CHECKING YOUR FINANCIAL HEALTH

Before embarking on investing a lump sum it is advisable to check your financial health, to see how you measure up to the ideal.

Preparing background information

If you consult a financial adviser, you will first be asked for some background information. Here you are the adviser as well as the client so, although much of this information will be obvious to you, it is still worth writing it down as it will affect what comes later.

Personal profile

A financial adviser will ask:

• your age;
• whether you are employed, self-employed, unemployed or retired;
• whether you are married, have children still dependent on you (or any other dependants, such as a widowed mother without much pension); and
• what is your highest income tax rate (your marginal rate).

Budgeting

If you do not have a clear idea of your weekly or monthly income and expenditure prepare a budget on the lines of Figure 1. Include in it any savings you are making for a specific event.

Your financial assets and liabilities

List any savings and investments you have, followed by a list of any liabilities – bank overdraft, credit card debt, etc. The difference between the two is the value of your net current assets (if it is a negative amount, you need to plan to reduce your debt).

Your mortgage is a separate issue because it is a long-term liability.

Doing your financial health check

The ten steps which follow are in order of priority.

1.Reducing borrowing

Are you borrowing money, except against your home? If so, consider paying it off as soon as possible as the interest will be expensive.

2.Establishing an emergency fund

Have you got a cash reserve to fall back on – at least one month’s normal expenditure and preferably two or three, in an instant-access deposit account or as a borrowing facility? At least half the population has less than £1,000 readily available and 10% have nothing at all. (See Chapter 8 for information about accumulating an emergency fund.)

3.Avoiding financial disaster

Is your income protected by insurance against the death, sickness or permanent disability of the breadwinner? Do you have adequate home and car insurance?

4.Retirement planning

Are you paying towards a pension? It is never too early nor too late to start. (See Chapter 8 for retirement planning.)

5.Getting tax and social security advantages

Are you getting all the income tax allowances, reliefs and credits, and social security benefits you are entitled to?

6.Estate planning

Will your heirs have to pay inheritance tax? If so, consider how to avoid it or pay for it yourself. (See Chapter 10 for inheritance tax.)

7. Saving for special events

Do you need to save up for – your next holiday, a new car, a wedding, long-term care in old age? Putting aside just a small amount regularly is the best way. (Chapter 8 gives more information about providing for special events.)

8. Paying for education

If you have young children, are you saving up to pay for private education and/or university? (See Chapter 8 for financing your children’s education.)

9.Reducing your mortgage

It is worth considering a reduction before investing surplus income or a lump sum. (Chapter 8 also gives more information on this.)

10.Investment planning

Have you surplus income which can be channelled into a savings scheme or do you have a lump sum to invest?

Making strategic decisions

The result of your financial health check may cause you to change your budget, for example to pay for more insurance cover.

Or you may wish to change your existing savings and investments to fit in with the ideal – perhaps to put more into your cash reserve.

Make a list of your shortcomings compared with the ideal and decide what action to take.

SAVING TO INVEST

If you do not have a lump sum to invest but can afford to save, there are many investment products which accept regular monthly payments.

In other cases, where the minimum investment is low and monthly savings are high enough, they can be invested directly. For example, National Savings certificates have a minimum of £100.

Otherwise, savings can be put into deposit accounts until enough has been accumulated to make a lump sum investment.

The advantage of investing regular savings is that there need be no commitment to maintaining payments, e.g. there is no harm done by missing a monthly purchase of a savings certificate.

Analysing your savings needs

If you need or wish to save, consider the following:

• What are you saving for – to increase your cash reserve, for a special event, for your children’s education, for retirement – and how much do you need? If you have more than one reason, decide the priority.
• How much can you save, each week or month, and so how long will it take to achieve your objective?
• Do you need quick access to the money? Bear in mind that, if not, you might get a higher return from a longer-notice deposit account, or even in an equity investment, which should grow more in the long run (say at least five years).
• Do you pay tax and if so what is your marginal rate? Compare returns on an after-tax basis.
• Can you save regularly? It is better if you can, but be wary of committing yourself to a regular savings contract if there is a penalty for missing a payment. Irregular deposits when you can afford them are better than nothing.
• Is your priority income or capital growth? Some investments are better for one, some for the other, but many achieve both.

How much risk are you prepared to take? Higher risk should lead to higher returns but only in the longer term. Risk is dealt with in more detail in Chapter 2 under ‘Grasping the language of investment’.

CASE SCENARIOS

Amanda

Amanda works for a Lloyds insurance broker. She is an independent young woman, a high earner and a high spender. She rents an expensive flat in central London. She does not have a regular boyfriend, but she would like to have a family in the future. Most years she gets a big year-end bonus.

Her financial health check shows no need for a recognised emergency fund, as she has plenty of cash in her bank account, and she has adequate insurance but no provision for a pension. Amanda realises that she should look to the future and start taking action. She can easily afford to direct some of her earnings to a pension scheme.

Alistair and Jean

Alistair and Jean live together, having both been divorced. She has custody of her two children from her first marriage and they have a baby of their own. Alistair is a civil servant. Jean does part-time secretarial work at home. They own their own home, with a £50,000 mortgage. They have recently inherited a lump sum from Alistair’s parents.

Their financial health check shows they have an adequate cash reserve and pension provision but are not covered for the loss of family income should Alistair become unable to work through a serious illness. They think about permanent health insurance.

Gwen and Hugh

Hugh is a welder in a metal-bashing factory. He is nearing retirement age. Gwen has never worked since marriage; she has been too busy bringing up their three children, who have all now left home and are self-sufficient. There is one grandchild so far.

They live in a council house which they bought from the council some years ago. Hugh can take a tax-free lump sum from his company pension scheme when he retires.

The financial health check shows good coverage for pension and insurance but an inadequate cash reserve. They decide to build it up as soon as possible as a matter of priority, by adding to the small amount they already have in a building society.

POINTS TO CONSIDER FURTHER

• 1.If you are borrowing money (other than a mortgage) and you have a cash reserve, should you use the reserve to reduce the borrowing? What could replace the reserve fund?
• 2.Is your mortgage sufficiently flexible to allow you to pay some off early without penalty? If so, what priority does this have on your list for using a lump sum?
• 3.If you are saving out of income to build up a lump sum for investment, where do you propose to put the money meanwhile in order to make it work for you?