December 2003

A WORD OF ADVICE FOR 2004 – BEWARE HIDDEN AGENDAS AND HIDDEN TAXES

Hidden Agendas

In recent years we have seen many Banks, Insurance companies and IFA networks fined for incorrectly selling financial products to the UK consumer. I suspect that their "consultants" are being asked to generate sales from client lists without due consideration being given to individual client circumstances. In other words the hidden agenda is extra sales.
I believe that no amount of regulation will prevent miss-selling unless in their heart of hearts, advisors and their employers are working ethically. I have devised a screening technique which will help separate the unscrupulous from the genuine.
When approached by a sales person offering any form of financial advice, and before discussing any of your financial details, insist on receiving a signed copy of their organisations code of ethics and ensure that it clearly shows that your interests will come first.

Check the organisation for independence. Are they subject to product bias because they are tied to one provider? Are they subject to product bias because their Head Office or Network has agreed distribution deals with major product providers? Are they paid by their clients or paid by product providers?

Beware investment solutions which involve large lump sums going into a "product" like a bond of some description. These give the illusion of being tax effective but frequently are not because the product provider will be taxed on income and gains.

Beware investment solutions which would place a high proportion of your invested assets with a single product or a single provider.

Beware any product whose outcome is linked to indices being measured over a period of say 5 years from the date of purchase. No one can predict the future, and to have investment return depend on an index 60 months forward from date of purchase is a very risky strategy. Flexibility is the key to sound financial planning, and products with no flexibility on exit deserve no place in your investment portfolio.

And finally but most importantly, you have to be entirely comfortable with the combination of advisor and organisation you are dealing with.

Hidden Taxes

Nobody likes paying tax, so much so that there is a whole sector of the financial community dedicated to finding ways for our tax paying corporations, businesses and private individuals to legally minimise their tax exposure through tax planning.
As a professional Financial Planner, I have identified some "hidden taxes " that did not originate with the Government or the Inland Revenue and are often ignored by many who give financial advice. An awareness of these and a strategy to deal with them could improve the financial position of many.

Inflation tax

We tend to ignore inflation when it is seems to be under control at around 2% per year, but when inflation is low, interest rates also tend to be low. This is why I regard inflation as a "hidden tax" on interest received. If a saver receives interest of 4% and inflation is running at 2%, inflation is the equivalent of a 50% tax charge. This is why investing in real assets is so important. Assets such as property and shares in quoted companies have consistently outpaced inflation over the years and still produce an element of income.

Of course you need liquidity to deal with emergencies and planned expenditures, so it is essential to have access to liquid reserves to meet these. To this extent Inflation tax is unavoidable but beyond these two elements, you should look to have the balance of your investments in asset classes which have proved resistant to inflation over the long term.

Depreciation Tax

We Brits love our cars and we love to upgrade to new models as often as we can. But now that cars are so reliable, I wonder if buying a new car every 3 years makes as much sense as it did say 25 years ago when build quality was nothing like it is today. If a car depreciates to zero over 10 years then depreciation tax is 10% per year. If the same car depreciates by 50% over the first 3 years then an owner who upgrades his car every 3 years pays depreciation tax at 16.3%. Whether you are a business owner or a private individual, look at depreciation as a tax and see what you can do to improve your position.

Appreciation tax

There is no appreciation tax or Capital Gains tax on our homes. If we purchase a house to live in, the government does not seek to tax gains when we sell it. Neither does the government seek to collect tax on all gains realised from business and investment assets. There are generous annual allowances and time based reliefs which reduce appreciation tax often to negligible proportions.

The key therefore is to have substantially more capital in appreciating assets than in depreciating assets. As a rule of thumb I would be comfortable with a ratio of 10 to 1, in other words aim to have 10% or less of your net worth in depreciating assets.

Transaction Tax

This is the tax that is most difficult to detect. It is pretty clear when buying or selling a property that there are fees, stamp duty etc to be paid. As we tend to have only a few property transactions in a lifetime, we quite rightly view the transaction costs billed by our lawyer as part of the transaction and do not give them much further thought.

With investment funds, such as unit trusts or pension funds, transaction costs need further examination. First, transaction costs are not billed; they are netted off in the price. Second there are 3 levels:

• Commission paid to the seller
• Management fees paid to the fund manager
• Brokerage, stamp duty etc paid by the fund manager

The investment community trade shares every single day, each doing their best to ensure that their fund is placed to benefit, as they see it, from opportunities on the buying side and threats on the selling side. This is exactly as it should be except when we consider that fund managers for the most part are buying and selling to each other, because it is they who make up the bulk of the buyers and sellers in the market. This is why so few fund managers outperform their benchmark indices. Even if they do possess investment insights that could add value (and there is evidence that the majority don’t), after transaction costs this value is reduced or even negative.

The key for investors is find ways of participating in the various asset classes in a way that effectively reduces transaction costs. This is easier said than done, but managing down transaction costs in a low inflation low return era is a key component of total return.