Should you buy an escalating annuity?

By Elementary Financial | Published: June 4, 2013

escalatorWhen taking pension benefits, most people buy an annuity.  This is the process of exchanging a pension fund for an annuity, or ‘income for life’.

Annuities come in many different shapes and sizes, and the buyer will need to make some key decisions.  Decisions which cannot be un-made, due to the nature of the contract being entered into.

One of these decisions is whether to buy a level annuity, which as the name implies will pay a level income for life; or to buy an escalating annuity, which will escalate or increase each year for life.  Not surprisingly, an escalating annuity is considerably more expensive than a level annuity.  Or put another way, with an escalating annuity the income will be considerably lower for a given size of pension fund, when compared with a level annuity.

As an example of the relative costs involved, let us consider Mr Average who is about to retire at the age of 65.  According to the latest UK Interim Life Tables, Mr Average can expect to live for another 17.8 years.  He has a pension fund of £80,000, and wants to take the maximum tax free cash when he retires.  This is £20,000, which leaves a fund of £60,000 with which to buy an annuity.  £60,000 will buy the following: -

Annuity, level                            £3,402 p.a.

Annuity, escalating at 3% p.a.  £2,367 p.a.

Source: MAS 30/05/2013. Male 65. Monthly in arrears.

The reduction in initial income when choosing an annuity that escalates at 3% p.a. is £1,035, a full 30%.

Even without adjusting for inflation and the benefit of having more income earlier, Mr Average would need to survive for more than 24 years before the escalating annuity produced more in total income received.

After adjusting for inflation at 3% p.a., Mr Average would need to survive for more than 27 years to be better off with an escalating annuity.  This is 50% longer than the average 65 year old male actually does survive.

On balance, unless you expect to live for 50% longer than average, a level annuity is likely to prove the most cost effective option.

 

Posted in Advice, Annuities, Investments | Tagged , , | Comments closed

Tier 1 (Investor) Visa

By Elementary Financial | Published: September 15, 2012

Foreign nationals seeking to obtain residency in the UK can obtain this via a Tier 1 (Investor) Visa. 

Passport - Tier 1 InvestorAfter the visa has been held for 5 years applicants can apply for Indefinite Leave to Remain (ILR), and from that point effectively have UK residency as the visa has no further restrictions.

Criteria for application

Visas are awarded on a points based system with points awarded for the following

1.) The applicant must hold funds in a regulated financial institution and be able to transfer or already hold no less than £1 million in the UK.

 

or alternatively

 

2.) The applicant must have worldwide net assets greater than £2 million – net of liabilities and must be able to borrow £1 million against these assets from a regulated financial institution.  As above, no less than £1 million should be held in the UK.

Applications should be made from the applicant’s home country or country of legal residence.  If already in the UK under a different immigration path, in some circumstances this may be switched to Tier 1 (Investor).  Documentation is usually handled by an agent. Once the relevant forms are completed and necessary documents obtained, the agent submits the paperwork to the UK Border Agency for approval, and if successful a visa is issued for 3 years.

A Tier 1 (Investor) migrant must have made a minimum investment of £750,000 in equities and fixed interest within 13 weeks of the Specified Date.  The Specified Date is either: -

  • The date of entry to the United Kingdom, where an applicant is granted clearance as a Tier 1 (Investor) migrant and there is evidence to establish the applicants date of entry to the United Kingdom; or
  • The date of the applicant’s grant of entry clearance, where an applicant is granted entry clearance as a Tier 1 (Investor) migrant and there is no evidence to establish the applicant’s date of entry to the United Kingdom; or
  • The date of the applicant’s grant of leave to remain as a Tier 1 (Investor), in any other case.

This does not apply where the applicant’s last grant of leave prior to the grant of leave that he currently has, was as a Tier 1 (Investor) migrant or as an Investor.  Where the applicant has been found not to have made the investment within three months of the specified date, they may have their leave curtailed.

Investment requirements

Within 3 months of the Visa issuance, or for overseas applicants within 13 weeks of the Specified Date, at least £750,000 of the minimum £1 million must be invested in any of the following investments: -

Gilts (UK Government Bonds)

UK Shares (where the company is UK registered or has a registered office in the UK and is listed on the UK stock market)

Loan capital in active UK registered companies (specifically excluding property companies)

Whilst the full £1 million can be invested in the above, applicants can also invest any balance over £750,000 in a UK bank, or in direct property in the UK.

Investment Trusts, Unit Trusts and other forms of collectives are specifically excluded as the underlying investments cannot be guaranteed to be UK based.

Evidence of investment

Paragraphs 245AA and 59 of Appendix A of the Immigration Rules state that only specified documents will be accepted as evidence of this requirement.

A portfolio of investments certified as correct by a UK regulated financial institution, which must: -

  • Cover the required period of the applicants permission to stay in this category. This period begins no later than 13 weeks after the applicant’s specified date.
  • Continue to the last reporting date of the most recent quarter of the year directly before the date of the application for an extension.
  • Include the value of the investments.
  • Show that any shortfall in investments was made up by the next reporting period. For example if the investments are shown to have fallen in value in the February report in a year, and the investments have a quarterly reporting period, the value has been made up by the June report. Effectively a portfolio can fall below the minimum value in a quarter as long as it is corrected by the next quarterly report.
  • Show the dates that the investments were made.
  • Show the destination of the investments, which should be United Kingdom companies/debt as described above.
  • (for investments made as loan funds only) Include audited accounts or unaudited accounts with an accountant’s certificate (see section 2c of Home Office UK Border Agency document on SharePoint for more details) for investments made as loan funds to companies, which must give the full details of the applicant’s investment.
  • Show the name and contact details of the financial institution that has certified the portfolio as correct, and confirmation that this institution is regulated by the Financial Conduct Authority (FCA) – this will normally appear on the letterhead of all official documentation.
  • Show that the investments were made in the applicant’s name and/or that of his/her spouse, civil partner, unmarried or same-sex partner and not in the name of an offshore company or trust even if this is wholly owned by the applicant.
  • Include the date that the portfolio was certified by the financial institution.
  • State that the institution will confirm the content of the letter upon request.

Visa completion period

Towards the end of the initial 3 year period the applicant can apply to extend the Tier 1 (Investor) visa by an additional 2 years.  In order to satisfy the requirements for an extension the assets must have been correctly invested during the entire 3 year period.

These requirements are: -

  • Have no less than £750,000 invested in the assets noted under Investment requirements, within 13 weeks of entry to the UK.
  • Have maintained a total level of funds in the UK (including the above) in excess of £1 million, throughout the period of residence.

Obtaining permanent residency

After 5 years of continuous residence within the UK a Tier 1 (Investor) can apply for Indefinite Leave to Remain.  Once approved the ILR visa has no further restrictions.  Full British citizenship can be obtained when an applicant has lived in the UK under a Tier 1 (Investor) application for 5 years (although see below) and held ILR for at least 1 year.

Fast track applications

Applicants can speed up the route to ILR status by: -

  • Investing at least £10 million in the UK; reduces the continuous residence period to 2 years.
  • Investing at least £5 million in the UK; reduces the continuous residence period to 3 years.

 

Posted in Advice, Investments | Tagged , , , | Comments closed

EU gender equalisation rules

By Elementary Financial | Published: August 31, 2012

Europe

From December 21, 2012, new EU gender equalisation rules will come in to force in the UK.  These rules will require insurers and providers of pensions to eliminate the difference  in rates that currently apply to males and females, by equalisation.

It will also affect other types of insurance, such as motor insurance.

Pension income

For annuities, this means that men will get slightly worse rates and women slightly better rates.  It is difficult to know by how much the respective annuity rates will change, as, in aggregate, more annuities are purchased by men than women.  What we do know is that in the future there will be a single annuity rate based upon age, and gender will not be a factor.

Any males that are intending to purchase an annuity in the next year or two should consider bringing forward the purchase prior to December 21.  Of course, there are factors other than gender that determine annuity rates.

Likewise, females should consider postponing the purchase of an annuity until after December 21.

This will also affect the GAD rates for those using a pension fund for Capped Income Drawdown.  HM Revenue and Customs (HMRC) has announced that it will apply the same limits on capped drawdown for women as they do for men from 21 December 2012.   The current lower rates can be explained by women’s longer average life expectancy.

The move will allow women to drawdown 8% more than they currently can at the age of 65.  It will not affect the drawdown rates for men.

Please note: Capped Income Drawdown rates are not based solely upon gender, and there are other factors to consider.

Life insurance

Life insurance premiums are currently higher for men than they are for women.  This is due to men dying, on average, at an earlier age than women.  These premium rates will also be equalised, with the likely effect being higher rates for women and lower rates for men.

As with annuity rates, it is difficult to know by how much the respective life insurance premium rates will change, as, in aggregate, more life insurance is purchased by men than women.
Posted in Advice, Insurance, Pensions | Tagged , | Comments closed

Drawdown, capped & flexible

By Elementary Financial | Published: August 1, 2012

When a pension fund holder reaches the point at which they wish to take benefits, they will need to choose between buying an income-for-life in the form of an annuity, or ‘drawing-down’ from the pension fund; this is known as drawdown.

Drawdown, capped & flexibleThere are two forms of drawdown since the latest rule changes in April 2011, capped drawdown and flexible drawdown.

Capped drawdown

The majority of people moving into drawdown will have no choice but to opt for the capped version.  The reason for this is that they will not meet the MIR test – see flexible drawdown.

As the name implies, this form of drawdown is subject to a cap on the level of drawdown income that can be taken.  The cap is set by reference to: -

  • the size of your pension fund
  • your age
  • the GAD rate (Government Actuary‘s Dept)

The cap is reviewed automatically every 3 years, although you can request a review more frequently if you wish.

All other things being equal, which they are often not, the amount that can be drawn down may increase with age.  You should note however that this amount is very sensitive to fund size, which can and will fall and rise; and 15 year Gilt yields (which determine the GAD rate), which can and will fall and rise.

Flexible drawdown

Flexible drawdown is open to those individuals that can meet a Minimum Income Requirement (MIR) test.  To meet the test, an individual needs to prove an income from pensions of at least £20,000 per annum.  Only pensions actually in payment count towards the £20,000 minimum income requirement for flexible drawdown.  To qualify, the pension(s) must be guaranteed for life and, in general, not be pensions that can reduce from one year to the next.

As the name implies, this form of drawdown is flexible in terms of the income that can be drawn down.  There is no maximum drawdown, other than the entirety of the pension fund.

Please note: -
Nil income can be drawn from either version
Drawdown income is subject to income tax

Posted in Advice, Pensions | Tagged , | Comments closed

Owner or lender?

By Elementary Financial | Published: December 16, 2011

The forthcoming issue of a Tesco Personal Finance inflation-linked bond is creating a stir in the financial press.  This follows a similar offering from National Grid. 

TescoFor the record, the new Tesco bond will pay a coupon of 1% per annum, increasing in line with RPI (so if RPI increases by 5%, the coupon will increase to 1.05% p.a.).  The redemption price will also be increased in line with RPI.  The bond matures in 2019.

It is not easy to compare this bond with other Tesco bonds that are currently on the market, as these are fixed-income bonds.  However, it does provide an opportunity to revisit a question that all investors should ask; whether to be an owner or a lender.  This could relate to asset classes in general, or to individual shares and bonds, and I am highlighting Tesco only as a topical example.

If you wish to lend money to Tesco, there are 3 fixed-income bonds on the market that can be bought by retail investors: -

Maturity

 year

Fixed

coupon p.a.

Current

price

Redemption

 price

Redemption

 yield p.a.

2029

6%

122

100

4.25%

2019

5.50%

112

100

3.75%

2018

5.20%

107

100

4%

07/12/2011.  All figures are gross, and do not include purchasing costs.  2018 bond is issued by Tesco PF; other bonds issued by Tesco plc.

Note that, as each of the issues currently trades above the ‘par’ value (100), the redemption yield is much lower than the fixed-income yield.  The redemption yield reflects the fact that the redemption proceeds will be less than the price paid, that is, the current price.

Of course, an alternative to lending money to Tesco, or anyone else, is to buy the company’s shares.  Owners of Tesco shares are owners of the company.  They benefit from dividends that the company pays in the form of income, and they also participate in any appreciation or depreciation of the share price.  Tesco shares currently have a dividend yield of around 4% p.a., which is roughly the same as the redemption yield on the bonds. The dividend can be increased or decreased, and will depend upon the performance of Tesco’s business.

Investment advice should always be sought before buying shares or bonds.

Posted in Advice, Investments | Tagged , , | Comments closed

The risk-free rate of return

By Elementary Financial | Published: November 25, 2011

All economic and financial models assume that there is a risk-free rate of return to be had.  This is useful as a reference point when deciding whether to take on additional risk to earn an additional return.  For example, if an investor is happy to earn a return of 2%, and this can be had ‘risk-free’, it would be irrational to take on additional risk to earn an additional return that isn’t needed and/or wanted.

BankingEven though economists, financial advisers and investment managers know that there is not a risk-free return available, we assume that there is for modelling purposes.  More often than not this rate of return is taken to be that available from government debt; that is, a government bond.

The rationale here is that a government will pay its debts.  It will pay both the promised coupon (income), and the return of capital borrowed (the redemption proceeds).  Of course, in the case of a government that issues bonds denominated in its own currency, there is no reason why that government would not pay both the income and the redemption proceeds.  It can simply print the money to do so.

This does not make the government bond ‘risk-free’, as there are inflation risks.  For example, at the moment you cannot buy a UK government bond that yields more than the current rate of inflation.  So buying a UK government bond guarantees that you will lose money in real terms (assuming that it is held to redemption, and inflation does not fall).  Clearly, there are investors that are prepared to accept this risk.

However, this is a problem no longer confined to economic and financial models.  All banks are likely to own ‘developed world’ government bonds, due to them being able to carry these assets as risk-free on their balance sheets.  In recent months it has become clear that government bonds are not risk-free, particularly in the Eurozone where governments cannot simply print the money to meet their promises.  Banks now have to recognise the ‘risk-free’ fallacy of Eurozone bonds, which will lead to them having to raise fresh capital in the coming months and years.

The risks associated with government bonds are no longer just inflation related.  Governments that do not control their own monetary policy may well be forced to default on their bonds in the future.

Posted in Advice, Banking, Investments | Tagged , , , | Comments closed

Enhanced Transfer Values

By Elementary Financial | Published: November 4, 2011
Pensions Minister Steve Webb

Pensions Minister Steve Webb

Pensions minister Steve Webb announced on October 20th that the government will introduce a code of practice, next year, for enhanced transfer values (ETVs).  An ETV exercise is the process whereby employers offer final salary scheme members the option of transferring out of their scheme the notional value of their pension fund, and in addition they receive a cash sum as an incentive to transfer.  The offers are usually made to deferred members, rather than active members.

Once the code of practice is introduced, employers will have to offer access to a paid-for independent financial adviser to every final salary scheme member to whom they offer cash as an incentive to transfer out of the scheme.

Steve Webb said that the use of cash incentives was unfair to members who were likely to lose out by taking the transfer because they would lose the valuable defined benefit guarantees.  This obviously needs to be balanced against the value of the cash sum offered as an incentive to transfer, and the needs and objectives of individual members.

The code of practice is to be enforced jointly by the Financial Conduct Authority (FCA) and The Pensions Regulator (TPR).  All members that are offered an ETV will also have to be offered independent financial advice, paid for by the employer, prior to accepting a transfer offer.

Final salary schemes carry out ETV offer exercises in order to offload scheme liabilities.  Most deferred members of final salary schemes can transfer-out at any time, and this will not affect their right to do so.  All pension scheme members should seek independent financial advice before transferring pension rights.

 

Posted in Advice | Tagged , , , | Comments closed

Portfolio rebalancing

By Elementary Financial | Published: October 21, 2011

Portfolio rebalancingAs well as constructing an investment portfolio based upon the objectives and risk profile of a client, a good investment adviser will also monitor that portfolio.  So an investment portfolio asset allocation is agreed upon, and, broadly speaking, that asset allocation should be maintained.

Most investment portfolios will contain different asset classes, such as equities, debt and property as agreed between an adviser and an investor.   Over time, asset classes produce different returns, so a portfolio’s asset allocation will change.

To capture a portfolio’s original risk/return qualities, the portfolio should be rebalanced.  Portfolio rebalancing is extremely important because it helps investors to maintain their target asset allocation.  The question is, when should we rebalance?

A recent study by The Vanguard Group revealed that risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly or annually.  However, the number of rebalancing events and resulting costs (taxes, time, and execution costs) increase significantly if rebalancing is carried out frequently.  Rebalancing too frequently could therefore reduce returns without reducing risk.

The same study also revealed that setting a threshold for rebalancing can help reduce the frequency without having a material impact on risk/return characteristics.  The portfolio would not be rebalanced unless a threshold was crossed.  For example, if any asset class allocation moves by 5% or more, then the portfolio is rebalanced.

The Vanguard Group findings indicate that whilst there is no optimal frequency or threshold when choosing a rebalancing strategy, a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than a portfolio that is never rebalanced.

Posted in Advice | Tagged , , | Comments closed

Convertible Bonds

By Elementary Financial | Published: October 7, 2011

Inflation and the abnormally low level of interest rates mean that the ‘real’ return from cash deposits and Gilts is negative.

Corporate Bonds are an alternative that offer a fixed income to investors.  However, yields on some corporate bonds are now lower than those available from the dividends payable on the company’s shares.  Buying the shares is always an option, providing you can stomach the volatility of equities.

Another option is a Convertible Bond.  This is a corporate bond that provides the holder with an option to convert the bond (debt) into the company’s shares (equity), at a predetermined price.

If the company’s shares appreciate in value then the convertible bond can be exchanged for shares, and an immediate profit.  If the company’s shares do not appreciate in value, the convertible bond holder will not exchange the debt for shares.

Convertible bonds provide downside support as the face value of the debt is redeemable at a future point in time, by the company.  Between issue and redemption, the convertible bond holder will be paid a coupon, or income yield.  This yield will be lower than that payable on the conventional bonds issued by the same company, but could still exceed the current returns from cash.

It should be noted that between the time of issue and redemption, the price of a convertible bond will be determined by the market, and an investor selling during this time could get back less than they paid.  That said, a convertible bond should be less volatile than shares in the same company, and can offer the prospect of better overall returns than the company’s conventional bonds.

There are a large number of convertible bonds in issue, and a good way to access these is via funds that hold a diverse portfolio of convertibles.

Posted in Advice | Tagged , , | Comments closed

Trivial commutation lump sum

By Elementary Financial | Published: September 23, 2011

For those with small pension funds, where it might be impractical or impossible to purchase an annuity, an alternative could be to commute the whole fund(s) for cash.

The legislation provides for trivial benefits to be commuted and paid as a one-off lump sum payment once the member has reached the age of 60 but has not reached age 75. This can be done only if the value of the member’s benefit entitlement under all registered pension schemes, along with all rights that have previously crystallised (ie become payable) for lifetime allowance purposes (including any pensions in payment on 5 April 2006), do not exceed a maximum value (the commutation limit) as valued on a specific date (the nominated date).

The combined value of those rights is referred to as the member’s pension rights. A member does not have to retire to apply for a trivial commutation lump sum.

The commutation limit, referred to above, is currently £18,000.

Where crystallised rights are paid as a trivial commutation lump sum the whole payment will be taxed as pension income. Where uncrystallised rights are paid as a trivial commutation lump sum, only part of the payment will be taxed as pension income. This is because normally, one quarter (25%) of the uncrystallised rights can be paid in cash, tax free. Pension income is taxable under the PAYE system.

Example: -

A pension scheme member aged 61 has a total fund of £12,000.
The member applies for a trivial commutation lump sum, and is paid the following: -
£12,000 x 25% = £3,000 tax free
£12,000 x 75% = £9,000 which is added to taxable income in the year of receipt*

* Income tax will be deducted at source at the rate of 20%, under the PAYE system. Any income tax that has been ‘overpaid’ can be reclaimed from HMRC.

Posted in Advice | Tagged , | Comments closed
  • IFA in the West Midlands providing financial advice for individuals, families, companies, trustees and charities.