BUYING ANNUITIES

As explained in Chapter 8, money-purchase, personal and stakeholder pensions must eventually be used to buy an annuity. This is called a compulsory purchase annuity (CPA) and all the proceeds are taxable.

The tax-free lump sum from the pension scheme and any other lump sum can be used to buy an annuity. In this case it is called a purchased life annuity (PLA) and only the interest element of the proceeds is taxable (about half the proceeds are capital repayment).

The provider of the annuity normally deducts tax at the standard rate of 22% so, if your marginal rate is higher or lower, you will have to pay the extra or claim a refund.

Types of annuity

There is a wide choice, including:

• Single life, the simplest type, which pays a flat rate over the remaining life of the annuitant. You need to remember that, even with inflation of only 3% a year, over 20 years the income will have fallen by 40% in real terms.
• Joint life, which continues until the second death of a couple, either at the same rate or a lower rate after the first death.
• Impaired life, where you get a higher amount because you have a terminal illness.
• Escalating, where the payout increases by a fixed percentage each year, but starts lower than a flat rate annuity. With an escalation rate of 3%, it takes some ten years for the payout to catch up and a further ten years to recover the shortfall over the first ten.
• Investment related, that is in a unit-linked or with-profits fund. Here the income will vary depending on performance, which may not suit you. (With-profits gives a smoother performance; unit-linked is more volatile.)

In the case of with profits annuities, you usually have to choose a growth rate (called the hurdle rate) of between 0 and 5%. If the bonuses are consistently below the hurdle rate your income can fall, so it pays to choose a low rate.

However, it is possible to get a with-profits annuity which gives a guarantee, such as that the payout will never fall below the starting amount, naturally at a lower starting figure.

In choosing between flat rate and escalating, you need to think about how long you may live, taking into account your health and your family history of life expectation -not an easy decision.

There can be a wide variation in annuity rates, so it pays to shop around. Some newspapers show the best rates currently available for standard annuities. (See Figure 12 for examples of current annuity rates.)

The most important thing to remember about an annuity is that it usually dies with you, so there is nothing left to pass on to your heirs, although it is possible to arrange for some at least of the capital sum to be preserved, again obviously at a lower starting payout.

Annuity Direct have a guide to pension income, which includes annuities – ring 08450 756 550.

INVESTING FOR CHILDREN

It is possible for children to have investments in National Savings (and there is a special account for them, children’s bonus bonds – see Chapter 3), and bank and building

society accounts. Below the age of seven, they cannot operate these accounts themselves, but someone (usually a parent) can act for them.

Children are entitled to the personal tax allowances. However, if the parents have provided the capital, then income of over £100 a year for each parent is treated as their income and is taxed accordingly.

This does not, though, apply to anyone else; in particular grandparents can give their grandchildren as much as they choose (subject to inheritance tax restrictions – See Chapter 10) without the income being treated as theirs.

Inland Revenue form R85 can be submitted to arrange for interest to be paid gross if there is no tax liability.

Because investing by children is frequently of a long-term nature, equity investment is highly appropriate, particularly pooled investments such as unit trusts, investment trusts and friendly society bonds. Tax deducted at source from dividends cannot of course be recovered. The normal capital gains tax allowances apply.

Children under the age of 18 cannot sign documents of title, so the usual basis is for an adult to act as bare trustee, shares or units being registered in the name of the adult with the addition of the child’s initials. To make the position quite clear, it is a good idea to leave with your will a note explaining the ownership of the investment.

See Appendix B under investment trusts and unit trusts for leaflets from the AITC and AUTIF and under National Savings for the leaflet on children’s bonus bonds.

Baby bonds

There is a proposal to introduce, possibly in the year 2003, the Child Trust Fund, or baby bond. At birth, children will be allocated a sum of £250 (£500 for poorer families) from public funds. Further amounts of £100 (£200 for poorer families) will be added at the ages of 5,11 and 16. Funds will grow tax-free.

Rules about the usage of funds have yet to be agreed, but they will be restricted to such matters as education or mortgage downpayments and will not become available for use until age 18 or 21.

There may be an arrangement for parents (or others, such as grandparents) to make matching contributions, including the possibility of transfers from savings under the proposed Savings Gateway (See Chapter 3).

MAKING ETHICAL INVESTMENTS

Ethical or green investments are made in companies which do not pollute, do not make or supply arms and respect the environment and/or ethical issues. Investment and unit trusts have ethical funds.

It is questionable whether the limitation on investment adversely affects income/growth although logic says it must. The counter-argument is that unethical companies suffer from government interference, sooner or later, so perform less well in the long run. Certainly some ethical funds have a good record of performance.

Ethical funds generally follow one of two approaches, either positive screening by selecting companies which provide an ethical benefit such as supporting charities out of profits, or negative screening which leaves out companies which are involved in ‘unethical’ businesses such as gambling.

There are advisers and stockbrokers who specialise in ethical investing and EIRIS (ring 0845 606 0324) provides lists. A free guide can be obtained from the Ethical Investment Association, c/o Ethical Investment Services, 33 Ribblesdale Place, Preston PR1 3NA.

INVESTING BY THE ELDERLY

Conventional wisdom says that the elderly should reduce their equity holdings as the years roll on. The main reason for this is that the shorter the period of investment the more likelihood there is of suffering a loss from a stock market fall.

However, there may not the same need to realise investments as there is in respect of pension schemes and returns on equities average much more than on fixed interest.

Income from equities can be lower than on fixed interest but if more income is desired it can be achieved by realising capital gains and, if the gains are within the annual exempt amount, the gains are free of tax. It is the total return that matters.

The only time that total returns on equities can be beaten is when you reach an age where an annuity provides greater income. Even then, the loss of the capital must be taken into account because you may wish to retain the capital to pass on to your descendants.

INVESTING IN PROPERTY

Property tends to grow in value like equities and so is a good long-term investment.

The biggest investment you can make in property is owning your own house. Some experts say this is enough exposure to the property sector.

Indirect investment in property can be achieved through companies whose business is investing in property, usually commercial property, or via pooled investments in property such as unit trusts and investment trusts.

Buy to let

Further direct investment in property – buying to let for example – is a specialised area of investment which can be yield both income and capital gain.

It has become increasingly popular in recent years as the demand for rented property has increased (and may continue to increase with people living longer and the trend towards more single-parent families) and it can be a way of using the lump sum from your pension scheme on retirement to provide additional income – and something to keep you busy!

Most buyers to let take out a mortgage and there special mortgages available, based on the rent you can charge rather than your income, so that only part of the cost needs to be put up (perhaps no more than 20%).

Mortgage interest and other expenses can be set against income for income tax purposes. For a higher cost, a manager can be appointed to take away some of the work and worry.

There are risks in direct ownership, such as not being able to find a tenant, rent not being paid and damage to the property. Provision for these events and for the cost of repairs should be made when calculating the viability of the investment.

There are legal expenses, too.

You need to take care in choosing a suitable area and size of property (number of bedrooms). Do not fall into the trap of choosing a place merely because you like it.

Using an unapproved pension scheme

A more sophisticated version of buy to let, suitable for higher-rate taxpayers, is to finance the purchase through a funded unapproved pension scheme (FURBS) in a company which you set up for the purpose.

The pension scheme buys the property and your pension contributions finance the mortgage repayments.

There are significant tax advantages:

• profits are taxed at the favourable small company rate of 22%;
• the company pays a lower rate of capital gains tax (34%);
• inheritance tax is avoided as the property passes to your heirs from the company and so stays out of your estate.

There are substantial costs involved in setting up the arrangements, so this method is only suitable for people who can finance a large property portfolio.

University accommodation

A particular area of buying to let arises if you have a child going to university. It may well be worth finding a property near the university and arranging for your child to buy it, by loaning the deposit and if necessary acting as guarantor for the mortgage.

The primary ‘income’ is the saving through not paying rent but the property needs to be large enough to let out rooms to other students, thus providing an income against which the costs can be set for tax purposes, bearing in mind that a child has the income tax personal allowance, so income tax should not be payable.

If the child’s income exceeds the income tax personal allowance, the ‘rent-a-room’ tax relief will also apply whereby if a room is let for less then £4,250 a year, the income is tax-free (There is an Inland Revenue leaflet explaining this – see Appendix B.)

At the end of the course, the property can be sold, the mortgage and your loan repaid and hopefully a capital gain made, which your child can save or use as a deposit on a further home. It would be subject to capital gains tax, but this would be reduced or eliminated by taper relief and the annnual exempt amount – See Chapter 10.

Investing in ground rents

Ground rents are paid by leaseholders to the owner of the freehold of a property. So investing in ground rents means buying the freehold of such properties.

There are two types:

• those which pay a reasonable income; and
• those which have a very low income but are expected to show capital growth.

Freeholds are available for houses and flats and for commercial premises such as shops and there is a wide variety of prices. Those where the leaseholders are responsible for maintenance and insurance (usually commercial premises) are less troublesome.

Leaseholders rarely fail to pay ground rent because the consequences for them might be drastic – the freeholder can sue for repossession. Therefore the income should be steady and around 10% before tax is achievable.

Capital growth freeholds usually have a relatively short period to run before the lease expires and the freeholder is hoping that the leaseholder will then wish to buy the freehold – at what is called the marriage value.

Freeholds are usually sold at auctions and the income is set, so the return is easily calculable. There may be rent reviews at intervals in the remaining life of the lease.

It is possible to get a mortgage for buying a freehold, but it needs to be of the income type so that money is forthcoming to pay the interest on the loan. Borrowing to invest for growth is more risky.

COLLECTING

This heading refers to the purchase of assets which it is hoped will increase in value, such as antique furniture and paintings.

The disadvantage of ‘collectibles’, as they are sometimes called, is that they produce no income – all the return is in the potential increase in value and that value is usually subject to fashion and whims.

On the other hand, it can be argued that they give pleasure – that is the return.

Collectibles can be damaged or stolen, so they must be insured at current replacement value, which means getting regular valuations: these can cost around 1 % of value each time. It is also a good idea to keep coloured photographs and written descriptions.

In the event of a dispute about value, you can get help from the appropriate trade association.

Buying and selling at auctions involves the payment of high commissions (buyers 15%, perhaps, and sellers 10%). Buying in a shop avoids commission, but how far can you trust them to buy and sell at accurate values?

For all collectibles, you do need to be aware of value and you should not buy for investment unless you have a lot of knowledge of your chosen category.

Art and antiques

A London art dealer recently said that art has not kept pace with conventional investment over the last 20 years.

Sothebys have an art index which shows changes in value over 1, 2, 5 and 10 years, by category (paintings, ceramics, furniture, silver).

Classic or vintage cars

Classic cars are post-1939, over 20 years old. Vintage cars are pre-1939.

As on all cars, capital gains are not taxable and compared with ordinary cars there should be no depreciation.

Insurance may be difficult and you probably need to be a mechanic as repairs are expensive.

It might be possible to earn some income by hiring out, for example for weddings.

Stamps

Most serious collectors specialise. A good collection can be assembled for £2,000.

Low value stamps tend to stay low in value – only expensive ones appreciate.

British sets currently issued are valued at only 80% of face value so are not a good investment.

If you are selling a collection of stamps, perhaps inherited, and they are muddled, do not try to sort them out first as they are more exciting to an enthusiast in their mixed up state and so of more value.

Wine

The most established markets are vintage ports and Burgundy and Bordeaux wines.

You can start with as little as £500, which will buy three cases (12 bottles to a case) at around £150 each, but you must be prepared to keep them for a long time. Better to start by using a dealer rather than bidding at an auction.

You can of course make a larger investment to start with, intending to drink some, sell some and buy some more, but try to drink your loss items rather than the profitable ones!

Value is greater if bought and kept ‘in bond’ as duty and VAT are not paid. Storage costs about £5 a year for each case.

Consider buying Parker’s Wine Buyers Guide (£30) and/or subscribing to their newsletter, The Wine Advocate.

MAKING THE MOST OF REDUNDANCY PAY

If you are made redundant you should receive a lump sum compensation payment, some or all of which is tax-free and which needs to be invested.

Most people need to use their redundancy payment to live on while looking for another job. In those circumstances, an instant-access deposit account is the only sensible investment.

You may be fortunate enough to get compensation beyond the tax-free amount. If you can afford to forgo some of the taxable compensation, consider asking your employer to use it to buy extra pension for you. As you do not receive the money, it is not taxable on you and employer contributions to a company pension scheme are not limited.

Another possibility is to invest part at least of your compensation in a new business of your own, if you think the prospects of success are better than finding another job.

CASE SCENARIOS

Amanda buys a flat

It is time Amanda entered the property market, her friends tell her. She is very happy in her flat and there is no opportunity to buy it. So she considers buying another flat to let. She carefully picks an area which is said to be ‘going up’ and gets details from estate agents in the area.

She doesn’t have time to manage it herself, so she reviews the estate agents with a view to appointing one as manager.

She does her sums and finds that she can make a profit after expenses providing she has a tenant for at least ten months of the year, so she decides to go ahead with the investment. In addition, she hopes for some capital gain.

Alistair and Jean

Alistair and Jean consider putting some of the inherited lump sum into savings accounts for the children, to introduce them to saving and money care. They know about the tax liability if annual interest exceeds £100 each for each child, so they calculate the maximum lump sum accordingly.

Later they will consider pooled equity investments, recognising that these could give better returns over the long term.

Gwen goes green

Gwen reads in a wildlife magazine that there are companies which are recognised as complying with environmental standards and suggests to Hugh that some at least of their future investments should be in such companies.

Hugh is sceptical, pointing out the risk of inadequate performance, but Gwen gets hold of a list of ethical investments and picks out some unit trusts that have a good record, so Hugh agrees to give one of them a try.

POINTS TO CONSIDER FURTHER

• 1.Have you got some surplus funds which could be channelled into investments for your children or grandchildren? If so, what do you consider the best investment?
• 2.If as a shareholder you consider that a company has been unethical in some way, what do you do? Write a letter of complaint to the chairman? Go along to the next AGM and raise the issue? Just sell the shares? Which do you think would have the most impact?
• 3.Assuming you own your own home, how do you feel about further property investment? In particular, would you consider buying to let? What are the risks? Would you have time to manage it yourself?