Client Newsletter – July 2013

Client Newsletter – July 2013

A New Sheriff in town

After an eventful decade at the helm of the Bank of England (BoE), Sir Mervyn King will be replaced as governor of the UK’s central bank on 1 July 2013 by Mark Carney, the former governor of the Bank of Canada. Considerable anticipation surrounds Carney’s accession, amid speculation he will seek to implement sweeping changes to the BoE’s approach to monetary policy.

Carney believes the BoE faces “many and varied” challenges that fall into two key areas – policy challenges and institutional challenges. The principal policy challenges centre on the delivery of price stability while supporting economic recovery, boosting employment and promoting financial stability. Carney also wants the BoE to improve the accuracy of its forecasting, to conclude its “unconventional” monetary policy measures in a way that will provide a boost for public sentiment, and to ensure confidence in the UK’s banknotes can be maintained. Meanwhile, at an institutional level, he wants to increase cohesion within the Bank and to build a central support function that will reinforce every area of the BoE and its expanded responsibilities.

Carney believes the BoE faces “many and varied” challenges that fall into two key areas – policy challenges and institutional challenges. The principal policy challenges centre on the delivery of price stability while supporting economic recovery, boosting employment and promoting financial stability. Carney also wants the BoE to improve the accuracy of its forecasting, to conclude its “unconventional” monetary policy measures in a way that will provide a boost for public sentiment, and to ensure confidence in the UK’s banknotes can be maintained. Meanwhile, at an institutional level, he wants to increase cohesion within the Bank and to build a central support function that will reinforce every area of the BoE and its expanded responsibilities.

Carney has attributed Canada’s resilience during the global financial crisis to “responsible fiscal policy, sound monetary policy and a resilient financial system.” He considers flexible inflation targeting to be the most effective framework for monetary policy but believes it is important to undertake periodical reviews of the framework for policy. In particular, he judges it vital to achieve price stability – as measured by consumer price inflation – without aggravating volatility in output and the labour market. He also wants to develop and support a well-capitalised financial system that is “transparently resilient” and strong enough to withstand external shocks. It is worth noting that, in the coalition government’s Budget of March 2013, Chancellor of the Exchequer George Osborne expanded the remit of BoE policymakers to include an additional emphasis on economic growth.

The impending accession of the 120th governor of the BoE has been marked by a flurry of interest and speculation, and Carney believes serving as BoE governor will mark the “pinnacle” of his career. He takes on the role at a unique time in the BoE’s history, as it assumes additional and widespread regulatory responsibilities. Looking to the future, however, he appears anxious to be remembered for his planned achievements, stating his desire for his exit in 2018 to prove “less newsworthy” than his arrival.

FTSE 100 Hits Five Year High

Smaller UK companies performed better than their blue-chip counterparts. The FTSE 100 rose 2.4%, while the FTSE 250 and the FTSE Small Cap rose 2.9% and 3.3% respectively. Since January, the FTSE 100 rose 11.6%, the FTSE 250 rose 16% and the FTSE Small Cap rose 15.7%.

The UK government confirmed it intends to try harder to re-privatise the two banks after pressure from the IMF. HSBC’s first quarter pre-tax profits surged 95%, boosted by higher revenues in key trading areas.

The Office for National Statistics reported disappointing retail sales during April due to poor weather. Food sales dropped by 4.1%, their biggest drop since May 2011. Marks & Spencer announced a 14.2% drop in pre-tax profits, primarily due to disappointing non-food sales.

Equities remained the best-selling asset class during April according to the IMA, with UK equity funds the second best-selling equity fund group by region. UK Equity Income was the top-selling fund grouping during April, and had its highest sales since 2011.

Don’t get caught by ‘pension liberation’

Despite tentative signs of economic recovery, times remain hard for many people. The cost of living continues to rise faster than wages and unemployment remains high. For those struggling to finance their day-to-day living, the idea of ‘pension liberation”’ might sound attractive – but there are serious long-term risks.

Pension liberation involves the transfer of an individual’s pension savings to a scheme allowing them to gain access to the funds in their pension pot before the key age of 55. However, an “unauthorised payment” from a pension scheme is likely to incur tax charges of more than 50% of the total value of the pension pot. Although there are certain rare situations, such as a terminal illness, that might permit a scheme member to access their funds early, dipping into your pension pot before the age of 55 will almost certainly land you with a substantial tax bill.

The Information Commissioner’s Office (ICO) has reported a “dramatic” rise in unsolicited approaches to pension scheme members, encouraging them to withdraw a proportion of their savings before the age of 55. The ICO estimates up to £400m has been released from legitimate UK pension schemes into schemes that range from high risk to non-existent. Some members have had to absorb unexpected and substantial administration fees and taxes while others have had to face the fact their savings have been taken by fraudsters.

It is important to differentiate between pension liberation fraud and ‘pension unlocking’ – a legitimate move that allows a pension scheme member, aged 55 or over, to release up to 25% of their pension savings as a tax-free lump sum. Nevertheless, pension unlocking should still only be considered in the most exceptional circumstances, as it is likely to lead to a lower level of income in retirement.

The ICO reports that “spam” text messages relating to pension liberation have more than tripled during the past six months. Meanwhile, the Pensions Advisory Service has warned that pension liberation fraud is on the rise in the UK, and police investigations into pension liberation schemes have stepped up. Although the Pensions Regulator provides information for pension scheme trustees, there is still no law empowering trustees to prevent the transfer of a member’s pension savings into a liberation scheme. You can never be too particular about something as important as your pension savings so always take professional and unbiased advice from an expert.

21st century income generation

Investing to generate an income used to fall into the ‘straightforward and dull’ camp. Income-seeking investors would focus primarily on cash and UK government bonds or ‘gilts’ – so-called ‘safe-haven’ options that promised a relatively high income, albeit with little chance of capital growth or protection from inflation.

However, these more traditional asset classes are generating increasingly disappointing returns for income seekers. Four years of exceptionally low interest rates have crushed yields on cash deposits. Meanwhile, there are signs the bond market’s extended period of popularity could be starting to lose momentum. Although UK interest rates will at some point start to rise – thereby increasing cash yields and providing support for bond yields – there is no evidence to suggest Bank of England policymakers are in any hurry to increase rates.

On the brighter side, as times have changed, investors are no longer forced to sacrifice the long-term value of their capital in order to achieve an income. Over the years, for those comfortable enough to move further up the risk ladder, investment-grade corporate bonds and UK equities have proved fruitful strategies for income seeking investors. In particular, an equity income approach can offered the welcome potential for capital growth as well as a sustainable income stream.

That said, although yields on UK equities continue to run well ahead of gilts, the yields offered by both asset classes have fallen over the past year. As of the end of April 2013, the UK equity market yielded 3.2% , compared with the benchmark gilt yield of 1.68% . However, a year earlier, UK equities had yielded 3.4% , while gilts yielded 2.1% .

Looking ahead, some investors may need to consider reassessing their ideas about income generation. A number of options are available, ranging from traditionally lower-risk considerations, such as cash and gilts, through UK equities and investment grade corporate bonds, to still more speculative asset classes, such as overseas equities, high-yield bonds and property.

Taking a step up the risk ladder might sound daunting but it does not necessarily have to involve a wholesale change of approach. A controlled and well-thought-out income strategy with a robust core portfolio of relatively mainstream assets – such as gilts, investment-grade corporate bonds and high-quality equities – can be boosted by an element of exposure to more speculative income-generating investments such as high-yield bonds, say, or emerging-market equity income. As ever, diversification to spread risk across different assets remains vital.

UK banks – Working towards a new normal

The UK financial sector has undergone a torrid few years, rarely being far from the news headlines. Nevertheless, finance remains a major industry – and a major economic force – in the UK and a recent review undertaken by the International Monetary Fund (IMF) on the UK economy reiterated the importance of the financial sector to its long-term health and prosperity.

The IMF believes the current condition of the UK’s banks – particularly Lloyds and Royal Bank of Scotland (RBS), which are partly owned by the UK taxpayer – is hindering the Bank of England’s efforts to kick-start the country’s largely stagnant economic growth. In particular, the central bank’s programme of quantitative easing has not provided the desired boost to bank lending because the balance sheets of some UK banks are still weak.

The IMF has urged the UK government to focus on selling its holdings in Lloyds and RBS, commenting: “Restoring the health of the banks is crucial for restoring credit flow.” At present, the government has stakes of 40% and 82% in Lloyds and RBS respectively. Between them, Lloyds and RBS account for almost 40% of total UK lending, and so it is important to settle their future. In response, the coalition government confirmed its intention to re-privatise both banks and will announce its plans to return them to the private sector after the publication of the Parliamentary Commission on Banking Standards’ final report. Lloyds and RBS both expect to meet their capital requirements without having to issue new shares.

Crucially, however, the IMF believes any eventual sale should not only “maximise value for taxpayers” but also “strengthen confidence and competition in the sector”. The IMF went on to urge the UK to take action to boost overall competition within the country’s banking industry in order to “better serve the needs of UK companies and households, especially given few alternative sources of funds for start-ups and smaller enterprises”.

Looking ahead, the IMF believes UK banks should focus on building capital without compromising access to credit, and flagged possible strategies, including new equity issuance, balance-sheet

restructuring, and reductions to staff bonuses and dividend payouts. According to Capita Registrars’ Dividend Monitor, the banking sector paid almost one-fifth of all dividends in the UK as recently as 2008. Fast-forward a few years, and the sector now pays only one-tenth, and only three banks pay any dividend at all, compared with seven in 2007.

Watch out for the mortgage trap

More than two million UK homeowners have interest-only mortgages that have to be repaid at some point during the next 30 years. Interest-only mortgages differ from standard repayment mortgages because the borrower repays only the interest every month – the capital is repaid at the end of the term. Interest-only deals enjoyed considerable popularity during the housing boom as they enabled buyers to borrow a relatively large amount for a comparatively modest monthly repayment.

The Financial Conduct Authority (FCA) has found the majority of the UK’s interest-only borrowers have plans in place to repay the capital at the end of the mortgage term. However, the financial services regulator estimates around 48% of mortgage holders face a shortfall in the amount they will be able to repay at the end of the term. The average shortfall is calculated as some £71,850.

In addition, the FCA believes around 10% of interest-only mortgage-holders have no strategy at all for repayment. Furthermore, 9% of interest-only borrowers have other loans secured on their homes, while 40% have other borrowings such as credit cards and personal loans. Mortgage lenders have been instructed to contact mortgage-holders to ensure they have a viable repayment strategy in place. Lenders will concentrate first on borrowers whose mortgages are due to mature within the next seven years.

Interest-only mortgage deals have become much less common and new regulation is set to curb their availability, restricting them to borrowers who can demonstrate a viable repayment strategy. However, if you do have an interest-only mortgage, you should first verify what you will have to repay and when it will become due. Second, you should make sure you have a credible repayment plan in place. Finally, you should check regularly in order to ensure your repayment plan remains on target. Above all, you should take expert advice.

Death benefits and income drawdown

Research from Prudential has shown fewer than half of all couples in the UK (46%) make joint retirement arrangements to the effect that, when one partner dies, the other continues to receive an income. This is a particular problem with annuities where the original pension pot is used to buy an income stream as this often stops on death. Income drawdown on the other hand usually has more favourable death benefits, allowing some of the pension pot to be passed on either as income or capital.

On reaching retirement age, people have two options for taking their pension benefits – they may buy an annuity or they may opt for income drawdown. Buying an annuity is more secure as the annuity provides a guaranteed payout for life but, unless an individual specifically arranges for their partner to receive that income through a ‘dual life’ annuity, the income stream provided from the annuity ends on death. In contrast, with an income drawdown product, a spouse and/or other dependants have a number of options, the first being that they can take all or some of whatever remains of the pension pot as a lump sum. They should, however, be aware this will be subject to a 55% tax charge, whatever the inheritance tax situation.

The dependants may also choose to continue with income drawdown, or flexible drawdown if they already have a secured pension of £20,000. The level of income will be determined by the age of the spouse or dependant as well as by the Government Actuary’s Department (GAD) rates applicable at the time the policy is transferred. The GAD rates give the maximum amount that can be transferred from a drawdown policy. In both cases, the income received would be taxable but the pension pot would not form part of an individual’s estate for inheritance tax purposes.

The final option for dependants would be to use the remaining income drawdown fund to buy an annuity. Again, the pension pot would not form part of the estate for IHT purposes but the income from the annuity would be subject to income tax.

There are a number of decisions to be made when choosing the right income option on retirement but death benefits should not be neglected. If it is important to leave a lump sum or an income for a spouse or dependants, income drawdown can have advantages over an annuity.

The value of the investment can go down as well as up and you may not get back as much as you put in.