arrangements whereby individual small investors can contribute – by means of lump sums or regular savings – to a large investment fund. Pooled investments offer a number of advantages to individual investors:
• the services of a skilled investment manager are obtained at a cost that is shared among the investors. Individual investors do not need to research particular companies – or do they need to understand and deal with occurrences such as rights issues;
• investment risk can be reduced because the investment manager spreads the fund by investing in a large number of different companies – so that, if one company fails, the whole investment is not compromised. Such a spread could not normally be achieved with small investment amounts;
• fund managers handling investments of millions of pounds can negotiate reduced dealing costs for their investors;
• there is a wide choice of investment funds, catering for all investment strategies, preferences and risk profiles.
Investment funds can be categorised in a number of ways, for example:
• by location, eg UK, Europe, America, Far East;
• by industry, eg technology, energy;
• by type of investment, eg shares, gilts, fixed interest, property;
• by other forms of specialisation, eg recovery stocks, ethical investments.
Many funds are based on more than one categorisation, eg a UK equity fund.
Most companies also offer one or more managed funds. This is an unfortunate choice of name, since it seems to imply that other funds are not managed. Nevertheless, the name has become accepted as applying to the type of fund where its managers sometimes invest appropriate proportions in a range of the company's other funds to meet the managed fund's objectives. Most managed funds are middle-of-the-road in terms of risk profile, and are often chosen by people seeking steady market-related growth in situations where risk of loss needs to be kept to a minimum, such as pension provision or mortgage repayment.
A further categorisation is possible: into funds that aim to produce a high level of income (perhaps with modest capital growth); those that aim for capital growth at the expense of income; and those that seek a balance between growth and income.
The main forms of collective investment are:
• unit trusts;
• investment trusts;
• investment bonds; and
• open-ended investment companies (OEICs).
Although they may appear broadly similar to the unsophisticated investor, they are in fact very different, both in the way they operate and in the taxation treatment of both the fund managers and the investors.
A unit trust is a pooled investment created under trust deed. An investor may contribute to a unit trust by way of a lump sum or regular contributions, or a combination of both. Unit trusts have been particularly successful in attracting investment from individuals in the UK, with total funds under management of the order of £200 billion.
The unit trust will be divided into units, with each unit representing a fraction of the trust’s total assets. A unit trust is open-ended in the sense that a manager can, in response to demand, create more units.
The trust deed places obligations on both the manager and the trustee.
3.2.1.1 The role of the unit trust manager
The manager is responsible for:
• managing the trust fund;
• valuing the assets of the fund;
• fixing the price of units;
• offering units for sale;
• buying back units from unitholders.
The manager is obliged, under the terms of the trust deed, to buy back units from investors who wish to sell them, and he will generate profit from charging management fees and dealing in the units.
The trustees have an overall responsibility to ensure investor protection. To enable this to happen they have a number of duties:
• to set out the trust’s investment directives;
• to hold and control the trust’s assets;
• to ensure that adequate investor protection procedures are in place;
• to approve proposed advertisements and marketing material;
• to collect and distribute income from the trust’s assets;
• to issue unit certificates to investors;
• to supervise the maintenance of the register of unit-holders.
The trustees have a policing role to ensure that the manager complies with the terms of the trust deed. The role of trustee is often carried out by an institution such as a clearing bank or life company.
3.2.1.3 Authorisation of unit trusts
Unit trusts are primarily regulated in the UK under the terms of the Financial Services and Markets Act 2000, and have to be authorised by the Financial Services Authority (FSA).
To price the fund, the manager will calculate the total value of trust assets, allowing for an appropriate level of costs, and then divide this by the number of units that have been issued. The prices at which units are bought and sold are calculated by the managers on a daily basis using a method specified in the trust deed. The unit prices are directly related to the value of the underlying securities that make up the fund.
There are three important prices in relation to unit trust transactions:
• the offer price is the price at which investors buy units from the managers;
• the bid price is the price at which the managers will buy back units from investors who wish to cash in all, or part, of their unit-holding;
• the cancellation price is the minimum permitted bid price, taking into account the full costs of buying and selling. At times when there are both buyers and sellers of units, the bid price is generally above this minimum level, since costs are reduced because underlying assets do not need to be traded.
Many unit trusts still use bid and offer prices, with the difference between them (known as the bid offer spread) being of the order of 5% or 6%. Some unit trust managers, however, are moving to a single-price system because they believe that this is better understood by investors. In this case, they may impose an exit charge if units are sold within, say, three or five years of purchase.
3.2.1.4.1 Historic and forward pricing
A significant change in the pricing of units took place in 1988. Prior to that time, clients bought or sold at prices determined before the start of the dealing period – typically the previous day's valuation. (If a fund's daily valuation takes place, for example, at noon, the dealing period is from midday on one day to midday on the following working day.) This system, known as historic pricing, is now considered unacceptable because prices clearly do not reflect what is happening in the market: an investor might telephone for a price and complete a purchase, just before the newly calculated daily price is published, knowing that the market has risen in the meantime.
Concern about historic pricing led to the introduction of the system known as forward pricing, which is now standard practice for unitised funds. Under forward pricing, clients buy or sell in a given dealing period at the prices that will be determined at the end of the dealing period. The prices published in the financial press are therefore only a guide to investors, who do not know the actual price at which their deal will be made.
Fund managers are still permitted to use historic pricing if they wish, subject to the proviso that they must switch to forward pricing if an underlying market in which the trust is invested has moved by more than 2% in either direction since the last valuation.
3.2.1.4.2 Buying and selling units
Unit trust managers are obliged to buy back units when investors wish to sell them. There is consequently no need for a secondary market in units and they are not traded on the Stock Exchange. This adds to the appeal of unit trusts to the ordinary investor, for whom the buying and selling of units is a relatively simple process.
• Units can be bought direct from the managers or through intermediaries. They can be purchased in writing or by telephone: all calls to the managers' dealing desks are recorded as confirmation that a contract has been established.
• Purchasers receive two important documents from the managers:
– the contract note: this specifies the fund, the number of units, the unit price and the amount paid. It is important because it gives the purchase price, which will be needed for capital gains tax (CGT) purposes when the units are sold;
– the unit certificate: this specifies the fund and the number of units held, and is the proof of ownership of the units.
• In order to sell some or all of the units, the unit-holder signs the form of renunciation on the reverse of the unit certificate and returns it to the managers. If only part of the holding is to be sold, a new certificate for the remaining units is issued.
There are two types of charges applied to unit trusts:
• the initial charge that will cover the costs of purchasing fund assets and the commission payments to intermediaries such as IFAs. The initial charge is typically covered by the bid-offer spread;
• the annual management charge, which, as its name suggests, is the fee paid for the use of the professional investment manager. The charge varies but is typically between 0.5% and 2% of fund value. Although an annual fee, it is commonly deducted on a monthly or daily basis.
Unit trusts may offer the following units:
• accumulation units, which automatically reinvest any income generated by the underlying assets. This would suit someone looking for capital growth;
• distribution or income units will split off any income received and distribute it to unitholders. The units may also increase in value in line with the value of the underlying assets.
3.2.1.7 Taxation of unit trusts
Authorised unit trusts, other than fixed interest trusts, are treated as companies for tax purposes and, as such, are subject to corporation tax on income (though not on growth within the fund).
Dividend income received by the trust will already have borne tax at 10%; the unit trust has no further liability on such income.
• When the income is paid out to unitholders, it is treated as having borne tax at 10%.
• A non-taxpayer is not able to reclaim the 10% tax already deducted.
• Lower rate and basic rate taxpayers need take no further action because the 10% tax already deducted is deemed to satisfy their tax liability on the income.
• Higher rate tax payers have a further liability of 22.5% of the gross income distribution, ie on the income paid plus the 10% tax deducted at source. Thus the total liability for a higher rate taxpayer is 32.5%.
So, a distribution of £18 net received by a unit-holder is equivalent to gross income of £20. If the unit-holder is a higher rate taxpayer, a further £4.50 tax will be payable through self-assessment.
Income from overseas securities, cash and fixed-interest securities is subject to corporation tax at a rate of 20%. This will mean that when this income is paid out:
• non-taxpayers can reclaim the tax that has been deducted;
• lower rate taxpayers can reclaim half the tax deducted (ie they are only liable to tax at 10% and therefore can reclaim 10%);
• basic rate taxpayers have no additional liability;
• higher rate taxpayers must pay a further 20% of the gross dividend.
So, in this case, a distribution of £40 net received by a unit-holder is equivalent to gross income of £50. If the unit-holder is a higher rate taxpayer, a further £10 tax will be payable through self-assessment. A non-taxpayer can reclaim the £10 deducted.
No capital gains tax is levied within the unit trust, but the investor may be liable to capital gains tax on any gain made when units are encashed. The annual exemption allowance, the indexation allowance and taper relief, if applicable, can be used to reduce any liability to capital gains tax.
The legal constitution of a unit trust helps to mitigate risk of fraud because the trustees have responsibility to ensure there is proper management.
Given the nature of a unit trust as a pooled investment, the risk will be lower than that of an individual investing directly into equities on their own behalf. Unit trust funds will typically invest in a spread of between 30 and 150 different shares.
The actual risk will depend on the type of unit trust selected. The wide range of choice means that there are unit trusts to match most investors’ risk profiles. A cash fund will carry similar risks to a deposit account, specialist funds such as emerging markets are high risk by their very nature and overseas funds carry the added risk of currency fluctuations.
Unit trusts provide no guarantee that the initial capital investment will be returned in full or that a particular level of income will be paid.
Investment trusts are collective investments but, unlike unit trusts, they are not unitised funds. Furthermore – despite their name – they are not even trusts. They are in fact public limited companies whose business is investing (in most cases) in the stocks and shares of other companies. Investing in an investment trust is achieved by purchasing shares of the investment trust company on the Stock Exchange; similarly, in order to cash in the investment, it is necessary to sell these shares to another investor. As with all companies, the number of shares available remains constant, so an investment trust is said to be closed-ended (in contrast to the open-ended nature of unit trusts).
The share price of an investment trust obviously depends to some extent on the value of the underlying investments, but not so directly as in the case of a unit trust. The price can depend on a number of other factors that affect supply and demand. In many cases, the share price of an investment trust is less than the net asset value (NAV) per share; the NAV per share is the total value of the investment fund divided by the number of shares issued. This situation – referred to as being at a discount – means that an investor should achieve greater income and growth levels than would be obtained by investing directly in the same underlying shares.
One advantage of being constituted as a company is that an investment trust can benefit from gearing: this means that, like all companies, it can borrow money in order to take advantage of business opportunities (in their case, investment opportunities). This avenue is not open to unit trusts, which are not permitted to borrow. Gearing enables investment trusts to enhance the growth potential of a rising market, but investors should be aware that it can equally accentuate losses in a falling market. This factor led to some high-profile difficulties for certain investment trusts in the volatile stock market of the early 2000s.
3.2.2.1 Taxation of investment trusts
The taxation situation is broadly the same as that described for unit trusts. At least 85% of the income received by investment trust fund managers must be distributed as dividends to shareholders, who receive them net of 10%, with a tax credit. As with all share dividends, lower rate and basic rate taxpayers have no further liability, but higher rate taxpayers pay the balance of the special rate of 32.5% of the grossed-up dividend.
Fund managers are exempt from tax on capital gains, but investors are subject to capital gains tax on the sale of their investment trust shares.
3.2.2.2 Split-capital investment trusts
Sometimes known as split-level trusts or simply as splits, split-capital investment trusts are fixed-term investment trusts offering two or more different types of share. The most common forms of share offered by split-level investment trusts are:
• income shares, which receive the whole of the income generated by the portfolio but no capital growth;
• capital shares, which receive no income but which – when the trust is wound up at the end of the fixed term – share all the capital growth remaining after fixed capital requirements have been met.
Recent innovations have seen the introduction of intermediate types of shares, offering different balances of capital and income.
3.2.2.3 Real estate investment trusts
Real estate investment trusts (REITs – pronounced ‘reets’ to avoid confusion with rights) are tax-efficient property investment vehicles that allow private investors to invest in property while avoiding many of the disadvantages of direct property investment (see Section 2.4).
REITs will be available in the UK from January 2007. Similar schemes are already very successful in a number of countries, particularly the USA and Australia.
A summary of the main UK features of REITs is as follows:
It is expected that many property companies will convert into REITs – although this will be subject to a one-off charge of 2% of the value of their assets.
3.2.3 Open-ended investment companies (OEICs)
Open-ended investment companies (OEICs) have been popular in mainland Europe for a number of years and have been available in the UK since 1997. They share a number of characteristics with unit trusts and investment trusts. The similarity with unit trusts is not surprising, as there is a high degree of commonality between the Financial Services Authority’s two sets of regulations on OEICs and unit trusts.
OEICs are a pooled investment offered by a company that buys and sell the shares of other companies and deals in other investments. The OEIC will issue shares – typically participating redeemable preference shares – that can be bought and sold by investors.
Although operating as a company, an OEIC cannot borrow money to finance its activities other than for short-term purposes, unlike an investment trust.
3.2.3.1 Legal constitution of an OEIC
An OEIC is established under company law, not under trust. OEICs must be authorised by the FSA.
The role of overseeing the operation of the company and of ensuring that it complies with the requirements for investor protection is carried out by a depository, who will be authorised by the Financial Services Authority. The role of the depository is much the same as the trustee of a unit trust.
An authorised corporate director, whose role is much the same as the manager of a unit trust, manages the OEIC. The role of the corporate director is to:
• manage the investments;
• buy and sell OEIC shares as required by investors;
• ensure that the share price reflects the underlying net asset value of the OEIC’s investments.
The range of OEICs is similar to that of unit trusts. OEICs are available that offer: income; capital growth; fixed interest; access to overseas markets; access to specialist markets (eg commodities, technology or healthcare); index tracking.
As with unit trusts and investment trusts, investments can be made either by lump sum, regular contribution or a combination of both.
Investors will buy shares in the OEIC. The number of shares that are available is unlimited so the OEIC is, as the name would suggest, open-ended like a unit trust, rather than closed-ended like an investment trust. The value of the shares will vary according to the market value of the company’s underlying investments.
An OEIC may be structured as an ‘umbrella’ company that is made up of several sub-funds. Different types of share can be made available within each sub-fund.
3.2.3.3 Pricing of OEIC shares
The basic procedure for establishing the share price is the same as that for determining the unit price in a unit trust: the total value of OEIC assets will be established and then divided by the number of shares currently in issue.
There are, however, some differences in pricing when OEICs are compared to unit trusts. OEIC shares carry only one price, not a separate bid and offer price as for units in a unit trust.
• Initial charge: as already mentioned, OEIC units are single-priced so there is no bid offer spread. An OEIC will levy an initial charge, however, normally in the region of 3% to 6% of the value of the individual’s investment.
• Annual management charge: annual management charges based on the value of the fund are deducted, normally from the income that the OEIC generates. The range of annual management charges is typically between 0.5% for indexed funds and 2% for more actively managed funds.
Other administration costs may also be deducted from the income that is generated.
The tax treatment of OEICs is exactly the same as that for unit trusts and investment trusts.
Any dividend distribution will be paid net of tax at 10% and:
• a non-taxpayer cannot reclaim the tax;
• lower and basic rate taxpayers have no further tax liability;
• higher rate taxpayers must pay a further 22.5% of the gross dividend.
The fund managers are not subject to tax on capital gains, although a liability to CGT may arise for the investor when the OEIC is encashed. The amount of any CGT liability can be mitigated by use of the annual exemption, taper relief and the indexation allowance (if applicable).
The risks associated with investing in an OEIC are similar to those of investing in a unit trust. As a pooled investment employing the services of professional investment managers, the degree of risk is lower than direct equity investment. Risk is also mitigated by the spread that can be achieved for a relatively small investment. There is, however, no guarantee of the maintenance of the original capital invested or the level of income that will be generated.
3.2.4 Individual savings accounts (ISAs)
In 1997, the government decided that the existing tax-free savings schemes were not sufficiently accessible to a large proportion of the population. It was estimated that 50% of the population of the UK had less than £200 in savings, with about 25% having no savings at all. The government subsequently introduced, from 6 April 1999, the individual savings account (ISA). Its stated objectives are to develop the savings habit and to ensure that tax relief on savings is fairly distributed.
The government stated that ISAs would be available in their initial form for at least ten years (until 2009), with a review being held after seven years (in 2006) to consider possible changes to the scheme. In 2005 it was announced that ISAs would definitely remain available until 2010.
There are now two possible components of new investments into ISAs:
• stocks and shares (or equity) ISAs: this component can include:
– shares and corporate bonds issued by companies listed on stock exchanges anywhere in the world;
– gilt-edged securities and similar stocks issued by governments of countries in the EEA;
– UK-authorised unit trusts that invest in shares and securities;
– UK open-ended investment companies (OEICs);
– UK investment trusts – except for those investing in property;
• cash ISAs, including:
– bank and building society deposit accounts;
– certain taxable National Savings and Investments (NS&I) accounts – excluding the investment account and pensioners' bonds. NS&I also offers a deposit account-type ISA.
An earlier third type of component – life assurance – is no longer available for new investments, but existing life assurance ISAs can remain in force.
The minimum age for investing in an equity ISA is 18 years, but a cash ISA can be opened by anybody aged 16 or over. An ISA investor must be both resident and ordinarily resident in the UK for tax purposes, and an ISA can only be held in a single name, ie joint accounts are not permitted, although husbands and wives can have one each.
Investors are exempt from income and capital gains tax on their ISA investments. Prior to 5 April 2004, fund managers of equity ISAs could reclaim the 10% deduction from UK share dividends but this benefit has now been withdrawn. Fund managers are exempt from tax on other income and gains received for the benefit of ISA investors.
The maximum overall subscription to an ISA is £7,000 per tax year, of which up to £3,000 can be in the cash element. The full £7,000 can be placed in the stocks and shares element (provided that this done through a maxi-ISA – see Section 3.2.4.4). The maximum in a stocks and shares mini-ISA is £4,000 and the maximum in a cash mini-ISA is £3,000. There is no statutory minimum investment but individual ISA providers may set their own minimum levels.
Many ISAs allow no-notice withdrawals to be made, although there are now some fixed-rate cash ISAs available that do not permit withdrawals during the fixed-rate period. It is not possible to replenish withdrawals made during a particular tax year. For example, if an investor paid in £3,000 to open a cash mini-ISA on 20 November 2006 and then withdrew £2,000 on 25 March 2007, he could not add any further money to the account during the 2006/07 tax year because he would have already invested the maximum allowance of £3,000 during that tax year.
Each year, savers have two options: either to take an ISA with a single manager who offers an account that can accept the full subscription (a maxi-ISA) or to go to separate managers for each of two components (mini-ISAs). The rules surrounding these choices are complex and seem contrary to the government's stated aim of making the scheme accessible to less sophisticated investors.
3.2.5 Life assurance-based investment products
The most common form of savings contract offered by life assurance companies is the endowment assurance, which is, broadly speaking, a policy on which the sum assured is paid out at the end of a specified term or on the earlier death of the life assured (although some policies are open-ended and allow policyholders to choose when to receive the proceeds of their investment). The client's investment is made in the form of regular premiums to the life assurance company throughout the term of the policy. There are a number of variations, the most common of which are as follows.
3.2.5.1.1 Non-profit endowment
This policy has a fixed sum assured, which is payable on maturity (ie at the end of the policy term) or on earlier death. Because the return is fixed and guaranteed, the investor is shielded from losses due to adverse stock market movements; on the other hand, he is equally unable to share in any profits the company might make over and above those allowed for in calculating the premium rate (hence the name: ‘non-profit’). For that reason, non-profit policies are rarely used today.
3.2.5.1.2 With-profit endowment
Like its non-profit equivalent, a with-profit endowment has a fixed basic sum assured and a fixed regular premium. The premium, however, is greater than that for a non-profit policy of the same sum assured, and the additional premium (sometimes called a bonus loading) entitles the policyholder to share in the profits of the life assurance company.
The company distributes its profits among policyholders by annually declaring bonuses that become part of the policy benefits and are payable at the same time and in the same circumstances as the sum assured. There are two types of bonus.
• Reversionary bonuses: these are normally declared each year and, once they have been allocated to a policy they cannot be removed by the company. Some companies declare a simple bonus, where each annual bonus is calculated as a percentage of the sum assured; others declare a compound bonus, with the new bonus being based on the total of the sum assured and previously declared bonuses. Most companies set their reversionary bonuses at a level that they hope to be able to maintain for some time, in order to smooth out the short-term variations of the stock markets, but with the level of interest rates and other investment yields falling in recent years, bonus rates in general have also been falling. In spite of this, with-profit policies have produced much better returns in the long run than non-profit policies.
• Terminal bonuses: these are bonuses that may be added to a with-profit policy when a death or maturity claim becomes payable. Unlike reversionary bonuses, a terminal bonus does not become part of the policy benefits until the moment of a death or maturity claim, thus allowing the company to change the terminal bonus rate – or even remove the terminal bonus altogether. Terminal bonuses are intended to reflect the level of investment gains that the company has made over the term of the policy, so the rate of bonus often varies according to the length of time that the policy has been in force. In the current climate of reduced stock market values, many companies have reduced the level of their terminal bonuses.
A variation of the with-profit endowment, known as a low-cost endowment, is sometimes used for mortgage repayment purposes (see Section 3.5.1.3.1.1).
3.2.5.1.3 Unit-linked endowment
The first unit-linked policies were issued in the late 1950s and represented a revolutionary change in the way in which policies were designed. The development reflected the desire of many policyholders to link investment returns more directly to the stock market, or even to specific sectors of the market.
Unit-linked endowments work on the basis that, when a premium is paid, the amount of the premium – less any deductions for expenses – is applied to the purchase of units in a chosen fund. A pool of units gradually builds up and, at the maturity date, the policyholder receives an amount equal to the total value of all units then allocated to the policy. Most unit-linked endowments also provide a fixed benefit on death before the end of the term. The cost of providing this life cover is taken from the policy each month by cashing in sufficient units from the pool of units.
Over the longer term, the most successful unit-linked endowments have shown better returns than with-profit endowments. Unlike with-profit endowments, however, unit-linked policies do not provide any guaranteed minimum return at maturity; they are, therefore, a good illustration of the maxim that greater potential return generally goes hand-in-hand with the acceptance of greater risk.
3.2.5.1.4 Unitised with-profit endowments
Unitised with-profit endowments have been available since the late 1980s, when they were introduced in an attempt to combine the security of the with-profit policy with the greater potential for reward offered by the unit-linked approach. As with unit-linking, premiums are used to purchase units in a fund and the benefits paid out on a claim depend on the number of units allocated and the then-current price of units.
The difference from a standard unit-linked policy lies in the fact that unit prices increase by the addition of bonuses which, like the reversionary bonuses on a with-profit policy, cannot be taken away once they have been added. This means that unit prices cannot fall and the value of the policy, if it is held until death or maturity, is guaranteed. If the policy is surrendered (ie cashed in before its maturity date), however, a deduction is made from the value of the units. This deduction, the size of which depends on market conditions at the time of the surrender, is known as a market value adjustment (MVA).
Investment bonds are collective investment vehicles based on unitised funds. Because of the unitised structure of their funds, they may appear similar to unit trusts, but they are actually very different.
Investment bonds are available from life assurance companies and are set up as single-premium unit-linked whole-of-life assurance policies. Investing in a bond is achieved by paying the single (lump sum) premium to the life company. The investor then receives a policy document that shows that the premium has purchased (at the offer price) a certain number of units in a chosen fund and that those units have been allocated to the policy. In order to cash in the investment, the policyholder accepts the surrender value of the policy, which is equal to the value of all the units allocated, based on the bid price on the day when it is surrendered.
Investors are attracted by the relative ease of investment and surrender, by the simplicity of the documentation and also by the ease of switching from one fund to another: companies generally permit switches between their own funds without charging the difference between bid and offer prices.
The range of available funds is similar to those offered by unit trusts and investment trusts. In addition, some companies offer with-profits investment bonds, in which premiums are invested in a unitised with-profits fund (see Section 3.2.5.1.4). If a with-profits bond is cashed in within a specified period after commencement (typically five years), the amount received is likely to be less than the value of the units.
In the event of the death of the life assured, the policy ceases and a slightly enhanced value (often 101% of the bid value on the date of death) is paid out.
The funds in which the premiums are invested are internal life company funds and their tax treatment is different from that of unit trusts. In particular, they attract tax at 20% on capital gains (whereas unit trust funds are exempt) and this tax is not recoverable by investors even if they themselves have a personal exemption from capital gains tax. The taxation system for policy proceeds in the hands of the policyholder is complex but, broadly speaking, because gains have been taxed at 20% within the fund, tax on the gain is payable only by higher rate taxpayers, and then only at 20% – the excess of the higher rate over the 20% already deemed to have been paid within the fund. This is because investment bonds are non-qualifying policies (see Section 1.3.3.2.7).
Unlike investment trusts and unit trusts, investment bonds do not normally provide income in the form of dividends or distributions, but it is possible to derive a form of ‘income’ from them by making small regular withdrawals of capital (by cashing in some of the units allocated to the policy.). These withdrawals are tax-free to basic rate taxpayers, and even higher rate taxpayers can withdraw up to 5% of the original investment each year without incurring an immediate tax liability. This 5% allowance can, if not used, be carried forward and accumulated up to an amount of 100% of the original investment.
The Child Trust Fund is a tax-free savings account for children born on or after 1 September 2002. It is automatically available to all children for whom Child Benefit is payable and is an attempt by the government to encourage saving on behalf of (and perhaps eventually, by) children.
A summary of the main characteristics of the Child Trust Fund (CTF) is as follows.
• Each individual CTF begins with an initial payment of £250 (or sometimes more, see below) provided by the government in the form of a voucher, sent automatically to the Child Benefit claimant, who is usually, but not always, one of the parents. Only children living in the UK are eligible.
• If the child‘s family is eligible for the full Child Tax Credit (see Section 1.3.5.2.4), the initial payment is increased to £500.
• The parent or carer then uses the voucher to open a CTF account with a CTF provider. The voucher can be used only to open a CTF. The account remains in force until the child’s 18th birthday, at which point the child has access to the money in the account and can use it for any purpose they wish. There is no access to this money (or any added later) before the child’s 18th birthday.
• The parent remains responsible for the CTF until the child is 16, after which the child can manage their own account.
• There is a wide range of CTF providers, including banks, building societies, friendly societies and other financial institutions.
• There are three broad types of CTF:
– deposit-type savings accounts;
– accounts that invest directly or indirectly in shares;
– stakeholder CTF accounts.
• Stakeholder CTF accounts invest in a range of company shares, subject to certain government rules designed to reduce the risk. From the child’s 13th birthday, the money will gradually be moved to lower risk assets to protect it from stock market losses as the child’s 18th birthday approaches.
• The maximum annual charge permitted on a stakeholder CTF is 1.5%. There is no limit on charges on other types of CTF.
• Parents have 12 months in which to choose the type of account and the provider. If the voucher has not been used to open an account within 12 months of issue, a stakeholder account will automatically be opened by HM Revenue and Customs on behalf of the child.
• Parents (and other family, or even friends) can make additional investments into a CTF. The maximum additional investment in each CTF will be £1,200 per year (ie the year between the child’s birthdays).
• Neither the parent nor the child will be subject to tax on income or capital gains from the CTF. There is, however, no tax relief on any amounts invested into the CTF.
Very few aspects of life are entirely free from some element of risk and most people have some form of insurance to protect them against the financial effects of adversity. In some cases, it is compulsory – for instance, third party liability for drivers of motor vehicles on public roads. In many other cases it is wise to insure against the loss of (or damage to) items that are too valuable to replace out of normal income, such as a house and its contents. Similarly, most families need protection against unforeseen events that would deprive them of their sources of income, such as the untimely death or serious illness of a main breadwinner.The examples mentioned above illustrate the two main types of insurance available: general insurance and life assurance.
3.3.1 Life assurance protection
3.3.1.1 Whole-of-life assurance
A whole-of-life assurance is, as the name implies, designed to cover the life assured for the whole of that lifetime. It will pay out the amount of the life cover in the event of the death of the life assured, whenever that death occurs, provided that the policy remains in force.
Premiums may be:
• payable throughout life (ie for the full term of the policy, whatever that turns out to be); or
• limited to a fixed term (eg 20 years) or to a specified age (such as 60 or 65).
If limited premiums are chosen, the minimum term is normally ten years.
Because a whole-of-life assurance (unlike a term assurance) will definitely pay out sooner or later, life companies build up a reserve to enable them to pay out when the life assured dies. This enables companies to offer surrender values on whole-of-life policies that are cancelled by the client before death has occurred. These surrender values are, however, generally small in relation to the sum assured. In fact, in the early years of a policy, the surrender value will be less than the premiums paid. This emphasises the fact that whole-of-life policies are protection policies and not investment plans.
Whole-of-life policies can be taken out on a number of different bases:
• non-profit;
• with-profit;
• unit-linked;
• unitised with-profit;
• low-cost;
• flexible;
• universal.
The principles of non-profit, with-profit, unit-linked and unitised with-profit are described in Section 3.2.5.1. The others are described below.
3.3.1.1.1 Low-cost whole-of-life
A low-cost or minimum-cost whole-of-life policy has a sum assured that is payable on death whenever it occurs. It is however, made up of two elements: a whole-of-life with-profits plus a decreasing term assurance.
The basic whole-of-life with-profits sum assured is lower than overall level of cover required, with bonuses being added as the policy continues. A guaranteed death benefit is offered and, while the whole-life with-profits increases with the addition of bonuses, the shortfall is made up by a decreasing term assurance. Once the basic sum assured plus bonuses increases beyond the guaranteed death benefit, the decreasing term assurance element ceases.
This policy is suitable for anyone seeking maximum life cover on a permanent basis at minimum cost.
3.3.1.1.2 Flexible whole-of-life
When whole-of-life policies are issued on the unit-linked basis, they are generally referred to as flexible whole-of-life.
The flexibility to which the name refers lies in the fact that these policies can offer a variable mix between their life cover and investment content. The key to this flexibility is the method of paying for the life cover by cashing in units at the bid price:
• the policyholder pays premiums of an amount that he wishes to pay – or feels that he can afford to pay;
• the premiums are used to buy units in the chosen fund or funds, and these units are allocated to the policy;
• the policyholder selects the level of benefits that he wishes to have:
The flexibility of the system, under which benefits are paid for by cashing units, means that other options are often available. These include an option to take income, indexation of benefits (for automatic adjustment of death benefits) and the ability to add another life assured.
Although it can have a high level of investment, a flexible whole-of-life assurance should never be thought of primarily as a savings vehicle, but rather as a protection plan that could be adapted to investment if circumstances changed.
Most companies offer three main levels of cover on their flexible whole-of-life policies (although it is usually possible to choose other levels in between):
• maximum cover: this is normally set at such a level that cover can be maintained for ten years but, after that point, all the units will have been used up and increased premiums will be needed if the cover is to continue;
• minimum cover: a minimum level of life cover is maintained – probably the minimum required for the policy to remain qualifying – and the number of units attaching to the policy builds up to a substantial investment element;
• balanced cover: this is the level of cover, for a given premium, which the company expects to be able to maintain throughout the life assured’s lifetime.
To calculate the various levels of cover, the company makes an assumption about the future growth rate of unit prices.
In all cases, the initial life cover is guaranteed for a certain period, often ten years. Beyond that point, the company reserves the right to increase the premiums or to reduce the cover – to take account of increases in costs or to allow for the fact that unit prices have not grown as quickly as had been assumed. The death benefit is then guaranteed until the next review.
Further reviews are usually undertaken at five-yearly intervals, or even annually with older lives assured, and adjustments may again be made. The need for such reviews is the price that clients have to pay for the flexibility of the system. In fact, the reviews are beneficial to the client because they reveal possible shortfalls at any early stage, when they can be rectified before the cost becomes prohibitive.
3.3.1.1.3 Universal whole-of-life assurance
The flexibility of unit-linked whole-of-life is sometimes extended further by adding a range of other benefits and options to the policy. When that is done, the policy is usually referred to as universal whole-of-life. Benefits and options that may be added include:
• permanent health insurance;
• critical illness cover;
• accidental death benefit;
• total and permanent disability cover;
• hospital benefits or other medical cover;
• guaranteed insurability (to increase cover);
• indexation of benefits;
• flexibility of premium levels;
• waiver of premium during periods of inability to pay due to, for instance, disability or unemployment.
Most of the additional benefits will be at extra cost, the additional cost being met by cashing more units.
Whole-of-life policies are appropriate to those circumstances where the need is for a sum of money to be paid on the death of an individual, whenever that death may occur. Like all protection policies, therefore, their overall benefit is that they provide peace of mind. They can be used in personal and business situations, and for certain taxation purposes.
The uses of whole-of-life policies include the following:
• to protect dependants against loss of financial support in the event of the death of a breadwinner;
• to provide a tax-free legacy;
• to cover expenses on death;
• to provide funds for the payment of inheritance tax.
3.3.1.1.5 Joint-life second-death policies
When a whole-of-life policy is used to provide the funds likely to be needed to pay inheritance tax (IHT), it is normal to use a whole-of-life policy that will pay out on the death of the survivor of the husband and the wife (known as a joint-life second-death policy or a last survivor policy).
The reason for this is that, in most families, the estate of the first spouse to die passes to the surviving spouse (free of IHT), and the IHT becomes due only when the surviving spouse dies and the estate passes to the family or to others.
There is a wide variety of term assurances available, but they all share one common characteristic: that the sum assured is payable only if the death of the life assured occurs within a specified period of time (the term).
Term assurance is the most basic form of life assurance – pure protection for a limited period with no element of investment. For this reason, it is also the cheapest.
Term assurance can be used for personal and family protection and also for a wide range of business situations. Business use includes the provision of key person insurance, to protect against the loss of profits resulting from the death of an important employee, and partnership insurance schemes, to enable surviving partners to buy out the share of a partner who has died.
Other characteristics shared by term assurances are as follows:
• the term can be anything from a few months to, say, 40 years or more (for terms that end after age 65, it may be better to take out a whole-of-life policy instead);
• if the life assured survives the term, the cover ceases and there is no return of premiums;
• there is no cash value or surrender value at any time;
• if premiums are not paid within a certain period after the due date (normally 30 days), cover ceases and the policy lapses with no value. Most companies will allow reinstatement within 12 months provided all outstanding premiums are paid and evidence of continued good health is provided;
• premiums are normally paid monthly or annually, although single premiums (one payment to cover the whole term) are also allowed;
• premiums are normally level (the same amount each month or year), even if the sum assured varies from year to year.
There are a number of basic types of term assurance and a number of options that can be included. These are described below.
3.3.1.2.1 Level term assurance
With level term assurance, the sum assured remains constant throughout the term. Premiums are normally paid monthly or annually throughout the term, although single premiums can be paid.
Level term assurance is often used when a fixed amount would be needed on death to repay a constant fixed-term debt such as a bank loan.
It can also be used to provide family cover, for instance, until the children leave home. If it is used for that purpose, the policyholder should bear in mind that the amount of cover in real terms would be eroded by the effect of inflation.
3.3.1.2.2 Decreasing term assurance
The sum assured reduces to nothing over the term of the policy. Premiums may be payable throughout the term, or may be limited to a shorter period such as two-thirds of the term.
This policy could be used to cover the outstanding capital on a decreasing debt.
Two particular kinds of decreasing term assurance are:
• mortgage protection assurance: the most common use of decreasing term assurance is to cover the amount outstanding on a repayment mortgage. It is usually known as a mortgage protection policy. Be careful not to confuse this with short-term sickness and redundancy cover for mortgage repayments, which is sometimes also referred to as mortgage protection insurance.
The sum assured on mortgage protection assurance is calculated in such a way that it is always equal to the amount outstanding on a repayment mortgage of the same term, based on a specified rate of interest. The sum assured (like the mortgage) decreases more slowly at the start of the term than towards the end;
• gift inter vivos cover: decreasing term assurances can be arranged to cover special requirements. An example of this is gift inter vivos cover. A gift inter vivos means a gift made during a donor’s lifetime (as distinct from on his death). Under the inheritance tax rules, no tax is immediately due when such a gift is made from one person to another but does become due if the donor dies within seven years of making the gift. The amount of tax due is scaled down from the fourth year onwards.
The cover on a gift inter vivos term assurance is designed to provide an amount sufficient to pay the IHT due when a donor dies within seven years of making a gift. To achieve this, the sum assured is set, at the start of the policy, to the amount of the tax due. It remains at that level for three years, and then reduces to 80% in the fourth year, 60% in the fifth, 40% in the 6th and 20% in the seventh year. Cover ceases at the end of the seventh year, at which point liability for IHT has ceased.
3.3.1.2.3 Increasing term assurance
Some companies offer increasing term assurance policies where the sum assured increases each year by a fixed amount or a percentage of the original sum assured.
This type of policy can be used where temporary cover of a fixed amount is required but where the cover needs to increase to take some account of the effects of inflation on purchasing power.
3.3.1.2.4 Convertible term assurance
A convertible term assurance is a term assurance that includes an option to convert the policy into a whole-of-life or endowment assurance without further evidence of health (or indeed any additional underwriting). This guaranteed insurability means that no medical or other evidence is required and the conversion is carried out at normal premium rates whatever the state of health of the life assured.
The cost of this option is an addition, typically of around 10% of the premium.
The option is normally included only on level term assurance policies but there is no technical reason why it should not be included on decreasing term assurances and others.
Certain rules and restriction apply to the conversion option:
• the conversion is normally carried out by the time of cancellation of the term assurance and the issue of a new whole-of-life or endowment policy. A new endowment can extend beyond the end of the original convertible term policy;
• the option can only be exercised while the convertible term assurance is in force;
• the sum assured on the new policy cannot exceed the sum assured of the original convertible term assurance: if a higher level of cover is required after conversion, the additional sum assured will be subject to normal underwriting;
• the premium for the new policy is the current standard premium for the new term and for the life assured’s age at the conversion date.
3.3.1.2.5 Renewable term assurance
A renewable term assurance policy includes an option, which can be exercised at the end of the term, to renew the policy for the same sum assured without the need for further medical evidence.
The new term is the same as the previous term and the new policy itself includes a further renewal option, except that there is a maximum age, usually around 65, after which the option is no longer available.
The premium for the new policy is based on the life assured’s age at the date when the renewal option is exercised.
Renewable and increasable term assurance: is similar to the renewable policy, with the added option on renewal to increase the sum assured by a specified amount – often either 50% or 100% of the previous sum assured, again without evidence of health.
Some companies offer renewable, increasable and convertible term assurances, combining all three of the options described above.
3.3.1.3 Family income benefits
The aim of family protection is often to replace income lost on the death of the breadwinner. A family income benefits (FIB) policy is designed meet this need by providing income rather than a lump sum.
The policy pays out a tax-free regular income (monthly or quarterly) from the date of death of the life assured until the end of the chosen term.
Since the cover reduces as time passes, this policy can be described as a form of decreasing term assurance.
As an alternative to regular income payments, beneficiaries may choose to receive a lump sum payment that will be calculated at a discounted value of the outstanding instalments.
Policies can be arranged with escalating instalments, to combat the effects of inflation. Since these provide higher levels of cover than ordinary FIBs, the premiums are also higher.
3.3.1.4 Term assurances available under pension arrangements
Persons who are eligible for personal pension plans and stakeholder pensions may be able to take out pension term assurance and obtain tax relief on the premiums within specified limits.
Occupational pension schemes are not obliged to provide life cover for employees (known as death-in-service benefit), but many do. Where an occupational scheme does not provide the maximum death-in-service benefit permitted by law, employees can choose to make up the difference with life cover effected through a free-standing additional voluntary contribution (AVC) plan.
Note: Since 6 April 2006 (A-Day), employees who are members of occupational pension schemes can also take out personal/stakeholder pension term assurance and receive tax relief on the premiums. Provided the total of death benefits from the employer and the term assurance remain within a certain limit (£1.5m in 2006/07) the benefits will be tax-free.
For further details of pensions products, see Section 3.6.
3.3.2.1 Critical illness cover
Critical illness cover (CIC) will provide a tax-free lump sum payment on diagnosis of one of a range of specified illnesses. The illness need not be terminal and one significant purpose of critical illness cover is to provide a lump sum to meet the additional costs that someone may face if they are diagnosed with a serious illness.
The range of illnesses and conditions covered varies from one insurer to another but would typically include the following:
• most forms of cancer;
• heart attack;
• stroke;
• coronary artery disease requiring surgery;
• major organ transplant;
• multiple sclerosis;
• kidney failure.
Other conditions that are sometimes covered are:
• paralysis;
• blindness;
• loss of limb(s).
Many policies also make provision for payment of the sum assured in the event of total and permanent disability. Again, the definition of total and permanent disability varies between companies. Some take it as being a total and permanent disability that prevents the policyholder from doing any job to which they are suited by virtue of status, education or experience. Other companies employ a tighter definition that requires that the disability prevents the person from doing any job at all.
Typical uses of critical illness cover are:
• provision of long-term care, either in hospital or in the home;
• alterations to living accommodation;
• purchase of specialised medical equipment, eg a kidney dialysis machine;
• mortgage repayment;
• improving the quality of life of a terminally ill person.
3.3.2.2 Permanent health insurance (PHI)
Permanent health insurance (PHI) pays an income when accident/illness prevents someone from earning a living by carrying out their normal occupation. It is designed to protect people who are working and who would lose part or all of their income if they were unable to work due to illness or accident.
Many companies also offer PHI to housewives/homemakers. This is because although they may not actually earn an income there is usually a clear need to provide income in the event of their illness. The income could then be used to pay for housekeeping or childminding fees if the homemaker is unable to perform these duties due to illness or accident.
A major factor in determining the premium to be charged is the occupation of the life insured. A typical classification of occupations by a PHI provider might be:
• Class 1: the lowest risk covering those in clerical, professional or administrative roles. Examples would include accountants and civil servants;
• Class 2: occupations carrying a low risk of an accident. Examples would include hairdressers and pharmacists;
• Class 3: occupations carrying a moderate risk of accident or health problems. Examples would be farmers or electricians;
• Class 4: occupations with the highest risk of a claim. There will be a substantial risk of health problems or the risk of accident arising from the occupation. Examples would include coal miners and industrial chemists.
Certain occupations will be excluded from PHI cover on the basis that they represent too great a risk.
The occupation class that a person is deemed to fall within will determine the level of premium (Class 1 occupations get the cheapest rates) and may also influence the terms on which cover is offered.
Other factors that will influence the premium rate are:
• the age of the life insured;
• the amount of benefit;
• current state of health;
• past medical history;
• the sex of the life insured (premiums are higher for women than men due to the fact that women have a higher morbidity rate, ie a higher risk of being ill during a specified period of time);
• the length of the deferred period (see below).
The payment of benefits commences after a deferred period. This is the amount of time that elapses between the onset of the illness/injury and the point at which benefits payments commence. Typical deferred periods are four,13, 26, 52 and 104 weeks. The minimum four-week deferred period is to prevent multiple claims for minor ailments such as colds.
A self-employed person, who typically would suffer a loss of income after a very short period of illness, should opt for a short deferred period. Conversely, an employed person may wish to opt for a long deferred period if they have sickness benefits paid by their employer. If this is the case, the deferred period should be set to match the date at which the employer’s sick pay ceases. The longer the deferred period chosen, the cheaper the premium will be.
Benefit levels are set so that the claimant is unable to receive a higher income when not working than they could from working. Typical maximum levels of income benefit are around 60% to 65% of pre-disability earnings less state Incapacity Benefit. These limits apply to total benefits from all PHI contracts held by the individual.
Benefits are paid pro-rata if illness means that a person can work but only part-time.
Cover is ‘permanent’ in the sense that the insurer cannot cancel the cover simply because the policyholder makes numerous claims. The policy could be cancelled, however, if the customer fails to keep up their premium payments or takes up a hazardous job or pastime.
Some policies will allow benefits to be indexed either before or during a claim. The rate of increase may be at a fixed rate, perhaps 3% to 7%, or based on a published measure of inflation.
Benefit is normally paid until death, return to work or retirement, whichever event occurs first.
PHI is available as a standalone policy, either as a pure protection plan or on a unit-linked basis. Additionally, PHI can be available as an option on a universal whole-of-life plan.
3.3.2.2.3 Taxation of PHI benefits
Where permanent health insurance is taken out on an individual basis the benefits are tax-free.
Permanent health insurance can be arranged by an employer on a group basis; in this case the income will be taxable and employer contributions are taxable as a benefit in kind in the hands of the employee.
3.3.2.3 Accident, sickness and unemployment insurance (ASU)
Accident, sickness and unemployment insurance (ASU) plans are a type of general insurance that may be considered as an alternative to PHI.
ASU insurance is typically used to cover mortgage repayments in the event that illness, accident or loss of employment prevents the policyholder from earning a living. A level of income equal to monthly mortgage repayments is paid for limited period, usually a maximum of two years.
Additional cover can sometimes be included to cover other essential outgoings.
As with permanent health insurance, there will be a deferred period, normally one month, which must elapse before benefit payments can commence. Lump sums may be paid on certain events (death, disablement, and loss of a limb).
In contrast to PHI, these plans should be viewed as short term to protect mortgage payments rather than as providing total protection of earned income.
It would be more accurate to describe these policies as accident, sickness and redundancy insurance, as they do not offer protection from unemployment when the insured is sacked, or resigns voluntarily. The policy will often include the following restrictions:
• the proposer must have been actively and continuously employed for a specified minimum period prior to effecting the plan;
• any redundancy that the proposer had reason to believe was pending when he took the policy out will be excluded;
• no benefit will be payable if redundancy occurs within a specified period of the cover starting;
• a person may have to have been employed for a minimum period time either before they can take out this type of plan or before the unemployment element of the plan becomes valid.
ASU policies are annually renewable at the discretion of the insurer. This means that the insurer could increase premiums in light of poor claims’ experience or may even withdraw the cover offered. This is a major difference from PHI.
3.3.2.3.1 Taxation of ASU policies
All benefits are tax-free but there is no tax relief on contributions to an ASU plan, regardless of whether it is arranged on a group or personal basis.
If the scheme is set up on a group basis, any employer contribution will be allowed as an expense against corporation tax. Any employer contribution will be classed as a benefit in kind for employees earning in excess of £8,500 pa (including the value of the benefit).
3.3.2.4 Private medical insurance
Private medical insurance (PMI) is a pure protection plan designed to provide cover for the cost of private medical treatment, thus eliminating the need to be totally dependent on the NHS.
Plans can be arranged on an individual basis or as part of a group scheme established by an employer. Employer-sponsored schemes currently account for the vast majority of PMI provision in the UK.
In a non-emergency situation, PMI can offer the following benefits:
• avoidance of NHS waiting lists;
• choice of hospital where the treatment will take place;
• choice of timing of the treatment (to fit in with work demands, for example);
• high-quality accommodation;
• choice of medical consultant.
The range of cover normally provided includes reimbursement of:
• inpatient charges, including nursing fees, accommodation, operating fees, drugs, and the cost of a private ambulance;
• surgical and medical fees including surgeon’s fees, anaesthetist’s fees, Pathology, and radiology;
• outpatient charges including consultations, pathology, radiology, and home nursing fees.
Some policies offer additional benefits such as the payment of a daily rate if treatment is delivered within a NHS hospital and involves an overnight stay.
The way in which benefits are paid varies between providers. Some will offer a full refund of charges with payment direct to the healthcare provider. Other plans impose an upper limit on the amount that can be reclaimed in any one year.
Premium rates depend on a number of factors, including the following:
• location – this is mainly because the cost of medical care varies throughout the country (costs are particularly expensive in London);
• type of hospital to which the individual is allowed access under the terms of the plan – again, treatment in the postgraduate teaching hospitals in London is more expensive and will be reflected in higher premiums;
• the standard of accommodation available to the patient under the terms of the plan will also influence the premium to be charged.
A major factor will be the type of scheme that is taken out. For example, many providers offer a budget scheme, which may limit the patient’s choice of hospital or require treatment on the NHS if the waiting list does not exceed a maximum period, eg six weeks. Any limit on the range of cover provided will reduce the premium payable. The limit may take the form of a financial limit on the amount of benefit that is provided or limits on the range of treatment covered.
One other significant factor is the age of the person applying for cover. The morbidity risk increases with age and consequently so does the probability of a claim being made under the terms of the plan.
Certain events will be excluded from cover under the scheme. Cover will not be provided for any pre-existing medical conditions, and other general exclusions are the costs of:
• routine optical care (such as provision of spectacles or lenses);
• routine dental treatment;
• routine maternity care;
• chiropody;
• the treatment of ailments that are self-inflicted, for example, the consequences of drug abuse and alcohol;
• cosmetic surgery;
• alternative medicine.
Premiums are subject to insurance premium tax but the benefits are paid out tax-free.
Employers who contribute to PMI on the behalf of their employees are able to claim the cost as an allowable deduction against corporation tax.
Contributions paid by an employer are regarded as a benefit in kind as far as the employee is concerned and may be taxable if the employee’s total income, including all benefits-in-kind, exceeds £8,500 per annum (including the value of the benefit).
3.3.2.5 Long-term care insurance
The purpose of long-term care insurance (LTC) is to provide the funds the meet the costs of care that arise at a point in later life, when a person is no longer able to perform competently some of the basic activities that are involved in looking after themselves each day and consequently requires assistance.
The need for this cover has increased because families are more spread out than in earlier generations and less able to take care of elderly relatives. The problem has also been increased by the fact that life expectancy has increased and people’s expectations for their quality of life in their later years are higher than ever. There has been increasing concern over the standard of care that state support and the NHS can realistically be relied upon to provide.
The amount of benefit paid from a LTC plan will depend on the degree of care required by the insured. This will be established by ascertaining the person’s ability to carry out a number of activities of daily living (ADLs).
Typical ADLs would be:
• washing;
• dressing;
• feeding;
• using the toilet;
• moving from room to room;
• preparing food.
Each LTC insurer will have its own definitions of what constitutes an inability to carry out an ADL. Many follow the definitions laid down by the Association of British Insurers.
The greater the number of ADLs that cannot be performed without assistance, the greater the amount of care required and therefore the higher the level of benefit that will be paid. It is normal for insurers to require that the person must be incapable of performing at least two or three of the ADLs before a claim can be accepted. A person need not be confined to a nursing home to receive LTC benefits: for example, a person may be unable to dress themself in the morning and prepare and eat food without assistance. Therefore, the range of support they would need may be limited to a person coming in at certain points during the day to help with those specific activities.
3.3.2.5.2 Taxation of benefits
In general, benefits will be payable either direct to the insured or to the organisation that is providing the care. In either case, the benefits are free of tax.
If the plan is established on a life of another basis, any cash benefits paid to the policyholder will be classed as income and will therefore be taxable.
Where the plan is investment-backed and involves the purchase of an annuity to fund the long-term care, income tax at a rate of 20% will be deducted from the annuity payment at source. A higher rate taxpayer will have a further liability of 20%.
General insurance includes all types of cover that are not defined as life assurance. The types of losses that are covered by general insurance can be categorised in five broad bands. The first two relate to both personal and commercial situations:
• property loss: this is the best-known category, covering loss, theft or damage to static and moveable assets – from diamond rings to houses to supertankers;
• liability loss: resulting from a legal liability to third parties, eg personal injury or damage to property.
The remaining three are restricted to commercial situations. They are:
• personnel loss (due to injury, sickness or death of employees);
• pecuniary loss (as a result of defaulting creditors);
• interruption loss (when a business is unable to operate due to one of the other losses occurring, eg because its premises have suffered fire damage).
Some policies may combine protection against two or more types of risk. Comprehensive motor policies, for example, cover damage to the policyholder’s property and to third parties’ property.
Before looking at some of the common types of general insurance, it is appropriate to mention some important principles and practices that apply to general insurance: these are indemnity, average and excess.
Unlike life assurance policies, general insurance policies are contracts of indemnity. The principle of indemnity is that ‘in the event of a claim, insured persons should be restored to the same financial position after a loss that they were in immediately before the loss occurred’. In particular this means that an insured person should not be able to benefit from the event that caused the loss.
Life and personal accident policies, on the other hand, are not contracts of indemnity. They are benefit policies since it is much more difficult to measure accurately in financial terms the impact of a loss of life or of a serious injury.
The choice of the method by which indemnity is achieved in a particular case is normally at the discretion of the insurance company. There are four main methods:
• cash (normally a cheque);
• repair (used very commonly with motor insurance);
• replacement – sometimes, the purchasing power of the insurer can reduce costs;
• reinstatement, for instance, where the insurance company may arrange for a damaged building to be restored to its former condition.
It is not uncommon for policyholders to underinsure: in other words, to insure for a smaller amount than is actually required to replace or repair the lost or damaged property. This may be because they are unaware of the appropriate figure or because inflation has increased the amount required, or it may be deliberate in order to keep the premium down.
In the event of a complete loss, ie where a whole house is destroyed by fire, the amount paid out would be limited to the sum insured, even if the actual cost were considerably more.
Many losses are only partial, however, and in these circumstances it would be unfair if a policyholder who had paid less premium than was really appropriate should be indemnified in full, even where the actual claim amount is less than the overall sum insured. In such cases, the principle of average is applied, which means that the claim is scaled down in the same proportion that the premium actually paid bears to the premium that should have been paid for the full appropriate sum insured.
So, for example, a policyholder who insured his contents for £10,000, when their true insurance value was £15,000, would find that if he claimed £300 for a damaged carpet, the insurer would pay only £200.
Many general insurance policies are subject to an excess: in other words, a deduction is made from any claim payment. Many motor policies have an excess of, say, £100 on the accident damage part of the cover. This avoids the high administrative costs of dealing with a lot of small claims. An excess can be either compulsory or voluntary in order to obtain a reduction in premium.
Buildings are defined as ‘anything on the premises that would normally be left behind if the property were sold’. This generally includes sheds, swimming pools, walls, fitted furniture and all fittings and decorations.
Cover is normally provided against:
• fire and lightning strikes;
• explosions, subsidence and earthquakes;
• storms and floods;
• damage by vehicles and aircraft, and even by animals;
• damage by falling trees/branches or television aerials.
Policies normally also cover the costs of alternative accommodation during repairs;
Some types of cover are subject to the property not being left unoccupied for more than a specified period, typically 30 days. These include cover against damage caused by:
• riot, civil commotion and vandalism;
• theft or attempted theft;
• burst water pipes or oil leakages.
Most policies also cover property owner’s liability.
Cover is provided for contents, which can be defined as ‘anything you would normally take with you if the property were sold’.
Cover would typically be provided against the same events and circumstances as described above for buildings insurance, with a few additions, including:
• accidental damage to goods while being removed by professional removers;
• extended contents cover for specified personal property outside the home;
• damage to freezer contents due to electricity failure.
The aim of an ‘all-risks’ policy (sometimes known as extended contents cover) is to indemnify the policyholder for loss, damage or theft of items that are regularly taken out of the home. Cover is normally split into two categories:
• unspecified items: these need not be specifically named but each item must have a value below a specified amount;
• specified items: these items are above the single-item value limit and are individually listed.
Both of the above categories require the policyholder to take reasonable care of the property.
3.3.3.7 Private motor insurance
There are three main types of motor insurance cover: third party only; third party, fire and theft; and comprehensive. There are variations in the exact nature of cover offered by different companies in each category – particularly on comprehensive policies – but a summary of what might typically be offered is shown below.
The Road Traffic Act 1988 makes it unlawful to use a motor vehicle on a public road unless there is in force a policy of insurance in respect of third party risks.
Third party only policies typically provide cover for:
• death or bodily injury to third parties, including passengers in the car – hospital charges and emergency medical treatment charges are also covered;
• damage to property;
• legal costs incurred in the defence of a claim.
Death, injury and damage cover is extended to include occasions when the policyholder is using another vehicle, and also to other drivers using the policyholder’s car with his permission.
Motor insurance differs from other personal insurances in that a policy of motor insurance is of no effect unless a certificate of insurance is given to the policyholder. The certificate is what provides evidence of the existence of the contract of insurance and, as third party motor insurance is compulsory, this is very important.
3.3.3.7.2 Third party, fire and theft
In addition to third party cover, a third party, fire and theft policy provides cover against:
• fire, lightning or explosion damage to the vehicle;
• theft of the vehicle, including damage caused during theft or attempted theft.
In addition to the third party, fire and theft cover, a typical comprehensive policy would include some or all of the following:
• accidental damage to the vehicle on an all-risks basis;
• loss or damage to personal items in the vehicle;
• personal accident benefits;
• windscreen damage.
The private motor insurance market is large and extremely competitive, and many other extensions to the cover are offered in order to attract business. These may include: roadside breakdown assistance; legal protection services; provision of a courtesy vehicle while repairs are carried out; out-of-pocket expenses resulting from an accident.
Travel insurance cover is available for individual journeys (typically from five days to one month) or on an annual basis. A typical policy might include cover against the following:
• cancellation due to illness or injury of the policyholder or a close relative;
• missed flights due to transport failure;
• delayed departures;
• medical expenses;
• personal accident;
• loss of personal possessions or of a passport;
• personal liability;
• legal expenses.
Because of the increased risk of injury, cover for winter sports holidays is usually more expensive.
A derivative is a financial product that is indirectly based on, or ‘derived from’, another financial product. It is usually related to a commitment to buy or sell that other product at a fixed price on a future date or between two dates. The key factor is that, because they convey rights (such as the right to buy at a price different from the current market price), derivatives themselves have a value and, in most cases, can themselves be traded. The most common products dealt with in this way are ordinary shares, commodities, interest rates and exchange rates. The main forms of derivatives are described below.
• Options: options are the best-known form of derivative. An option is the right (but not the obligation) to buy or sell a specific amount of an asset – which might, for instance, be a certain number of ordinary shares – at a specified price (the exercise price) within a specified period. An option to buy is known as a call option, whereas the equivalent right to sell is referred to as a put option. The buyer of an option contract pays a purchase price, or option premium, to the seller (who is also known as the writer) of the contract.
• Futures: futures are similar to options, except that with futures there is an obligation to buy or sell at the specified price on a specified date. Futures are available in a range of financial products as well as commodities (eg coffee) and currencies, for which they can be used as a hedge against movements in exchange rates. Some such deals are contracts directly between two parties and are not traded, in which case they are known simply as forward contracts.
• Warrants: warrants are similar to call options, except that they are generally issued by companies and give the holder the right to purchase that company's ordinary shares. This allows the company to raise new capital.
Most large purchases such as houses, cars and holidays, are now made with the aid of borrowed money, and the success of most western economies is based on credit. Financial institutions have not been slow to develop products to satisfy the wide-ranging needs of borrowers.
Since a mortgage loan is such a large, and long-term, transaction the consequences of making a mistake can be very serious. It is therefore particularly important for an adviser to choose wisely and to suit the products chosen to the client’s needs.
• Choosing the wrong lender or the wrong interest scheme can lead to the client paying more than is necessary for the loan.
• Choosing the wrong investment product can lead – at worst – to the mortgage not being repaid in full at the end of the term. At best, it will mean that the client misses out on possible surplus funds.
• Failing to protect the outstanding capital or the repayments against sickness, death or redundancy, can leave a client’s family destitute or lead to them having to leave their home.
A house purchase loan is usually known as a mortgage loan (or simply a mortgage) because the borrower mortgages the property, in other words creates a legal charge over the title deeds to the lender as security for the loan.
The parties involved in a mortgage are as follows:
• the mortgagor: the individual borrower who transfers his property to the lender for the duration of the loan;
• the mortgagee: the lender (bank, building society or other institution) who has an interest in the property for the duration of the loan.
With a repayment mortgage (sometimes also known as a capital-and-interest mortgage), the borrower makes monthly repayments to the lender and each monthly amount consists partly of interest and partly of capital repayment: the higher the interest rate (for any given mortgage amount and term), the higher the monthly repayment.
The repayment is calculated in such a way that, provided interest rates do not change, it will remain the same throughout the term of the mortgage. If interest rates do go up or down, the repayment is increased or decreased, or alternatively the mortgage term can be extended or shortened.
Because the repayment remains unchanged (ignoring fluctuations in the interest rate), the relative proportions of capital and interest vary throughout the term: for example, at the beginning, when very little capital is repaid, the repayment is mainly interest; then, as more capital is repaid, the interest proportion of the repayment grows less and less.
The result is that the amount of capital outstanding decreases by smaller amounts each month at the start compared with towards the end of the term.
Two important factors that should be noted are:
• the mortgage will be repaid at the end of the term, provided that changes in interest rate have been allowed for and that all repayments have been made when due;
• if the borrower, or the breadwinner in the borrower’s family, dies before the end of the mortgage term, the repayments will have to be continued or the outstanding loan repaid. Separate life assurance is required to cover this eventuality.
3.5.1.3 Interest-only mortgages
In the case of an interest-only mortgage loan, the monthly payments made to the lender are solely to pay interest on the loan. No capital repayments are made to the lender during the term of the loan and the capital amount outstanding, therefore, does not reduce at all.
The borrower still has the responsibility of repaying the amount borrowed at the end of the term, and this is normally achieved through the borrower making regular payments to an appropriate savings scheme, although the loan might be repaid out of other resources, eg from the proceeds of a legacy. The main schemes used for this purpose are: endowment assurances of various kinds; individual savings accounts (ISAs), and personal pension or stakeholder pension plans.
Borrowers should be made aware of the risks involved in taking out an interest-only mortgage, in particular that repayment of the mortgage is dependent on the performance of an investment plan achieving a pre-determined rate of return. If this is not achieved, then the borrower will be left with a shortfall: the value of the policy or plan will be lower than that of the total debt.
3.5.1.3.1 Endowment assurances
Both with-profit and unit-linked endowments can be used for mortgage purposes. In each case, special adaptations have been developed to take account of the particular needs of mortgage repayment.
One feature of life policies is that they can be legally assigned to a third party, who effectively becomes the owner of the policy and is entitled to receive the benefits in the event of a claim. Some lenders require the endowment to be assigned to them as part of the mortgage deal; others may simply require that the policy document be passed into their possession, without a formal assignment.
3.5.1.3.1.1 Low-cost endowment
Borrowers prefer to use with-profit policies rather than non-profit because of the potentially better returns. The problem is, however, that the premiums are higher – an important consideration for most borrowers, who are seeking to minimise their mortgage costs.
The low-cost endowment provides a suitable compromise by basing premiums on a sum assured that is lower than the mortgage loan amount but which, including the bonuses that are expected to be declared over the policy term, should become sufficient to repay the loan. Since bonuses are not guaranteed, the basic sum assured is calculated using a conservative estimate of future bonus rates – often around 75% of the company's current reversionary bonus rate. Terminal bonuses are not taken into account.
If the borrower were to die before the bonuses had reached the required level, the amount paid out would be insufficient to repay the loan. To cover this shortfall, a decreasing term assurance is added to the policy, the additional benefit being calculated as just sufficient to make up the difference between the mortgage amount and the current level of sum assured plus reversionary bonuses. Some companies add a level term assurance, or even a level convertible term assurance, in place of the decreasing term assurance.
If the total of sum assured plus bonuses does not reach the amount of the loan at the end of the term, it is, of course, the borrower's responsibility to fund the difference. Life companies help their policyholders to avoid this by including regular progress reviews of mortgage-related endowments, to check whether the policy is on target to reach the required amount by the end of the term. If the policy does not seem to be on target, the company may either recommend an increase in premium, possibly without further medical evidence being required, or suggest other ways of addressing the problem.
On the other hand, if the total benefit at maturity, including bonuses, proves greater than the amount required to repay the loan, the surplus will provide a tax-free windfall for the borrower.
3.5.1.3.1.2 Unit-linked endowment
When used for mortgage purposes, the premium required to fund a unit-linked endowment is calculated as the amount that will provide sufficient to repay the loan at the end of the term if unit prices increase at a specified conservative rate of growth. Policyholders can choose which fund or funds to use for their investment, but it is usually recommended that premiums be invested in a managed fund: it would certainly not be wise to use a very speculative fund for mortgage repayment purposes.
The growth rate is not guaranteed, and it is the borrower's responsibility to ensure that the policy will provide sufficient funds to repay the loan. Regular reviews, by the life company, of the policy's progress enable the borrower to increase the premiums (or make other provisions) if the policy is not on target. Most companies also provide the facility to switch to a cash fund, or similar, in order to protect the policy value from sudden market falls towards the end of the term.
One advantage of the unit-linked policy as a repayment vehicle is that, in a strongly rising market, the value of the policy may reach the required amount before the end of the term. In that event, the policy can be surrendered and the loan repaid early – thus saving on future interest, and freeing the repayment amounts for the client to use for other purposes.
3.5.1.3.1.3 Performance review
The actual performance of endowment plans during the 1990s has led to a major review of this area of financial advice and, during 1999, the regulatory authorities instructed providers of endowment plans to review the actual performance of these products. This was for three main reasons:
• poor performance of endowment plans during the 1990s;
• concern over the standard of advice provided by financial advisers in making sure customers understood the risks involved with investment-backed schemes;
• concern that holders of endowment mortgages would be faced with a large shortfall on the maturity proceeds, leaving them unable to repay their mortgage debt.
One of the benefits of a personal pension plan or stakeholder pension is that up to 25% of the accumulated fund can be taken as a tax-free cash sum when the pension payments commence. This fact means that these plans have the potential to be used as mortgage repayment vehicles, with the loan being repaid out of the cash lump sum.
The plans have other financial benefits.
• Regular mortgage repayments, because they take the form of pension contributions, qualify for tax relief at a person's highest rate of tax. The practical effect of this for a higher rate taxpayer, for instance, is that each £100 of contribution costs him or her only £60. (There is no tax relief on endowment policy premiums.)
• The fund in which the contributions are invested is not subject to tax on capital gains, meaning that it should grow faster than an equivalent endowment policy fund, which is taxed on both income and capital gains.
On the other hand, there are a number of factors a borrower might feel are possible drawbacks to the use of a pension plan for mortgage repayment purposes.
• There is a minimum age at which the lump sum can be taken: in most cases this is 50, which means, in effect, that the term of the mortgage must run until at least age 50 and the mortgage cannot be paid off earlier, even if the fund has grown to a sufficient value. This minimum age will increase to 55 in 2010.
• Because only 25% of the fund can be taken in cash, a fund of four times the loan value must be built up, which means that contributions must be four times what is actually required to repay the loan. The remaining 75% is not wasted, of course, because it will provide a retirement pension – nevertheless, it may mean that total contributions are more than the borrower can afford or more than are permitted by the regulations.
• A personal pension or stakeholder pension, unlike an endowment assurance, does not automatically carry with it any life assurance, so a separate policy will be required to cover the repayment of the loan in the event of premature death. It may be possible to use a pension term assurance for this purpose, to obtain tax relief on the premiums.
There is a further characteristic of the use of a pension plan that might be considered a disadvantage by the lender: as with all pension contracts, personal pensions and stakeholder pensions cannot be assigned to a third party as security for a loan or for any other purpose. The lender cannot therefore take possession of the plan or become entitled to receive benefits directly from it. This fact has not, in practice, prevented the majority of lenders from moving into the pension mortgages market.
3.5.1.3.3 Individual Saving Accounts (ISAs)
ISAs are recognised as an attractive means of repaying an interest-only mortgage. All managers allow investments to be made on a regular monthly basis, provided, of course, that the overall annual limits are not exceeded.
The ISA managers calculate the amount of regular investment that would be required to produce the necessary lump sum at the end of the mortgage term, based on an assumed growth rate and on specified levels of costs and charges.
The main benefits of using an ISA as a repayment vehicle are:
• the funds grow free of tax on capital gains, thus reducing the cost of repaying the mortgage;
• if the fund's rate of growth exceeds that assumed in the initial calculations, the mortgage can be repaid early.
One drawback to the use of ISAs is that they may not be available in the longer term. Since mortgages are generally long-term contracts, this might lead to many borrowers having to change their repayment vehicle ‘mid-stream’. The government has, however, guaranteed that ISAs will be available in their present form until at least 2010.
Other drawbacks associated with the use of ISAs (and other similar investment schemes) are:
• if growth rates do not match the initial assumptions, the final lump sum will fall short of the mortgage amount – unless additional investments have been made;
• in the event of premature death, the value of the ISA investment is unlikely to be sufficient to repay the loan. Additional life assurance cover is required to meet this eventuality.
3.5.1.4 Mortgage interest options and other schemes
Regardless of whether a customer chooses a capital-and-interest repayment mortgage or an interest-only mortgage with some kind of a repayment vehicle, there are often a number of different types of mortgage product available. The main variations are described below but remember that these are not necessarily specific products in themselves; they are characteristics of products. Some of these characteristics can be combined within a single product, eg a fixed-rate mortgage with a cashback.
Remember also that how interest is charged will vary from one lender to another: some charge interest on an annual basis; some on a monthly basis; and some on a daily basis.
A variable rate is the basic method of charging interest, with monthly payments going up or down without limit as interest rates change. One disadvantage is that borrowers cannot easily predict the level of future payments, which can cause budgeting problems.
A discounted mortgage takes the form of a genuine discount off the normal variable rate (eg 2% off for three years). It is not a deferment of capital or interest payments. There is usually a restriction on how soon the mortgage can be repaid, or a penalty for repaying within a certain period.
With a fixed-rate mortgage, the borrower is able to ‘lock in’ to a fixed interest payment for a specified period, usually between one and five years. At the end of the period, the rate reverts to the lender’s prevailing variable rate. This scheme is popular with first-time buyers and others who want to be able to budget precisely. There is often a substantial arrangement fee, however, and there may be restrictions or penalties on changing to another lender.
An interest rate might have an upper fixed limit, known as the cap. The lender’s normal variable rate will apply to this type of mortgage, but it will be subject to the capped rate. Should the variable rate exceed the cap, the borrower will still pay not more than the capped rate. If there is also a fixed lower limit, it is known as a cap and collar mortgage.
3.5.1.4.5 Base rate tracker mortgages
As the name suggests, base rate tracker mortgages are linked to the base rate set by the Bank of England. The base rate is reviewed once a month and reflects the cost of borrowing money from the Bank of England. Base rate tracker mortgages give the borrower the certainty that their payments will rise and fall in line with base rate changes. It should be noted that most lenders offering this type of mortgage do charge a premium above the base rate. A typical example would be a borrower being charged interest at 0.95% above the base rate.
The flexible mortgage is a relatively recent innovation in the UK. It gives the borrower some scope to alter his monthly payments to suit his ability to pay, as well as the opportunity to pay off the loan more quickly. Although there is no precise definition of a flexible mortgage, it is generally considered that such a product should offer the following basic features:
• interest calculated on a daily basis;
• the facility to make overpayments at any time without incurring an early repayment charge;
• the facility to underpay, but only within certain parameters set out by the lender when the mortgage was arranged;
• the facility to take a payment holiday, again within certain parameters laid down at the outset.
The combination of a daily interest calculation and occasional, or regular, overpayments will result in considerably less interest being paid overall and the mortgage term being reduced.
The ability to reduce monthly payments, or suspend them entirely, for a limited period will benefit the borrower who is experiencing temporary financial difficulties. Such a situation can be further relieved by the borrower being able to ‘borrow back’ previous overpayments.
Most flexible mortgages allow the borrower to draw down further funds as and when required, although the lender will have set a limit on total borrowing at the outset. Some lenders provide borrowers with a chequebook to enable additional funds to be drawn. Flexible mortgages involve a much easier administrative process than is usual when dealing with further advances. The wording of the mortgage deed generally used for flexible mortgages is such that all additional funds withdrawn will automatically take priority over any other subsequent charges registered against the property.
3.5.1.4.6.1 Current account mortgage
An increasingly popular version of the flexible mortgage is the current account mortgage. This enables the borrower to carry out all of his personal financial transactions within the single account. The account is able to receive salary credits and pay standing orders and direct debits in exactly the same way as a conventional current bank account. The borrower will be provided with a chequebook and a debit/credit guarantee card.
The combination of salary credits and the calculation of interest on a daily basis considerably reduces the amount of interest payable and consequently also the mortgage term.
A more recent development is the offset mortgage. This requires the borrower to have savings or other accounts with the lender and enables the interest payable on such accounts to be offset against the mortgage interest charged. For example, if a borrower has an offset interest-only mortgage for £80,000 and £25,000 in a savings account with the lender, he can opt to waive payment of interest on his savings, enabling interest to be charged on a net loan of £55,000.This calculation is repeated on a daily basis.
Even more complex offset mortgages are becoming available that enable the borrower to offset interest payable on various savings accounts against interest charged on his mortgage and on any other secured or unsecured loans held with the lender.
Many lenders now offer flexible mortgages with a fixed, discounted or capped rate for an initial period. Early repayment charges do not normally apply to these products but an arrangement fee may be payable and, in some cases, it may be a condition of the loan that a particular insurance product is purchased from the lender.
A cashback is a relatively common incentive offered by many lenders. A lump sum is paid to the borrower immediately after completion of his mortgage, either as a fixed amount or as a percentage of the advance. Generally, lower loan-to-value ratios will result in higher cashbacks. For example, the cashback may be 3% of the advance for a loan-to-value ratio of up to 80%, and 2% for a higher loan-to-value ratio.
It is usually a condition of the mortgage that some or all of the cashback must be repaid if the loan is redeemed within a specified period.
Discounted rates and cashbacks are sometimes used by lenders either to tempt borrowers away from competitors or as a loyalty bonus to persuade them to stay. Payment of legal fees is another offer that is commonly made to encourage switching of the loan between lenders while incurring minimum costs.
The low-start mortgage is a repayment mortgage designed to assist borrowers who want to keep down costs in the early years. The low initial repayments are achieved by deferring the capital instalments for the first few years. Borrowers need to be aware that payments will increase at the end of the initial period and that no capital will have been repaid.
In the early years of a deferred interest mortgage, some of the interest is not paid but is added to the outstanding capital. This is a useful method for those who expect an increasing income, and who wish to maximise the loan while minimising the costs in the early years.
This type of mortgage is not suitable for people who borrow a high proportion of the property price – especially at a time when prices may be falling – because there is an increased danger of negative equity.
3.5.1.4.10 CAT-standard mortgages
The government has introduced specified CAT (charges, access and terms) standards that can be applied to mortgage products, although lenders do not have to offer CAT-standard mortgages, and there is no guarantee by either the government or the lender that a CAT-standard mortgage will be the most suitable product for a particular borrower.
CAT-standard mortgages are likely to appeal to borrowers who wish to have clearly stated limits on charges. Examples of the limits set on charges and other costs are:
• the variable interest rate must be no more than 2% above Bank of England base rate and must be adjusted within one calendar month when the base rate is reduced;
• interest must be calculated on a daily basis;
• no arrangement fees can be charged on variable-rate loans and no more than £150 can be charged for fixed-rate or capped-rate loans;
• maximum early redemption charges apply to fixed-rate and capped-rate loans;
• no separate charge can be made for mortgage indemnity guarantees;
• all other fees must be disclosed in cash terms before the customer makes any commitment.
Other rules relating to access and terms include:
• normal lending criteria must apply;
• the customer can choose on which day of the month to pay;
• all advertising and paperwork must be clear and straightforward;
• purchase of related products cannot be made a condition of the offer.
3.5.1.5 Methods of releasing equity
Equity in a mortgage context is the excess of the market value of a property over the outstanding amount of any loan or loans secured against it. There are a number of ways to release the equity in a property. Releasing equity means using the excess value to obtain capital or income, which can then be used for another purpose.
Home income plans are designed mainly to enable elderly homeowners who do not have a mortgage on their property to release some of the equity in order to supplement their retirement income. They are now officially known as lifetime mortgages, under FSA regulations, but are still commonly referred to as home income plans.
The customers take a loan, secured on their property, which is mortgaged in the normal way. The actual amount of the loan depends not only on the value of the property but also on the age of the applicant. This is because many home income plans are arranged on the basis that no interest payments will be made to the lender during the lifetime of the borrower. Instead, interest is allowed to roll up and is repaid, along with the original loan, when the property is sold on the death of the borrower (or second borrower, if a couple). Clearly, a 60-year-old borrower is statistically likely to accumulate considerably more unpaid interest than a 70-year-old borrower. Hence, the 60-year-old will not be able to borrow such a high percentage of the value of his property as the 70-year-old.
The maximum permitted loan varies between lenders but, as a guide, this will range from around 15% to 20% of the property value for a 60-year-old applicant up to around 50% for a 75-year-old. In the case of joint borrowers, the maximum loan will be based on the age of the younger partner, as the property will not be sold until the second death.
In some cases the borrower uses the loan to purchase a lifetime annuity. In these cases, the interest is not rolled up but is paid on a monthly basis out of the annuity income. The balance of this annuity payment is used to augment the borrower’s retirement income. This type of home income plan allows a higher loan-to-value ratio for the simple reason that the debt is not increasing and is therefore not reducing the remaining equity. The major disadvantage of annuity purchase is that annuity rates are currently very low and, once the annuity has been purchased, the borrower is locked into a rate that is fixed for the remainder of his lifetime.
In recent years, the main providers of home income plans have joined together and formed a trade association called Safe Home Income Plans (SHIP). This has established a Code of Practice that is designed to safeguard the interests of borrowers. The main safeguards are:
• the applicant must be encouraged to seek independent legal advice to ensure that he fully understands the risks involved and that any children and other beneficiaries will receive a reduced inheritance;
• any negative equity situation that arises will be funded by the lender ie the amount that has to be repaid will not be more than the price that is obtained when the property is sold;
• the borrower will be entitled to remain in his home for the rest of his life – in the case of joint borrowers this applies to each of them;
• the plan must be portable, ie the borrower must be allowed to transfer the loan to another property, although part of it may have to be repaid if the value of the new property is insufficient to cover it.
Since 2004, additional protection for customers taking out home income plans has been provided their regulation under the Financial Services Authority.
3.5.1.5.2 Home reversion schemes
Home reversion schemes are an alternative to home income plans and involve the homeowner selling all or part of his property to the company in return for an income for life. The customer(s) retain the right to live in the house until their death(s), after which the company sells the property and retains all the proceeds.
At first, it was believed that home reversion schemes would not be regulated by the FSA because they do not involve a mortgage – but the FSA has announced plans to regulate these schemes. The process is currently (May 2006) at the consultation paper stage.
Shared-ownership mortgages combine owner-occupation with rental. They enable the borrower to buy a stake in the property and rent the remainder. For example, the borrower can purchase a 25% stake in the property, funded by mortgage, with the option of buying subsequent 25% shares in the future. As the borrower increases his or her share in the property, the mortgage element increases and the rented element reduces. This process of increasing one’s share in the property is sometimes called ‘staircasing’.
This type of scheme (usually arranged by housing associations) enables those on relatively low incomes to become owner-occupiers, even though they cannot afford a conventional mortgage.
3.5.1.7 Related property insurance
A lender’s security depends on the property being maintained in an acceptable condition. For that reason, borrowers have to covenant (ie promise under the terms of the mortgage deed) to maintain the property in good condition.
They also have to covenant to insure the property adequately. A lender is permitted by law to:
• insist that a property subject to a mortgage is continuously insured by means of a policy that is acceptable to the lender;
• have its interest as mortgagee noted on the policy;
• secure a right over the proceeds of any claim and to insist that the proceeds be applied to remedy the subject of the claim or to reduce the mortgage debt.
3.5.2 Other secured private lending
With all secured loans, the borrower offers something of value as security for the loan so that, in the event of default, the lender can take and sell that asset (ie realise the security) and be repaid out of the proceeds.
The major form of secured personal lending is of course the mortgage loan for house purchase, the security being a first charge on the borrower’s private residence.
When property values increase significantly, as they have over the last ten years, it is common for people to borrow against the increased equity in their property (ie the excess of the property value over the amount owing on the mortgage loan). They then use the loan to fund purchases that are not related to the house purchase but which improve their lifestyle in other ways.
This may be done by way of a further loan from their existing mortgage lender, a second mortgage from a different lender or by remortgaging for a larger amount.
Most secured lending, therefore, is secured on ‘bricks and mortar’, even where its purpose is not directly – or even indirectly – related to house purchase or improvement.
A second mortgage is one that is created when the borrower offers the property for a second time as security while the first lender still has a mortgage secured on the property. The new lender takes a second charge on the property; the original lender retains the deeds and his charge takes precedence over subsequent charges. This means that, in the event of a sale due to default, the original lender’s claim will first be met in full (if possible) and, if sufficient surplus then remains, the second mortgagee’s charge will be met.
Lenders will, of course, only offer a second mortgage if there is sufficient equity in the property and, since second mortgages represent a higher risk to lenders, they are likely to be offered at higher rates of interest than first mortgages.
In contrast to secured loans, an unsecured loan relies on the personal promise, or covenant, of the borrower to repay. Unsecured loans are therefore generally higher risk than secured lending, with the consequence that they are subject to higher rates of interest and are normally available only for much shorter terms. For example, while a mortgage secured on a property will be available for 25 years or even longer, a personal loan is rarely offered over much more than six or seven years.
Unsecured loans have long been available from banks and finance houses, but it was not until the passing of the Building Societies Act 1986 that building societies were able to move into this area of business. Initially they were restricted to no more than 5% of their commercial assets being in the form of unsecured loans, although this has since been increased to 15%.
Unsecured personal lending takes a number of forms, the most common of which are described below.
These are offered by banks, building societies and by some finance houses. They are normally for a term of one to five years, and the interest rate is generally fixed at the outset and remains unchanged throughout the term. Many of the larger lenders operate a centralised assessment of loan applications through telephone call centres, using a form of credit scoring to assess the suitability of the borrower.
The loan can be used for any purpose by the customer: typically it might be used to purchase a car, fund a holiday, or consolidate an existing higher-cost borrowing such as a credit card balance.
The purpose of the loan determines whether it is regulated under the terms of the Consumer Credit Act 1974. Most such loans of £25,000 or less are regulated by the Act unless they are for house purchase or home improvement.
An overdraft is a current account facility, offered by all retail banks and some building societies, which enables the customer to continue to use the account in the normal way even though its funds have been exhausted. The bank sets a limit to the amount by which the account can be overdrawn. An overdraft is a convenient form of short-term temporary borrowing, with interest calculated on a daily basis, and its purpose is to assist the customer over a period in which expenditure exceeds income – for instance, to pay for a holiday or to fund the purchase of Christmas gifts.
Because it is essentially a short-term facility, the agreement is usually for a fixed period, after which it must be renegotiated or the funds repaid. Overdrafts that have been agreed in advance with the institution are normally an inexpensive form of borrowing, although there may be an arrangement fee. Unauthorised overdrafts, on the other hand, attract a much higher rate of interest.
Revolving credit refers to arrangements where the customer can continue to borrow further amounts while still repaying existing debt. There is usually a maximum limit on the amount that can be outstanding, and also a minimum amount to be repaid on a regular basis.
The most common way of providing revolving credit is through credit cards, although some institutions do provide revolving personal loans that allow the borrower to draw down funds as the original debt is repaid.
It is hard to believe that plastic cards, now an integral part of most people's financial affairs, have only been around for the last 35 years. Their development and their impact have gone hand-in-hand with the rapid advance of the electronic processing technologies on which their systems now largely depend. Many cards can now hold a wealth of information about cardholders and their accounts, and can therefore interact directly with retailers' and banks' electronic equipment: these cards are often referred to as smart cards.
Credit cards enable customers to shop without cash or cheques in any establishment that is a member of the credit card company's scheme.
Originally all credit card transactions were dealt with manually at the point of sale, but most retailers now have terminals linked directly to the credit card companies' computers, enabling online credit limit checking and authorisation of transactions.
As well as providing cash-free purchasing convenience, credit cards are a source of revolving credit. The customer has a credit limit and can use the card for purchases or other transactions up to that amount, provided that at least a specified minimum amount (usually 3% of the outstanding balance) is repaid each month. The customer receives a monthly statement, detailing recent transactions and showing the outstanding balance. If the balance is repaid in full within a certain period (usually 25 days or so), no interest is charged; if a smaller amount is paid, the remainder is carried forward and interest is charged at the company's current rate.
Credit cards are an expensive way to borrow, with rates of interest considerably higher than most other lending products. There is also normally a charge if the card is used to obtain cash either over the counter or from an automated teller machine (ATM), or if the card is used overseas.
Credit card companies charge a fee to the retailers for their service. This is deducted as a percentage (typically around 3%) of the value of transactions when the credit card company makes settlement to the retailer. There are, however, a number of advantages to retailers, in addition to the fact that more customers may be attracted if payment by credit card is available. For instance, payment is guaranteed if the card has been accepted in accordance with the credit card company's rules. Furthermore, the retailer can reduce his or her own bank charges because the credit card vouchers paid into a bank account are treated as cash.
Two other types of card are mentioned below for completeness, although they do not offer credit facilities (except in a very limited sense, in the case of charge cards).
Although used by the customer in the same way as a credit card to make purchases, the outstanding balance on a charge card must be paid in full each month. The best-known examples are American Express and Diners Club.
Introduced in the late 1980s, debit cards enable cardholders to make payments for goods by presenting the card and signing a voucher, in just the same way as with credit cards or charge cards. In the case of debit cards, however, the effect of the transaction is that funds equal to the amount spent are transferred electronically from the cardholder's current account to the account of the retailer. This is known as EFTPOS (electronic fund transfer at point of sale) and the system effectively replaces the use of cheques, leading in the longer term to reduced handling costs.
Debit cards can also be used to withdraw cash from ATMs and many debit cards now also act as cheque guarantee cards.
There is an extensive market for what might be called ‘commercial’ lending, ie loans to businesses of all sizes from sole traders and partnerships to family companies to multinational traders. Loans may be required to start up or expand businesses, to purchase shops, factories or hotels, or to refurbish premises.
All the high-street retail banks have departments operating in this field and there is also a wide range of companies specialising in commercial lending.
The lending is normally secured on the company’s property or other assets, with the interest rate set at a specified margin above base rate. The exact interest rate will depend on the risk that the lender believes is involved in lending to the particular company; this will be assessed by looking at the company’s past performance where applicable, business plans, projected profits and management quality, as well as the business sector in which it will operate.
Investment in commercial property is also described in Section 2.4.3.
3.6 Pension productsAs we have seen in section 1.3.5.5, individuals who have made sufficient National Insurance Contributions will be entitled to a basic state pension and, in certain circumstances, additional state pension/pension credit.
However, these are set at a fairly low level and most people would prefer a higher level of income in retirement than the state provides.
Employees may also be members of an occupational scheme although not all employers offer occupational pensions. Occupational schemes fall into two types:
• final salary (defined benefit) – the employee will receive a pension that is calculated as a percentage of final salary (the salary on or near retirement). The longer the employee has been a member of the scheme, the higher the percentage.
• money purchase (defined contribution) – an agreed contribution is invested for each member. On retirement, the accumulated fund is used to purchase benefits.The level of benefits is not guaranteed by the employer.
As people live longer in retirement, employers are finding final salary schemes more expensive. As a result, many are being forced to reduce their commitment and to transfer the responsibility to individuals.
Many individuals may therefore wish to supplement retirement income by contributing to private arrangements. The following are tax-efficient pension arrangements:
• additional voluntary contributions (AVCs);
• free-standing additional voluntary contributions (FSAVCs);
• personal/stakeholder pension plans (PPP/SHPs).
AVCs and FSAVCs are available to employees who are members of occupational schemes. Personal/stakeholder pensions are generally available to anyone under the age of 75.
Some AVCs are final salary arrangements although most are money purchase.
All FSAVCS, PPP/SHPs are money purchase schemes.
The funds do not pay capital gains tax, pay no income tax on savings income and no higher rate income tax on dividend income.They are, however, unable to reclaim the 10% tax credit on UK dividends.
Any individual, who is a UK resident and under the age of 75, can receive income tax relief at their highest marginal rate on annual contributions up to a maximum of the higher of:
100% UK earnings
or
£3,600
These contribution limits apply to the total of annual contributions to the following: occupational schemes (including AVCs/FSAVCs, personal/stakeholder pensions and death benefits (occupational and pension term assurance)).
(Before the new regulations came into effect on A-Day, different schemes had different maximum contribution limits, eg contribution to:
• occupational schemes (including AVCs/FSAVCs) maximum 15% salary;
• personal pensions. Age-related percentage of earnings;
• pension term assurance maximum 10% of actual pension contribution.
These limits have all been replaced by the new contribution levels.)
However, there is an annual allowance limit (£215,000 in 2006/07). If the combined total of employer and employee contributions in a year exceed this figure, tax will be charged on the excess.
Benefits can (normally) be taken from the schemes from 50 onwards. This minimum pension age will rise to 55 on 6 April 2010. 25% of the fund can be taken as tax-free cash and the remainder must be used to provide a taxable income.
The minimum pension age of 50 (until 2010) and the limit of 25% tax-free cash have not changed with the new legislation.
The income may be taken by purchasing an annuity with the remaining fund. It is not essential to buy the annuity from the company that supplied the pension plan.An individual can ‘shop around’ to see if higher annuity rates are available from other providers.This facility is known as an open-market option.
As an alternative to purchasing an annuity, an individual can make regular withdrawals of capital from the fund (within certain limits) – this is referred to as drawdown or pension fund withdrawal.
Before 6 April 2006, it was compulsory to purchase an annuity by the age of 75. However, it is now possible to continue with drawdown beyond 75.
3.6.1 Additional Voluntary Contributions (AVCs)/Free Standing Additional Voluntary Contributions (FSAVCs)
AVCs are additional contributions to an occupational scheme. Sometimes, this will purchase additional years service in a final salary scheme. However, most AVCs operate as money purchase arrangements and the employee will only have a limited choice of funds.
The employer will usually cover some or all of the costs.
Contributions to AVCs are deducted from gross salary and the employee therefore receives full tax relief at the same time.
Alternatively, an individual may contribute to a FSAVC which is a money purchase fund provided by a separate pension provider. FSAVCs are available from a range of financial institutions, including insurance companies, banks and building societies.
A FSAVC may be attractive to an employee who wishes to keep financial arrangements independent from the employer. FSAVCs offer a wider range of investment funds than AVCs. However, they tend to be more expensive as the employer is not bearing the costs.
Contributions to FSAVCs are made from taxed income. 22% tax relief is given at the time. Higher rate taxpayers will need to claim additional relief separately.
Note: since April 2006, all employees have been able to contribute to personal/stakeholder pensions. FSAVCs, which are generally more expensive, are expected to become obsolete.
These are individual money purchase arrangements provided by financial services companies such as life assurance companies, banks and building societies.
Before 6 April 2006, employees who were members of an occupational scheme could only contribute to a PPP/SHP (from the same earnings) if the earnings were less than £30,000pa.The maximum contribution for such employees was £3,600pa.
However, all employees can now contribute to PPP/SHPs, up to an overall maximum of 100% of earnings (as above).
As above individuals with no earnings/low earnings can also contribute up to £3,600 pa (gross) into PPP/SHPs. This includes children.
Contributions receive 22% tax relief at source, even for non-taxpayers. A higher rate taxpayer will need to claim additional relief separately through self-assessment.
This form of private pension became available from 6 April 2001. The government's aim in introducing it was to take some of the pressure off the state provision of pensions by encouraging more individuals to contribute to their own pension arrangement. They felt that this could be achieved by organising a scheme that is simple and has lower costs.
Although stakeholder pensions are available to most people, they were intended to be particularly attractive to people at lower earnings levels, who traditionally do not have pension provision and who rely on the state pension.
Early indications suggest that this move to include the lower paid has largely failed, with the majority of stakeholder pensions being purchased by people who are financially more sophisticated, who would have been making pension provision anyway.
One common misconception is that stakeholder pensions are state pensions. They are in fact private pensions, although there are certain circumstances in which the government makes it compulsory for stakeholder pension facilities to be provided by employers. Where an employer has five or more employees, but does not provide an occupational pension scheme, the employer must make a stakeholder scheme available to all employees who meet certain criteria. The employees are not obliged to join, but the employer must provide a payroll deduction scheme for those who do join and pass on the employees’ contributions to the scheme. The employers themselves are not obliged to contribute to the scheme.
As mentioned earlier, stakeholder pensions are a form of personal pension and, as such, subject to the same rules. In order to encourage those on lower incomes or with limited understanding of pensions, certain standards were introduced for stakeholder pensions. The key standards are:
One effect of the restriction on charges is that the low limit precludes the payment of commission to independent financial advisers – and this may result in people finding it difficult to obtain advice on stakeholder pensions. To overcome this problem, the government has prepared a set of decision-making flowcharts, known as decision trees, which people can use to determine whether stakeholder pensions are appropriate to their own circumstances.
Test your knowledge and understanding with these questions
Take a break before using these questions to assess your learning across Section 3. Review the text if necessary.
Answers can be found at the end of this unit.
1. What are the main advantages to an investor of collective investments?
2. Who owns and controls a unit trust fund’s assets?
(a) The depositary.
(b) The fund manager.
(c) The trustees.
3. How would you define ‘forward pricing’?
4. How does ‘gearing’ benefit investment trusts?
5. Michael invests £4,000 in an equity mini-ISA in July 2006 and then withdraws £1,000 in September 2006. How much can he invest in the same ISA in December 2006?
(a) Nothing.
(b) £1,000.
(c) £3,000.
6. In what circumstances might a terminal bonus be added to a with-profits endowment policy?
7. What rate of tax would be payable on the proceeds of a non-qualifying policy?
8. How much can parents invest in a Child Trust Fund?
9. In what circumstances might a gift inter vivos term assurance be used?
10. How does the deferred period on a PHI policy affect the premium?
11. Which of the following would NOT normally be excluded from a private medical insurance claim?
(a) Dental treatment.
(b) Chiropody.
(c) Outpatient consultation.
12. What is the definition of ‘indemnity’?
13. Which of the following would not normally be covered against damage under a buildings insurance policy?
(a) Garden shed.
(b) Fitted wardrobe.
(c) Dining room table.
14. What is a ‘mortgagee’?
15. Whose responsibility is it to ensure that an interest-only mortgage is repaid at the end of the term?
16. A self-employed plumber aged 25 takes out a pension mortgage. What is the minimum term for which his mortgage could run?
17. What is a ‘cap and collar’ mortgage?
18. Why do mortgage lenders insist that properties on which they lend should be continuously insured?
19. What is the most common form of ‘revolving credit’?
20. What is the maximum permissible contribution to a stakeholder pension in 2006/07?
Answers
1. The services of a skilled investment manager; reduction of investment risk by spreading the fund; reduced dealing costs; wide choice of investment funds.
2. (c) The trustees.
3. Under forward pricing, clients buy or sell units in a given dealing period at the prices that will be determined at the end of the dealing period.
4. A company’s gearing relates to the amount of borrowing it has taken on. Investment trusts, being companies, are able to borrow in order to take advantage of investment opportunities (whereas unit trusts and OEICs cannot borrow).
5. (a) Nothing.
6. On maturity or on earlier death of the life assured. Terminal bonuses are not usually added to surrender values.
7. Higher rate taxpayers would pay 20% on the gain (policy proceeds less premiums paid). For others there would be no tax due.
8. Up to £1,200 per year.
9. To cover the possible inheritance tax on a gift if the donor dies within seven years.
10. The deferred period is the length of time before benefits commence. The longer the deferred period, the lower the premium.
11. (c) Outpatient consultation.
12. In the event of a claim after loss, insured persons should be restored to the same financial position that they were in immediately before the loss occurred.
13. (c) Dining room table.
14. A lender (bank, building society or other institution) who has an interest in the property for the duration of the loan.
15. The borrower.
16. 25 years – because the minimum age at which he could take the cash lump sum on his pension plan is 50. (From 2010, this will increase to 30 years, as the minimum age will be 55.)
17. A mortgage where the interest rate cannot rise above a specified maximum rate or drop below a specified minimum rate.
18. Because if the property is damaged, the value of the lender’s security is reduced.
19. Credit cards.
20. The greater of £3,600 or 100% of earnings, with an overall limit of £215,000.
Section 4
The financial planning and advice process
Introduction
The relationship between the adviser and the client is formally defined by a number of legal elements, such as the law of agency and data protection legislation of each, which are described in Section 6 and in Section 4 of Unit 2 respectively.
It is also essential that the customer should understand the terms on which any business will be transacted, and advisers are required to hand over a terms of business letter, the exact nature of which is described in Unit 2.
It is, however, vital that the relationship should also be one of mutual trust. This will be much more easily achieved if the adviser can show an understanding not only of the products that he sells, but of human nature and of the situations in which people find themselves – and both the perceived and real needs that they consequently have.
Part of this relationship of trust will be the confidentiality with which the adviser treats the customer’s personal and financial information. Some confidentiality requirements are specified by legislation – for example the Data Protection Act 1998 – but an adviser should make it clear that all of the customer’s information will be kept confidential at all times unless there is a legal requirement for it to be revealed.
An adviser must also be aware of all of the major consumer protection legislation that regulates his relationship with the client, much of which is described in Section 6 of this Unit and in Unit 2.
In this section, we will consider how advisers obtain the information they need from their clients, how they assess and structure that information to determine the most suitable products and services to recommend, and how they communicate effectively with their clients at all stages of the relationship.
Section 4 covers the topics in part 5 of the Unit 1 syllabus, ie the process of giving financial advice.
There is a well-established pattern to the way in which most savers and investors build up and hold their assets. It begins with savers' attitudes to the need for liquidity and safety and then, as incomes and savings grow, moves gradually away from liquidity and towards an acceptance of greater risk.
The first stage in the saving pattern is cash; after that, a current account with a guarantee card is virtually as good as cash. People do not generally hold any other form of asset until their cash requirements are met. The next stage is secure, short-term investment such as instant access (or short-notice) bank and building society deposits.
With a sufficient balance in short-term savings, investors look next at products with less flexibility but a greater return, such as fixed-term bonds.
Further down the line, individuals may be attracted to products that offer greater long-term potential but at the risk of short-term loss. Shares and other equity-linked investments, such as unit trusts, are good examples. In times of stock market volatility, however, these investments may prove considerably less popular.
Similar patterns can be recognised in relation to other types of financial products, though perhaps to a less pronounced extent: for example, the first type of bank account that most people open is a personal current account, often out of necessity to enable receipt of their wages or salary. It is only later, as their financial situation improves, that they begin to use a wider range of accounts and other banking products. Similarly with insurance products, where the first experience is often of compulsory cover, particularly for motor insurance, and of holiday insurance.
In terms of borrowing, many people commence with short-term unsecured borrowing, by way of credit cards or personal loans, to pay for holidays or a car.
In all of these examples, the pattern is determined to a greater or lesser extent by the market segment, or segments, into which the individuals fall. These can be categorised in a number of different ways: it is well established that the financial needs of individuals and families change as people pass through the different stages of life. While accepting that everyone is different, there are some broad statements that can be made about a typical financial lifecycle as follows.
The very young may be attracted by small lump-sum or regular savings schemes; it is typical for accounts to be opened for young people by grandparents or other relatives, at birth or later as birthday gifts. National Savings and Investments products (including Premium Bonds) and building societies are popular homes for such savings. Stakeholder pensions can be opened on behalf of children, from birth onwards.
Few teenagers and students have any surplus income, although some who have started to work full-time or during holidays may be able to accumulate savings. Some may borrow to purchase a car or to fund a holiday. Many students now have to borrow to finance their college or university studies, mainly through special schemes established for that purpose.
4.2.3 Post-education young people
The ability to save increases for those young people in employment, with the possibility of higher incomes as careers progress. If they establish a home of their own (often initially by renting), their savings may be modest at first. Some may decide to save towards a deposit for a first house purchase. Short-term accessible saving schemes are their most likely choice. Many telephone-based and Internet-based financial services are aimed at this market.
Although statistics indicate that fewer young people today get married, many still form relationships and raise families. This often leads to increased borrowing, particularly for a mortgage. At the same time, income may be reduced if one partner gives up work to look after children or, alternatively, outgoings may increase if a childminder is employed. Similar factors affect the growing number of one-parent families. Whatever the situation, there is often little scope for savings at this stage. Protection of the earners' income against illness or death becomes very important. Young people should also begin to think about pension provision, although in practice very few do.
As families settle into an established lifestyle, they tend to become better off financially. There may be a return to a two-income situation. People often trade up to a larger house, increasing their borrowing accordingly. Creditworthiness may improve, enabling greater borrowing for cars and household goods. This is also the beginning of the time when wealth may be increased by the receipt of inheritances from the estates of parents or other relatives.
Maturity is generally the period of highest earning potential and outgoings may also decrease as children leave home and mortgages may be paid off. At this stage, pension provision becomes a priority for many people as they begin to realise that they may not have as high an income in retirement as they had hoped.
Prior to retirement, most people's financial planning is centred on converting income into lump sums (or lump sums into bigger lump sums). At retirement, when income from employment ceases, the focus changes: the requirement is now to produce income from capital. Other factors also become more relevant: the need to prepare for possible inheritance tax liabilities should be considered. Similarly the cost of health care, and possibly of long-term care in old age, may become an issue.
Age or time of life is not, of course, by any means the only way in which market segments can be defined, but it has been analysed in detail to give an illustration of the concept. Other breakdowns are possible, for instance, by the level of annual income or by an individual’s attitude to investment risk. Both of these characteristics can contribute to determining the appropriate financial product for a particular investor or borrower.
Regulations that were first introduced by the Financial Services Act 1986, and which now continue to operate under the Financial Services and Markets Act 2000, oblige advisers to ‘know your customer’. Advisers must be able to identify the client’s needs, which are the starting point for the sales process.
Most, if not all, advisers will complete a comprehensive computer or paper-based factfind to obtain their client’s details. An adviser’s responsibility during the factfind is to define the client’s needs and objectives quickly and accurately.
Knowing the customer makes it necessary to ask questions in respect of all of the following:
• the client’s existing and future needs;
• their ability to provide for them;
• their attitude towards providing for them;
• the client’s objectives.
This means, in practice, that any factfind should look at both the client’s circumstances and preferences.
These relate to three main areas: personal details; financial details; objectives.
4.3.1.1 Personal and family details
Current personal and family situation information includes the details of all of the people who may need to be included in the planning exercise, together with any constraints that may apply. The following basic information will be needed.
• Name and address: full name of the client, along with their contact address and telephone number.
• Date and place of birth: dates of birth for all those included in the factfind. The client’s place of birth may be important for underwriting or taxation reasons, but any hint of racial discrimination must be avoided.
• Marital status: the use of the word ‘marital’ in this context now carries a wider meaning than in earlier generations, and may include single, married, civil partners, cohabiting, divorced, widowed, etc. It is usually preferable to have both partners of a relationship involved in the financial planning process, since the decisions made will often affect both partners. Some clients, however, prefer to keep their financial affairs separate.
• Family details: the client’s family details are important for a number of reasons:
– there may be family members who are, or who will be, financially dependent on the client;
– the client may become the beneficiary of gifts or trusts;
– the client may wish to become a donor, now or in the future;
– from a marketing viewpoint, there may be an opportunity for referrals to family members.
• The most important group of family members is usually the children. In order to give appropriate advice about protection against death and disability, as well as about savings for school or university fees for example, it is necessary to know how old the children are. This may include children from previous relationships.
The information required will include the following.
Is the client employed, self-employed, unemployed or retired? If the client is a director or a partner, it may be necessary to delve deeper and establish basic information about their business arrangements.
It also helps to know whether they are part-time or full-time, temporary or permanent, as well as gaining details of the client’s profession or trade.
Details of the client’s income and benefits package (or net profit, if self-employed) will need to be established. It is often useful to ascertain an exact breakdown of income by its component parts, eg basic, commission, bonus and overtime, together with the average level of overall earnings. Similarly, an adviser must establish the exact nature of benefits provided, eg private medical insurance, company cars, pension and/or death-in-service details, subsidised loans etc.
Additional information that may be required will include details of previous employment (especially if the client has preserved pension entitlement), details of share-option schemes or profit-related pay schemes, or even details of additional employment. It may be helpful to obtain copies of payslips, P60s, tax returns, and notices of tax coding.
4.3.1.2.2 Income and expenditure
By analysing a client’s income and expenditure, it is possible to identify more easily the implications of, say, premature death on the family income and spending patterns. It is also possible to identify any ‘surplus’ income that could be used to fund the purchase of any additional products recommended.
To calculate a household’s income is usually relatively straightforward. An analysis of clients’ expenditure can be more difficult: certain items are easily determined, ie those paid by standing order such as rent and some household bills. Other items will cause a degree of difficulty – or even embarrassment when trying to pin down how much is spent on, for example, food and drink, holidays or motoring.
For each of the client’s assets, from their home (if they own it) to all their various bank accounts, some or all of the following details, as appropriate, should be obtained:
• ownership, ie single ownership or jointly owned;
• purpose of the investment;
• type of investment, eg property, deposit in a bank account, pension policy or fund;
• size of original investment and date;
• current value and/or projected future value;
• rate of return (if any);
• type of return, eg capital growth or income, and whether that return is fixed, guaranteed or variable;
• tax status of the investment or other asset;
• options available and/or penalties;
• sum assured and/or lives assured and maturity dates;
• name of the institution providing the asset.
The relevant information with regard to certain borrowing liabilities includes the following:
• lender;
• amount of loan;
• balance outstanding;
• original term and term remaining;
• type of loan, eg secured, unsecured (and if secured, on what);
• amount of monthly or other periodic payment;
• rate of interest;
• repayment method;
• protection of capital or payments.
Clients are often unaware of the details of any arrangements that they have. It is an adviser’s responsibility to try to obtain this information and clients should be asked, wherever possible, to bring all relevant details with them.
This part of the factfind is substantially different from the other two parts: the personal and family details and the financial situation are concerned with the gathering of hard facts, ie about tangible items and people. The client’s plans and objectives tend to be more intangible in nature: here the aim is to find out ‘why’?, ‘how’? or ‘do you feel that’?, in other words, to discover the client’s feelings about what they have, what they want and where they want to go from a financial point of view. These are known as soft facts.
Advisers need to know the following:
• how the clients feel about their current arrangements – or lack of them – in each area;
• their objectives within each area, now and in the future;
• why they have certain arrangements, or goals or views;
• their willingness to take action in each area;
• the likelihood of change in their situation.
Having knowledge of their feelings about their situation and their existing arrangements will help build understanding of clients in a number of ways:
• by discovering the reasons behind the client’s existing arrangements, which may in turn indicate the client’s level of understanding of their finances;
• by determining the level of the client’s interest in their situation, their level of motivation towards improving their situation and the likelihood of their taking action;
• ascertaining the client’s views on a number of possible alternative solutions will help in constructing acceptable recommendations.
As well as the soft facts, additional information is needed to ascertain correctly the client’s attitude to risk, or risk profile. It is essential to take full account of this attitude when giving recommendations to a client and attitude to risk will differ from client to client.
The client must understand what the risk is, which may mean providing explanations, for example, to distinguish between the degrees of risk. There is, for example, risk to the capital that is invested: the value of an investment may fall as well as rise; the amount of income or capital growth may not be guaranteed. The client’s attitude towards this must be explored. Historically, many so-called low-risk investments, such as bank or building society accounts, have provided a safe haven and a relatively stable level of income, although inflation will cause the value of the investment to fall.
It is important to take note of a client’s stated preferences, but advisers should also be aware of their own duty of care: this means recognising that, whilst clients may have a clear view on what they want to do, their appreciation of what they ought to do can be less than clear. This means that advisers may have an ‘educational’ role in helping clients to explore their own financial circumstances and to make the right choices.
4.4 Identifying and agreeing needs and objectives
We can categorise an individual’s financial needs and objectives into the following five areas:
• protecting dependants from the financial effects of either a loss of income or a need to meet extra outgoings in the event of premature death;
• protecting self and dependants from the financial effects of losing the ability to earn income in the long term;
• providing an income in retirement, sufficient to maintain a reasonable standard of living;
• wanting to increase and/or to protect the value of money saved or invested; wanting to increase income from existing savings or investments; wanting to build up some savings in the first place;
• saving tax.
In seeking to assess any of these areas an adviser should look for examples of typical things that clients either do wrong or fail to do at all. This might include:
• a young family, with little or no savings, relying solely on mortgage protection cover as their only form of life assurance. It would repay the mortgage but is not designed to meet the ongoing costs of running the house and bringing up the family;
• a low level of life assurance premiums being paid, suggesting that cover might need to be increased for the required protection to be adequate;
• unnecessarily large amounts being held on deposit in banks and building society accounts over the long term and so not gaining access to better returns available elsewhere;
• substantial taxable investment income being received by an individual who pays higher rate income tax;
• a non-taxpayer holding investments where tax on interest received cannot be reclaimed;
• too many small holdings of shares over a wide range of companies causing administration and monitoring difficulties;
• a married couple owning most of their assets in an individual’s sole name and paying more tax as a result;
• no pension contributions being paid, or very small pension contributions as a percentage of total earnings, which will mean being dependent upon state benefits unless action is taken;
• people aged over 65 who have their age-related tax allowances reduced because of their income;
• people who have not made a valid will, whose assets on death may therefore not be distributed as desired.
The adviser’s role is to define the client’s needs and objectives accurately, to enable him to see the key issues facing him and to recommend and discuss a priority order for the client’s action.
4.4.1 Agreeing order of priority
Failing to establish a priority order with the client can result in a client ignoring an adviser’s recommendations. The client’s priorities may well differ from those that the adviser feels appropriate, and so the process is one of discussion and agreement rather than straightforward selection by any single person. In the end, however, deciding a plan of action and agreeing its priority order remains the client’s decision, assisted by the adviser’s recommendations.
Once an adviser has gathered all of the necessary information about the clients’ circumstances and preferences, has a clear appreciation of their ability to pay, and has obtained agreement on priorities, then the process of matching solutions to requirements can begin. The adviser’s aim should be to help the client to:
• put the right amount of money...
• in the right form...
• in the right hands...
• at the right time.
In practice, these four aims mean that advisers will look in detail at a number of specific areas. These will include:
• state benefits: the nature and level of state benefits to which a client may be entitled;
• existing arrangements: there is no point in recommending products that satisfy needs already met by the client’s existing arrangements or by state provision;
• affordability: any recommendations made must not, in terms of total cost, jeopardise the client’s current and likely future financial situation;
• taxation: one purpose of the recommendations may be to mitigate tax but it is also important to ensure that any course of action recommended does not unnecessarily add to or create a tax burden;
• risk: there must be a close correlation between the risk inherent in the product recommended and the client’s risk profile;
• timescale: the product recommended should meet the client’s needs within a defined timescale;
• flexibility: recommendations should display the flexibility to deal with possible changes in the client’s circumstances.
4.6.1 Presenting recommendations
When a solution is recommended to a client, it is vital that he understands exactly what it will do. The client needs to know why the particular recommendation is being made.
The first rule of presentation is to ‘keep it simple’: avoid using jargon and stick to the particular features that are relevant to the needs of the client, provided that a fair and accurate explanation is given.
For each type of product recommended, it is a good idea to have a planned way of presenting it. This ensures that the adviser covers all of the relevant details, some of which may be mandatory under the Financial Services and Markets Act 2000. It also helps the adviser to avoid irrelevant details that are of no interest to the client.
The best way to proceed is to go step by step through each product, at the client’s pace. As each feature and its benefits are covered, the adviser should check that the client understands the benefits, perhaps by asking a few simple questions.
There are a number of steps that should always be included when presenting recommendations:
• the purpose of the product and the client’s needs that the product will address;
• the benefits that the client will enjoy;
• the risks and limitations inherent to the product;
• any options that exist within the product that may be appropriate to the client;
• a summary of reasons why the product is being recommended.
For each product, part of the presentation should involve a ‘features and benefits’ analysis. This means going through the product and identifying each of its features, and then putting into simple terms what specific benefits these features provide to the client.
The first point in handling an objection is to ‘qualify’ it. This means finding out whether it is a real or a false objection and how important it is. This can be done by trying to understand the objection as specifically as possible, ie by clarifying exactly what the client means by what they are saying. A good way of doing this is by paraphrasing what the client has said: ‘So what you’re saying is...?’
Once the nature of the objection and its importance is clear, then an attempt can be made to solve the problem. If the problem lies in the client’s understanding or interpretation of what he has heard, then it should be straightforward to solve. If the problem lies in something specific and the client is not willing to move, then the obstacle should be put into perspective and other compensating factors stressed.
The handling of objections or queries is another step in helping the client to buy something for which they have seen a clear need and of which they can now see the full benefit.
4.6.3 Obtaining commitment to buy
Obtaining a commitment from the client in the form of a completed application form will depend on how effectively all of the earlier stages of the sales process have been carried out. Attempting to close a sale too early is clearly not sensible, and deciding when to close a sale is determined by two factors: the reaction of the client and their understanding of the proposal.
Closing the sale simply involves asking the clients if they are happy to set the wheels in motion and complete the application. Sometimes the client may expect the adviser to complete the form on their behalf. It is permissible to do this but only with the client’s permission to do so. If the adviser does complete the proposal form, the client must read it through thoroughly, checking what has been written before he signs it.
In particular, the client must be made aware of the consequences of non-disclosure. If the contract is later made void because of something that the client failed to disclose on the application form, then the whole process will have been a waste of time.
Advisers also have a duty to explain the ancillary factors such as the cancellation notice to clients. This notice explains the client’s right to withdraw from any arrangements within a defined period. Similarly a key features document together with a client-specific illustration must be given to the client before the sale is closed. These documents provide the client with all the information he needs in order to make a decision. The client should also be provided with a product brochure explaining product details and features in full.
The business card that the client will have been given during the meeting gives him a clear route back to the adviser should there be any queries later on.
Detailed records of the transaction must be kept securely stored but accessible for at least three years. For life policies and pension contracts, the period is six years and details of pension transfers, opt-outs and free-standing AVCs must be kept indefinitely.
Providing a professional service means more than selling a product to meet needs: it means ensuring that proper after-sales care is given and that reviews are carried out.
This will include ensuring that, where the acceptance procedure involves any delay, the client is kept fully informed. It will also mean dealing with other related matters such as direct debits, policy delivery, cancellation notices, standard reviews and any requests to alter the plan.
After these general areas, client servicing falls into two categories: proactive and reactive servicing.
Proactive servicing involves instigating action by contacting the client to discuss further needs.
This might be on a matter previously agreed, such as the next salary review, a job change, or even the taking up of recommendations of which the client was unable to take advantage originally.
Even where there is no known future event or requirement, it is a good idea to agree a time to review the client’s position. At a review, an adviser can find out if there have been any changes to the client’s circumstances and can update the appropriate records. By doing this, an adviser is in a strong position to identify opportunities to recommend new products appropriate to the client’s needs, or to recommend changes to existing products.
Reactive servicing happens as the result of a request from the client, eg a request to discuss the recommendation after comments made in the media or by competitors. The client’s circumstances might change unexpectedly, resulting in a request for advice.
The request may not be received directly from the client: it might be notification of non-payment of premiums or indeed, a request by the next of kin to sort out a death claim. In order to be fully prepared for all eventualities, clear and concise records must be maintained.
The keeping of all appropriate records will not only comply with the requirements of the Financial Services and Markets Act 2000, but it can also lead to more business.
Test your knowledge and understanding with these questions
Take a break before using these questions to assess your learning across Section 4. Review the text if necessary.
Answers can be found at the end of this unit.
1. What is likely to be the main financial priority of a couple with a young family?
2. What is the main objective of completing a factfind?
3. List the employment details of a client that an adviser would normally need to ascertain.
4. What details should an adviser request in relation to loans?
5. What risks might apply to investment in a bank or building society deposit account?
6. List the factors that an adviser might take into account when deciding on an appropriate solution/product for a client.
7. The first stage in handling an objection should be to:
(a) qualify it.
(b) agree with it.
(c) quantify it.
8. What is proactive servicing?
Answers to questions
1. Family protection, particularly the protection of income and assets against the effects of the death or illness of a breadwinner.
2. To define accurately the client’s needs.
3. Whether the client is:
employed, unemployed, self-employed, retired; part-time/full-time, permanent/temporary.
What are the details of their employer; nature of work; income (basic, overtime, bonuses, commission); benefits; pension scheme.
4. Lender, purpose of loan, balance outstanding, remaining term, secured/unsecured, interest rate, repayment method, repayment amounts.
5. Risk of loss due to collapse of bank/building society (small risk, some compensation available). Risk that interest rate falls below that expected. Risk of fall in capital value due to inflation.
6. State provision; client’s existing arrangements; client’s and product’s tax position; client’s risk profile; timescale of needs; flexibility required.
7. (a) qualify it.
8. Instigating action by contacting the clients to discuss their continuing needs.
The main areas of financial advice
Introduction
Clients often have a range of financial needs, even when they approach an adviser with one particular need in mind. In order to give the most appropriate advice, advisers must be aware of the nature of all of the needs that clients may have – and must be able to recognise those needs even where clients themselves are not aware of them. Some needs may be immediate, such as family protection, while others, particularly retirement needs, will seem a long way off.
This section looks at the different areas in which financial advice may be required. These are listed in Part 4 of the Unit 1 syllabus, and include budgeting, protection, borrowing, investment, retirement planning, estate planning and tax planning.
The need to budget underpins all other forms of financial planning. At its simplest, it reflects the need to have sufficient funds to purchase the necessities of daily living. It also encompasses the need to determine how much can be spent on other items: on capital purchases; on leisure pursuits and holidays; on provision for a secure retirement.
Many savings products can be used to budget for future capital and income needs, but advisers must be careful not to put pressure on the client’s current and future income when selling products paid for out of that income. An increase in mortgage interest rates, for example, could push a family’s expenditure beyond its means.
It might be argued that the need to balance the budget on a weekly/monthly basis is not as great as it once was, as a result of the easy availability of credit, but all borrowing must be repaid at some point, and advisers should exercise caution when considering clients’ likely future income and expenditure levels.
Life can be a risky business and it is not possible to avoid all the dangers and difficulties that it can bring. It is, on the other hand, possible to take sensible precautions against the impact of the risks that affect people, their lives, their health, their possessions, their finances, their businesses, and their inheritances.
Many people, however, make little or no provision for minimising the financial consequences of death or serious illness. This may be because they are not aware of the size of the risk or because they believe that they cannot afford to provide the cover, not realising how cheap it can be, especially if taken out when young.
The probability of dying before age 65 is about one in five for males in the UK. In a typical year, according to government statistics, about 150,000 males aged between 20 and 65 will die in the UK, while about four times that number (600,000) will be off work for more than six months due to ill health. In the same period, about 200,000 people in the UK are diagnosed as suffering from cancer and about 100,000 will suffer a stroke.
Many people take an ‘it won’t happen to me’ attitude but, the simple fact is, it might!
For most families, it is income rather than savings that enables them to enjoy their standard of living. Loss of that income on the death of the breadwinner usually causes a reduction in a family’s quality of life.
State benefits may be available but they generally do little more than sustain a very basic lifestyle, and increasing pressure on funding means that they are more likely to reduce than increase in real terms in the future. The surviving spouse/partner may therefore have to become the earner, leaving a problem of who will look after the children (or alternatively the problem of funding the cost of childcare).
Another consequence of the death of the main earner is that dependants may not be able to make loan repayments, particularly mortgage repayments. If the loan cannot serviced, the property may have to be sold and the family rehoused in less suitable circumstances. This problem can be addressed either by making provision for a monthly income equal to the loan to be payable for the remainder of the loan term, or by providing for a lump sum to pay off the outstanding loan capital.
It is equally important for the life of a dependent spouse or homemaker to be insured, even though they are not the family’s earner. In the event of their death, the normal earner may have to give up work in order to look after the children, or may have to pay the cost of full-time childcare.
5.2.1.2 Losses due to sickness
Many of the arguments for protection against the adverse financial consequences of death apply equally to the need for protection against the impact of long-term illness. In fact, the arguments for protection against financial loss through sickness may be even stronger than those for protection against that from death, not just because the likelihood of suffering a long-term illness is greater than that of premature death, but also because the financial impact on a family of long-term sickness can be even more severe than that resulting from a death.
Protection against the impact of sickness may fall into a number of categories:
• an income to replace lost income (for instance when the main earner suffers a long-term illness);
• an income to pay for someone to carry out the tasks normally undertaken by a person who is ill;
• an income to pay for continuing medical attention or nursing care during an illness or after an accident;
• a lump sum to pay for private medical treatment;
• a lump sum to pay for changes to lifestyle or environment, such as alterations to a house or a move to a more convenient house.
As in the case of protection against death, there may be a requirement to cover not just a main breadwinner, but also a dependent spouse.
A number of factors contribute to the amount and type of cover required, including the following:
• the ability of the insured person to adapt to other types of work;
• the extent to which an employer might continue to pay salary during an illness;
• the number and ages of children and other dependants;
• the availability of help from family and friends;
• the nature and amounts of state benefits available.
5.2.1.3 Losses due to unemployment
The problems resulting from unemployment/redundancy are, in many ways, similar to those caused by illness, but it is much more difficult for insurers to predict statistically the likelihood of loss of employment than it is to predict loss of health or loss of life. Unemployment cover is consequently much more difficult to obtain as a stand-alone insurance and, when it is available (normally only in conjunction with sickness cover and often only in relation to covering mortgage repayments), it is usually subject to a number of restrictions (see also Section 3.3.2.3).
There are a number of business situations in which the loss of a colleague can have severe implications for the financial health of an organisation. Life or sickness insurance can be used to mitigate the financial loss that may result. One or two of the more common circumstances are described below.
5.2.2.1 Death of a key employee
The death of an important employee, particularly in a small company, can have a devastating effect on a company’s profits. Key personnel, though more often found among the management of companies, can actually be found at all levels of a company. People with different roles may, for very different reasons, be key personnel on whom the company’s profits depend:
• a managing director with a strong or charismatic personality;
• a research scientist with specialised knowledge;
• a skilled engineer with detailed understanding of the company’s machinery;
• a salesperson with a wide range of personal contacts.
Determining the level of cover that is required can be difficult. A simple method is to use a multiple of the key person’s salary, say five or ten times. Another method is to relate the cover to an estimate of the key person’s contribution to the company’s profits. This contribution can be calculated by multiplying the amount of current annual profit by the ratio of the key person’s salary to the company’s overall wage bill. This estimate of the key person’s contribution is then multiplied by the length of time that the company would take to recover from the loss, often assumed to be five years.
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Example Using this method, calculate the level of cover for Goran, who is the production director of a firm whose last published gross profits were £4 million. Goran is paid £50,000 pa; the firm’s total wage bill is £2 million. The sum assured for a policy on Goran’s life could be calculated as: 50,000 x 4,000,000 x 5 = £500,000 2,000,000 |
The company would then take out a term assurance on the life of the employee, for the period during which the employee is expected to be a key person. This may be until retirement, or until the end of a contract or a particular project. If a term assurance of five years or less is chosen, the premiums are likely to be allowed as a business expense, which the firm can set against corporation tax. In the event of a claim, however, the policy proceeds will then be taxed as a business receipt and subject to corporation tax.
5.2.2.2 Death of a business partner
A partnership is defined in the Partnership Act 1890 as ‘the relationship that exists between persons carrying on a business in common with a view to profit’. Groups of professionals such as solicitors and accountants normally work together as partners.
On the death of one of the partners, the beneficiaries of that partner (often his spouse and/or family) may wish to withdraw his share of the partnership’s value. This can cause problems for the remaining partners because it might mean that they will have to sell partnership assets to pay the deceased partner’s family. Since much of the value may be in the form of ‘goodwill’, it may not be possible to realise it except by selling the whole business. ‘Goodwill’ is that intangible and yet real portion of the value of a business that relates to the firm’s good name or reputation. In such circumstances, the need for partnerships to insure against the death of each partner – in order to buy out their share – is clear.
There are three main types of scheme used for this purpose.
5.2.2.2.1 The automatic accrual method
Within the automatic accrual method, all partners enter into an agreement under which, on the death of a partner, his share is divided among the remaining partners in agreed proportions. The deceased partner’s family is compensated by the proceeds of a life policy written in trust for their benefit.
5.2.2.2.2 The buy and sell method
Under the buy-and-sell method, all partners enter into an agreement under which, on the death of a partner, that partner’s legal representatives are obliged to sell his share to the other partners, who are obliged to buy it. To enable them to do so, each partner takes out a life policy on his own life in trust for the other partners. One problem is that the person who inherits the share is deemed to receive cash rather than business assets, so no business relief from inheritance tax is available.
5.2.2.2.3 The cross-option method
The cross-option method is basically the same as the buy-and-sell method, except that the agreement specifies that the deceased partner’s estate has the option to sell their business share to the remaining partners, who have the option of buying it. They always do but, because there is no legal obligation to do so, those who inherit are deemed to receive business assets and relief from inheritance tax may be available.
5.2.2.3 Death of a small business shareholder
Small businesses are often run as private limited companies with a small number of shareholders, who are often family members or close relatives or friends. In the same way that partners may wish to buy out the share of a deceased partner, surviving shareholders in a small business will probably want to buy the shares of a deceased shareholder to prevent the shares from going out of the close circle of existing shareholders. The same types of schemes as described on Section 5.2.2.2 can be used for shareholder protection.
5.2.2.4 Sickness of an employee
If sickness prevents a key employee from working, the effect on profits can be just as serious as in the case of that employee’s death. The company may need funds with which to pay the salary of a replacement who can supply the skills and attributes lost through sickness.
5.2.2.5 Sickness of a business partner
If a partner falls ill, he may be able to continue to draw income from the partnership for some time, even if not contributing his skills to the partnership’s earning capacity. There will be a need to provide a replacement income to avoid the partner becoming a drain on the partnership’s resources. The remaining partners may even wish to buy his share of the business in the event of the partner being unable to return to work. Clearly there is a possible need for income protection and/or for critical illness cover in addition to life assurance.
5.2.2.6 Sickness of a self-employed sole trader
Although sole traders may employ others to work for them, they often do much of the key work themselves, including accounting and decision-making. If a sole trader ceases working, his income is likely to stop very quickly. Worse still, his customers may be lost to competitors, causing the business to collapse. The pressure and anxiety resulting from such a situation is likely to hinder recovery from the very illness by which it was caused.
House purchase is, for the majority of people, the largest financial transaction of their lives and, since most people are not able to fund the price of a house out of their own capital, a loan from a bank, building society or other source is normally required.
Since a mortgage loan is such a large and long-term transaction, the consequences of making a mistake can be very serious. It is therefore particularly important for an adviser to choose wisely and to suit the products chosen to the client’s needs. Choosing the wrong lender or the wrong interest scheme, for example, could lead to the client paying more than is necessary for the loan. For people who may wish to make their interest payments early, a daily interest scheme could help them to save money; a flexible mortgage might give yet more freedom, allowing overpayments, underpayments and even payment holidays. Lower interest rates can often be obtained by remortgaging.
Choosing the wrong investment product can lead, at worst, to the mortgage not being repaid in full at the end of the term. At best, it might mean that the client misses out on possible surplus funds. Recent industry experience of borrowers who were originally ill-advised to choose endowment assurances, without being warned about the possible disadvantages, has confirmed the importance of good advice in this area. The exact nature of what constitutes good advice in a particular case will depend on a variety of factors, including the term for which a loan is required and the tax situation of the borrower.
Failing to protect the outstanding capital or the repayments against sickness, death or redundancy, can leave a client’s family destitute or lead to them having to leave their home. Many clients are unaware of the magnitude of the risk or of the ease with which it can normally be mitigated.
Broadly speaking, there are two reasons why people invest: to provide income (either now or in the future) or to provide a capital sum. The particular purposes for which they may need income or capital include:
• short-term emergencies (‘rainy-day funds’);
• specific purchases;
• education fees;
• gifts to children;
• buying a business;
• loan repayment;
• retirement.
Saving and investment needs change over the course of a lifetime, as explained at the beginning of Section 4. The financial services industry provides a very extensive range of savings and investment products to meet the needs of a wide spectrum of customers. The products can be categorised in a number of different ways. Some of those categories are mentioned here, together with a few illustrative examples.
5.4.1 Regular savings or lump sum
Most people build up their savings by small regular amounts from their disposable income. They may use regular savings schemes such as deposit accounts or unit trusts, or pay regular premiums to endowment policies, or they may make contributions to pension plans.
The need to invest a lump sum may arise from the receipt of a legacy or other windfall, or it may reflect the desire to move money from one form of investment to another.
The level of risk ranges from products where there is virtually no risk to the capital, such as bank deposit accounts, to those where the customer accepts the risk of loss of some or all of the capital in order to speculate for higher returns. Most stock market-related investments fall into the latter category to some degree. The relationship between risk and reward is very important. As a general rule, products that carry a greater risk also have a greater potential for higher returns.
Many deposit accounts have instant access or require only short notice of withdrawal. At the other end of the scale, some investments are not directly accessible until a fixed maturity date: most gilt-edged securities fall into this category, although they can be sold prior to their redemption date (but without any guarantee of the price that may be obtained). Shares and some gilt-edged stocks (and other investments) are irredeemable, ie they have no maturity or redemption date. Here again, investors requiring access to their money must sell the securities to an investor who wishes to buy.
The main UK taxes affecting investors are income tax and capital gains tax. With many investments, tax is payable by investors both on the income received and on any capital gain made on eventual sale. Shares and unit trusts fall into this category. Some investments, eg gilt-edged securities, are taxed on income but are exempt from capital gains tax.
It is important to consider the tax regime of the product in conjunction with the tax position of the investor: for instance, an investor who does not pay income tax will not benefit from taking out a cash ISA.
One of the factors that is least understood by clients is the impact of inflation on investment returns. As long as there is inflation, the purchasing power of a given amount of money will fall. For example, the purchasing power of £1,000 after ten years of 3% inflation will have fallen to under £750. Before an investment can grow in real terms it must first increase in line with inflation: the aim of any investment should be to provide a real return. Over the long term, equity-linked investments have proven most likely to offer growth rates over and above the rate of inflation.
Inflation in the UK is currently running at a very low rate and this is expected to continue for the foreseeable future. It is important that advisers educate customers about the impact of low inflation on potential returns from investments. The significant measure for an investment is the real rate of return, which reflects the true purchasing power of invested funds. The real rate of return can be estimated by subtracting the rate of inflation from the interest/growth rate obtained on the investment: an investment paying 4% interest at a time when inflation is 3% is providing a real rate of return of only about 1%. If the rate of interest is less than the rate of inflation, the real rate of return will be negative and the purchasing power of the invested funds will fall in real terms.
Low inflation and low interest rates tend to go together, and one effect of this is that people tend to suffer from the so-called money illusion, ie they tend to think of interest rates in their nominal sense and not to adjust their thinking to allow for inflation. Both savers and borrowers can be affected.
• Savers feel that the low interest rates currently being paid on savings are a poor return for their money. They may therefore react to lower inflation by putting their money into riskier assets in order to seek higher returns – demand for high-yield bonds has certainly increased in recent years. But If a high number of people on average incomes lose their money because of opting for riskier investments, they may not be able to afford to retire and social problems will result.
• Borrowers (particularly those repaying mortgage loans) feel that they are gaining from the lower monthly repayments that have resulted from interest rate falls. This may persuade them to take out a larger mortgage since they feel they can more easily afford the monthly repayments. This is a misperception as, although less cash flows out in interest payments at the start of the mortgage term, a higher proportion of cash flow will be necessary to repay the capital later. Again, problems may be stored up for the future as people take on debt they cannot afford, especially if interest rates rise again. In the meantime, an increased demand for houses can push up house prices and threaten price stability.
One of the great difficulties faced by governments in recent years has been to convince the UK population, brought up for the most part in the era of the welfare state, that changes in its demographic structure and social environment make it increasingly difficult for the state to provide the social security benefits – and particularly pensions – that will be needed to maintain people’s lifestyles but which will represent a realistic and acceptable cost to the taxpayer.
The basic state pension – set at about one quarter of the national average earnings level – is clearly inadequate for anything more than subsistence living, yet many people are continuing to reach retirement age with little or no pension provision to look forward to apart from the basic state pension. This is particularly – although by no means exclusively – true of people at the lower end of the earnings scale. They are often financially unsophisticated and unaware of products such as stakeholder pensions that could have been used to boost their pension. Even when aware, these people may have more pressing demands on their income; and if they do know of the products, they may have been put off by talk of high charges or of product mis-selling.
It is not unrealistic to refer to the situation as a crisis. The extent of the problem is illustrated by the fact that recent estimates of the total shortfall in pension provision – popularly known as the savings gap – have varied between £27 billion and £33 billion. Statistics show that 90% of people now live to the age at which they receive their state pension, compared with 66% of people only 50 years ago – and those who do collect their pension receive it on average for eight years longer than did pensioners in the early 1950s.
The problem has been accentuated by the accelerating trend in occupational pensions away from final salary schemes (also known as defined benefit schemes) and towards money purchase (or defined contribution) schemes.
Successive governments have been increasingly aware of the potential problem, and have introduced certain measures to attempt to counteract it (such as stakeholder pensions), but these initiatives have not, on the whole, been a great success. Stakeholder pensions were supposedly targeted at people in the income range £9,000 to £20,000 – believed to include the greatest proportion of people who are failing to make adequate provision for their retirement. The product was designed with a number of features intended to attract the savings of this particular group, including low charges and low minimum contributions.
Despite this, initial evidence suggests that there has been very little take-up of stakeholder pensions among this main target group, with most of the sales being to people who would have been making pension provision anyway through other schemes and have chosen stakeholder pensions because of the lower costs. Some people feel that one of the reasons for the low demand for these pensions is that the maximum charge providers can incorporate is 1.5% of the fund. Not only does this low figure discourage providers from marketing the product but – perhaps more significantly – it effectively prevents them from paying realistic commission to independent financial advisers who might sell stakeholder pensions.
It remains a fact, however, that individuals will increasingly have to take responsibility for their own retirement provision, and they will need advice to help them through this complex area of financial services.
The nature of inheritance tax (IHT) is described in Section 1.3.3.5. It is, broadly speaking, a tax that is levied at 40% on the estates of deceased persons but there is a nil-rate band (set at £285,000 in 2006/07) that effectively exempts any estates – or portions of larger estates – that fall under that threshold.
There are basically two approaches that people can take to minimise the impact of IHT: one is to try to avoid having to pay it and the other is to make provision for paying it when it is due.
To avoid paying IHT, it is necessary to reduce the value of the estate to below the nil-rate threshold. This can be done by making use of the various exemptions described in Section 1.3.3.5 to make tax-free, or potentially exempt, gifts during one’s lifetime. Another method is to place assets in trust, since trust property no longer forms part of the settlor’s estate.
The largest component of most people’s wealth is the property in which they live. It is not possible to avoid IHT by giving the property away while continuing to live in it, as this would be caught by HM Revenue and Customs’ ‘gift with reservation’ rule, which specifies that if the donor retains any benefit from a gifted asset, the asset is treated for IHT purposes as remaining in the donor’s estate. In the past, many people avoided this restriction by the device of placing their property (known technically as a pre-owned asset) in a trust. The tax authorities have for some time been seeking a way of closing this loophole and this was finally achieved by means of Schedule 15 of the Finance Act 2004, which introduced new rules for the taxation of pre-owned assets. The rules came into force from 6 April 2005 but are partly retrospective, in that people will be liable to an income tax charge each year on the benefit of occupying or using any asset previously owned but disposed of after 17 March 1986. The tax charge will be based on a realistic annual rental for the property they occupy. If the deemed rental amount is less than £5,000, no tax charge is levied. Some people may decide that cancelling their schemes (with the loss of the benefits and some, or all, of the set-up costs) is better than paying the future tax bills.
Couples are normally advised to ‘equalise’ their estates, in other words for each to own half of the value of the estate (or at least up to the nil-rate threshold each). This enables each spouse’s nil-rate band to be used, maximising (perhaps even doubling) the amount of tax-free inheritance that can be passed on.
If avoiding the tax is not a realistic option, a life assurance policy for the anticipated amount of the IHT should be taken out. Whole-of-life assurance is appropriate and, in the case of a married couple, the policy should normally be payable on the second death (since no tax will be due if the estate of the first to die is left to the surviving spouse). To avoid the policy proceeds becoming part of the deceased’s estate – and therefore themselves subject to IHT – the policy should be written in trust for the benefit of the beneficiaries of the will.
Finally, it should be mentioned that a vital element of estate planning is for the client(s) to have an appropriate (and valid) will. Financial advisers should not generally become involved in writing a will, but should strongly advise that the client consult a legal adviser to ensure that a will is in place. If necessary, the financial adviser can provide a document explaining any financial objectives that the will should help to achieve.
The recommendation of a financial product should always take account of the product’s impact on the client’s tax situation, but not in isolation: it should be considered in context, in conjunction with other features of the product. For instance, contributions to a pension arrangement are often the most tax-efficient way for an individual to invest, but this should never be the main reason for recommending a pension product.
Just as it is wise to leave the writing of wills to solicitors, financial advisers should normally avoid becoming involved in complex tax-planning schemes, which should be left to taxation experts. On the other hand, it is important to be able to choose appropriate products that can compliment and improve a client’s current tax situation:
• clients should normally consider the use of ISAs and friendly society policies to maximise the advantage of tax-free income or growth;
• clients who expect to exceed their annual capital gains tax allowance might consider investments that are CGT-free, such as gilt-edged stocks.
Advisers should be aware of circumstances where tax that has been paid (in effect on behalf of the investor) cannot be reclaimed even though the investor is not a taxpayer. An example of this would be an endowment policy or a life office investment bond, where gains made within the life company’s funds are taxed at 20%: this deduction cannot be reclaimed by a policyholder who does not pay capital gains tax. By contrast, unit trust managers are not taxed on gains within their funds; holders of units are liable for CGT if they sell their units at a profit but they may be able to avoid this by use of their annual CGT exemption.
At any given time, one or more of the advice areas described above might be the most significant for a particular client. Circumstances can, however, change very quickly and the financial needs of a client and his family may change dramatically. Births, marriages (and divorces), deaths, moving home, changing jobs, losing a job and many other events can change people’s attitudes and desires, as well as their assets and liabilities. Advisers should take account of this by allowing (as far as possible) flexibility in the products recommended and also by making plans to review the client’s situation at regular intervals. This topic is also covered in Section 4.6.5.
Test your knowledge and understanding with these questions
Take a break before using these questions to assess your learning across Section 5. Review the text if necessary.
Answers can be found at the end of this unit.
1. Why should the life of a dependent spouse be covered with life assurance?
2. What main factors affect the calculation of the level of sickness cover needed by a family man with children?
3. What is the purpose of key person insurance?
4. How does the cross-option method differ from the buy-and-sell method of partnership protection?
5. What is the most common reason for remortgaging?
6. What is the relationship between risk and reward?
7. If the rate of inflation is 2.5%, what yield must an investor obtain on his deposit account in order to achieve a real return of 3%?
(a) 0.5%.
(b) 2.5%.
(c) 5.5%.
8. What is the purpose of married couples equalising their estates?
Answers to questions
1. Although not working in the conventional sense, the death of the dependent spouse can lead to severe problems in a family with young children. Either the working widow(er) must give up work to look after the children or funds must be found to pay for childcare.
2. The extent of any sickness benefit from an employer; the nature and amount of available state benefits; the number and ages of the children; availability of any family help with domestic tasks.
3. To mitigate the loss of a company’s profits caused by the death or long-term illness of an important member of staff.
4. Because it comprises an option to purchase the deceased partner’s share rather than a binding contract, the deceased’s family or heirs are deemed to receive business assets rather than cash, so business relief from inheritance tax can be claimed.
5. To get a loan with a lower rate of interest.
6. As a broad rule, investments that carry a greater degree of risk offer the prospect (but not the guarantee) of a greater reward in the form of interest income or capital growth.
7. (c) 5.5%.
8. It should enable them to increase the amount that is left to their heirs free of inheritance tax, through the use of both of their nil-rate bands.
Basic legal concepts relevant to financial services
Introduction
Section 6 covers part 6 of the Unit 1 syllabus, ie some of the more general legal concepts and legislation to the provision of financial services such as wills, trusts, contracts, agency agreements, powers of attorney and bankruptcy.
The legislation that is related specifically to the regulation of financial services is covered in more depth in Unit 2.
Legal persons in the context of financial services refers to those who have a separate legal existence and can therefore enter into contracts or be sued in a court of law. It is important to remember that this includes individuals in a personal/private capacity and those individuals acting in a formal capacity such as executors, as well as groups of individuals such as trustees. It also includes organisations such as limited companies.
6.2 Personal representatives and wills
The people who carry out the procedures necessary to distribute the estate of someone who has died are known as the deceased person’s personal representatives.
The exact procedure to be carried out in order to distribute a deceased person’s estate depends on whether or not there is a valid will. The following comments apply to the law of England and Wales (Scottish law differs both in the procedures involved and in the terminology used).
If there is a valid will, the executor(s) apply for a grant of probate. The executors are appointed (ie named in the will) by the testator (the person making the will) to ensure that the actions specified in the will are carried out. The grant of probate gives the executors legal authority to carry out the testator’s instructions, as set out in the will. An executor can also be a beneficiary of the will. The duties of an executor can be time-consuming and onerous and it is not uncommon for executors to appoint a solicitor to carry out all or part of their duties.
If there is no will (or the will is invalid), a grant of letters of administration is issued to an appropriate person, who is known as the administrator. This will often be the surviving spouse or on other close relative. The administrator’s responsibility is to deal with the estate as prescribed by the rules of intestacy (see Section 6.2.1).
A will is a written declaration of an individual’s wishes regarding what they want to happen after they have died. Although primarily concerned with how the person wishes to dispose of their assets, a will can also deal with other matters, such as giving instructions about burial.
The terms of a will only take effect on the death of the testator, the person who made the will. Before then, the testator can revoke (cancel) or modify the will at any time. Modifications are recorded in a document known as a codicil.
To make a valid will, two formalities must be followed:
• the will must be in writing;
• the will must be properly executed.
The minimum age for making a valid will under English law is 18.
The will should be a clear and unambiguous statement of the deceased’s wishes in respect of their estate, and must be signed by the testator in the presence of two witnesses, who must not be beneficiaries under the will (or the spouses of beneficiaries).
In the event of marriage or remarriage, a will is automatically revoked, unless specifically written in contemplation of marriage.
In the UK, approximately seven out of ten people die intestate, without leaving a valid will. Writing a will is the first step in gaining control over an estate and is therefore a vital part of financial planning.
The cost of writing a will is quite reasonable and should not be viewed as a barrier to making a will. A financial adviser’s role should not involve the writing of a will but it is important that clients understand the benefits of a valid will and the risks of not having one. If the client has no will, the financial adviser should recommend that they seek professional advice from a solicitor.
In certain circumstances it may be advantageous, following the death of the testator, for the beneficiaries under a will to vary the way the estate has been allocated. This can be achieved by executing a deed of variation. All those who would have benefited from the provisions of the will must be over 18 years of age and be in agreement on the terms of such a variation. A deed of variation is often executed for tax purposes: a change in beneficiaries or in the relative shares received could reduce the inheritance tax liability, for example. In order to be effective for tax purposes, the deed of variation must be executed within two years of the death and HM Revenue and Customs must be informed within six months of its execution. The variation must not be entered into for any consideration of money or money’s worth.
A person who has died without having made a valid will is said to have died intestate. This includes the situation where the deceased has left a will but where the will turns out to be invalid.
If a will makes valid provision for the distribution of some of the assets of the estate, but not of others, this is referred to as partial intestacy.
The distribution of the estate of a person who has died intestate is determined by a complex set of rules known as the rules of intestacy. They are very specific and there is no flexibility or discretion for their variation by the person dealing with the estate. The destination of property under the intestacy rules depends on the size of the estate and the deceased’s family circumstances. In many cases – especially if the estate is a large one – the distribution of the assets may not be as the deceased would have wished. In particular, it is not necessarily true – as many people believe – that a surviving spouse or civil partner will receive the whole estate.
The main rules require that:
• if the deceased leaves a spouse but no children: the spouse gets the first £200,000 plus half the remainder; the balance goes to the deceased’s parents or, if they are dead, to the deceased’s brothers and sisters;
• if there is both spouse and children: the spouse gets the first £125,000; half of the balance goes to the children; the other half of the balance goes into a trust from which the spouse receives income for life, and the capital goes to the children when the spouse dies;
• if there are children but no spouse: the estate is shared equally among the children;
• if there is neither spouse nor children: the estate goes to the deceased’s parents or (if they are dead) to the deceased’s brothers and sisters.
A trust (also known as a settlement) is a method by which the owner of an asset (the settlor) can distribute or use that asset for the benefit of another person or persons (the beneficiaries) without allowing them to exert control over the asset while it remains in trust. Depending on the nature of the trust, the beneficiaries may eventually become the absolute owners of the asset.
The settlor is the person who creates the trust and who originally owned the assets placed in the trust (the trust property). Once it is placed in trust, the asset is no longer owned by the settlor (unless he is also a trustee – see below).
The beneficiaries are the people or organisations that will benefit from the trust property. They may be named specifically or referred to as a group, eg ‘all my children’.
The trustees are the people, appointed by the settlor, who will take legal ownership of the trust property and will administer the property under the terms of the trust deed. The trustee or trustees, who can include the settlor, are named in the trust deed. Trustees must be aged 18 or over and of sound mind. If a trustee dies, the remaining trustees, or their personal representatives, can appoint a new trustee.
Trustees must:
• act in accordance with the terms of the trust deed. If the trust deed gives them discretion to exercise their powers (eg discretion over which beneficiaries shall receive the trust benefits), the agreement of all of the trustees is required before a course of action can be taken;
• act in the best interests of the beneficiaries, balancing fairly the rights of different beneficiaries if these should conflict. For example, some trusts provide income to certain beneficiaries and, later, distribution of capital to other beneficiaries; the chosen investment must preserve a fair balance between income levels and capital guarantee/capital growth.
Under the Trustee Act 2000, trustees who exercise investment powers are required to:
• be aware of the need for suitability and diversification of assets;
• obtain and consider proper advice when making or reviewing investments;
• keep investments under review.
Companies are legal entities, quite separate from their shareholders (see Section 2.3) or their individual employees. Shareholders of a limited liability company cannot be held personally responsible for the debts of the company, the limit of their liability being the amount that they have invested in company shares. This is the most they could lose if the company were to become insolvent with large debts.
The nature of the company, and the rules about what it can and cannot do, are set out in its memorandum and articles of association. In relation to a company’s ability to borrow money, for example, the memorandum normally includes the power to borrow, but may place limits or restrictions on that power in terms of amounts or purpose. This will be significant if the company wishes to take out a mortgage or other form of loan.
The actions of the company are, of course, carried out by people and, when making a contract with a company or lending money to a company, it is essential to check that the persons committing the company to a particular course of action are authorised and empowered to do so.
A partnership is an arrangement between people who are carrying on a business together for profit. Unlike a company, a partnership is not a separate legal entity and the partners jointly own both the assets and the liabilities of the partnership (see, however, notes on limited liability partnerships in Section 6.5.1 below).
Partnerships should have a written agreement that sets out in detail the relationship between the partners, including proportions in which they share the partnership’s profits and what will happen when a partner leaves, retires or dies (see also Section 5.2.2.2).
6.5.1 Limited liability partnerships
Since 2001, it has been possible to run a business as a limited liability partnership (LLP). This means that partners have a limited personal liability if the business should collapse: their liability is limited to the amount that they have invested in the partnership, together with any personal guarantees they have given, eg to a bank that has made a loan to the business.
As with companies, limited liability partnerships have to be registered with Companies House; they are clearly more like companies than are standard partnerships but the taxation of LLPs is not the corporation tax regime that applies to companies. LLPs are taxed in the same way as other partnerships: each partner is taxed on a self-employed basis, with their individual share of the profits being treated as their own personal income and subject to income tax.
Most business agreements, particularly in the world of financial services, are established as legally binding contracts. Some are made orally, some in writing and some by deed. Not all contracts can be made orally but all contracts generally are subject to certain basic requirements for them to be binding.
The basic requirements for contracts to be binding on the parties involved are:
• offer and acceptance: there must be an offer made by one party (the offeror) and there must be an unqualified acceptance by the other. This acceptance must be communicated to the other party. In practice there may be a number of counter-offers before agreement is reached;
• consideration: the subject of the contract (often a promise to do something or supply something) must be matched by a consideration (which is frequently, but not necessarily, the payment of money). This is given by one of the parties (the promisee) to the person making the promise, that is, the other party to the contract (the promisor). A promise to pay is valid consideration;
• capacity to contract: each of the parties to the contract must have the legal capacity, or power, to enter into the contract. Certain parties have only limited powers to enter into contract, for example, minors and those of unsound mind. For financial institutions such as insurance companies, capacity to contract depends on being authorised by the FSA;
• the terms of the contract must be certain, complete and free from doubt;
• there must be an intention to create a legal relationship, as distinct from a merely informal arrangement;
• legality of object: contracts cannot be made for illegal or immoral purposes;
• the contract must not have been entered into as a result of misrepresentation, or under duress or undue influence.
Some contracts have to be recorded in a specific legal form: all agreements for the sale of land must be made in writing and conveyances of land (the actual transfer of ownership) must be performed by deed.
Generally, there is no duty of disclosure between parties to a contract; most contracts are based on the principle of caveat emptor (‘let the buyer beware’). However, there are exceptions: for example, insurance contracts are based on the principle of utmost good faith, ie all material facts must be disclosed. For an insurance policy, this means that the person applying for the policy must supply all the facts that a prudent underwriter would need to decide the terms on which the policy could be issued. Non-disclosure by the customer makes the contract voidable at the option of the insurance company.
If a party fails to perform his side of the contract and does not have a legal excuse for doing so, then this is a breach of contract. Several court remedies are available in these circumstances. The main ones are to seek damages, an order for specific performance or an injunction. Of these, by far the most frequently sought is damages, where the injured party seeks to obtain financial compensation for his loss. The intention is to put him in the position he would have been in had the contract not been breached by the other party, as far as it is possible to do so with money. In certain circumstances, an order for specific performance can be obtained to compel the other party to complete the contract. Alternatively, an injunction can be sought – this is a court order preventing someone from doing something.
An agent is a person who acts on behalf of another, who is called the principal. The agent can conclude contracts on behalf of his principal. In law, the acts of the agent are treated as being those of his principal.
In any kind of agent–principal relationship, it is important to ascertain how much power and authority has been vested in the agent, just as it is important that the agent is fully aware of what he can and cannot do. Some agents are given very wide authority while some are severely restricted in what they can do.
An agent should only act within the authority given to him by his principal. This should be strictly observed, because, if an agent exceeds his power, it could result in his principal being liable on the contract. This happens when, although the agent acts outside of his actual authority, he acts within what is known as his apparent authority. Apparent authority is where something either done or said by the principal leads to the impression that he has authorised the agent’s actions.
Another result is that the agent may be made liable. This is protective of the third party who, if he is unable to rely on the agent’s claim that he has authority, must be able to hold him personally responsible. It would otherwise be unfair to the third party, who would have entered in good faith into the contract only to find himself without recourse to either the principal (if there is no apparent authority) or to the agent.
If the agent does exceed his authority, the principal can, if he chooses to do so, agree after the event to what the agent has done. This is called ratification.
This very brief introduction to agency cannot cover all the detail of agency law but it will serve to illustrate how important it is for advisers to know, understand and act within the extent of their authority.
Financial advisers who operate as company representatives of a product provider (tied agents) are acting as agents of that product provider. Independent advisers, on the other hand, act as agents of the customer who seeks their advice.
The law of England and Wales defines two distinct types of property; in this context, the word property is used to refer to all types of assets, rather than its more narrow reference to land and buildings. The two types are:
• realty: property is deemed to be real if a court will restore it to a dispossessed owner and not merely provide compensation for loss. Real property tends to be distinguished by being immovable, eg land and what is attached to it;
• personalty: all other property is called personalty.
There are two types of joint ownership, both of which are described in terms of tenancy (but the meaning of tenancy here does not relate to the letting of property). These phrases refer to the joint ownership of any form of asset (or liability):
• joint tenants: the whole property is deemed to be owned by each of the owners, so that if one owner dies, the property automatically transfers into the ownership of the other. The transfer on death to the surviving owner is automatic and cannot be overridden by any provision in the deceased person’s will;
• tenants in common: each owner has an identifiable share of the property; if one owner dies, his share of the property passes to whoever is entitled to inherit it under the terms of the will or under the rules of intestacy.
The concept of joint tenants or tenants in common can apply equally to debts, such as mortgages. In the former case, all borrowers are equally liable for the whole debt, while in the latter each is responsible for a portion of the debt. Banks, building societies and other commercial lenders always insist that joint mortgages are written on a joint tenancy basis.
An attorney is a person who is given the legal responsibility to act on behalf of another person. This may be necessary in the cases, for example, of an elderly person who is incapable of managing his/her own finances or of someone living abroad. The person who makes a power of attorney is called the donor and the person who acts for him is called the donee or simply the attorney.
A person who does not himself have the legal capacity to enter into a contract (eg a minor or a mentally incapacitated person) cannot appoint someone else as their attorney; and in fact, an ordinary power of attorney would automatically cease if a person were to become mentally incapacitated. If a person has anticipated the possibility of becoming mentally incapacitated, he can appoint someone to act for him under a special type of attorney called an enduring power of attorney, which will come into force if and when he becomes mentally incapacitated. Enduring powers of attorney have to be registered with the Public Guardianship Office and can be revoked only with the consent of the Court of Protection.
From 2007, enduring powers of attorney will be replaced by lasting powers of attorney under which attorneys will be able to make decisions not only about financial matters, but also about personal and health matters.
6.10 Insolvency and bankruptcy
Insolvency arises when:
• a person’s liabilities exceed his assets; or
• a person cannot meet his financial obligations within a reasonable time of their falling due.
Bankruptcy takes the position a stage further and arises when a person’s state of being insolvent is formalised under the terms of a county court order. A person can petition to have himself declared bankrupt or a creditor may petition to have someone else declared bankrupt. The bankruptcy level, ie the amount of money owed for which a person can be made bankrupt, is only £750.
The primary UK legislation on insolvency is the Insolvency Act 1986, but this has been subject to amendments over the years. In 2000, an EU Regulation on Insolvency Proceedings was adopted and it came into force in 2002. As a regulation rather than a directive (see Section 1.3.1) it had direct effect in the UK; to clarify the position in the UK, a number of statutory instruments were issued including, for example, the Insolvency (Amendment) Rules 2002.
In 2005, there were around 13,000 company liquidations in England and Wales, of which around 7,700 were voluntary liquidations. In the same year there were around 67,500 individual insolvencies, of which around 47,000 resulted in bankruptcies and the remainder were dealt with through individual voluntary arrangements (IVAs).
An IVA is an alternative to bankruptcy, under which the debtor arranges with the creditors to reschedule the debts over a specified period. The scheme must be supervised by an insolvency practitioner. An IVA can be initiated only if creditors who represent at least 75% of the debt agree to the arrangement.
As a result of the Enterprise Act 2002, which came fully into force in April 2004, most bankruptcy orders now remain in force for 12 months, during which time the person is said to be an undischarged bankrupt. During this time, a bankrupt person’s possessions are, in effect, surrendered to an Official Receiver, who can dispose of them and use the cash to pay off the creditors. The only exceptions are clothing and household items, and work-related items. Although bankruptcy cancels most kinds of debt and allows people to make a fresh financial start, it comes at a price: it normally makes it more difficult to obtain credit in the future and it can affect employment prospects.
One practical effect of bankruptcy is that a person will be unable to borrow, other than nominal amounts, during the period that the order is in force. Even after the end of the period, the person must, by law, disclose the existence of a previous bankruptcy when applying for a mortgage. This may mean that it will be more difficult for him to obtain a loan or that he may be charged a higher rate of interest to cover the greater perceived risk.
Test your knowledge and understanding with these questions
Take a break before using these questions to assess your learning across Section 6. Review the text if necessary.
Answers can be found at the end of this unit.
1. In what sense could a company be described as a ‘person’?
2. Harry has died without leaving a will. His estate will be distributed by:
(a) an administrator.
(b) a solicitor.
(c) a probate officer.
3. Which of the following statements about a will is correct?
(a) A trustee cannot be a beneficiary.
(b) A beneficiary cannot be a witness.
(c) A witness cannot be an executor.
4. Marian, who was married but had no children, died without leaving a will. If her estate was £300,000, how much will her husband inherit?
5. What is ‘consideration’ in relation to a contract?
6. Can a contract be made verbally?
7. In agency law, what is ‘ratification’?
8. Why do mortgage lenders insist that joint mortgages are always on a joint tenancy basis?
9. Whose consent is required before an enduring power of attorney can be revoked?
(a) The donee.
(b) The donor.
(c) The Court of Protection.
10. What is the normal period for which a bankruptcy order remains in force?
Answers
1. A company is a ‘legal person’ in that it has a separate legal existence and can, for instance, enter into contracts. The contract is not with the directors but is with the company.
2. (a) An administrator.
3. (b) A beneficiary cannot be a witness.
4. £250,000 (ie £200,000 plus half the balance).
5. It is the payment (or a promise to pay) for the goods or services that are the basis of the contract.
6. Yes, many can – eg contracts for the purchase/sale of unit trusts can be made by telephone, with a recording of the conversation providing proof. Contracts for the sale of land, however, must be in writing.
7. The process in which the principal formally agrees to stand by a contract made by his agent, even though the agent has exceeded the authority granted to him by the principal.
8. If one borrower should default on the contract, the lender will wish to be able to obtain full repayment from the remaining borrower.
9. (c) The Court of Protection.
10. 12 months.