Lexo | 2018

How much should you be saving for your retirement?

October 26, 2018 12:49 pm Comments Off

In most cases, the answer to this question is more than you’re putting in now! The minimum that you should be putting aside for your retirement plans, if you’re free of unsecured debts like credit cards and loans, is 12.5% of your income.

But why 12.5%? Because it’s the first hour of an eight-hour working day, so the first hour you work every day goes to paying yourself before anyone else, including HMRC. That’s not the maximum proportion I recommend – it’s the minimum. If you’re nowhere near 12.5%, then it’s a case of trying to build up to it.

An important step in doing that is to cut out all unnecessary expenses and follow my Bank Account System to reduce your outgoings.

Mindset matters

There’s no hiding that 12.5% is a chunk of anyone’s income, and we need to enjoy life now as well as in the future; we want to take holidays, have a great Christmas with the kids, enjoy new experiences – retirement is not the target of our life.

12.5% is a starting point. Some people will think, ‘no problem’. Others will think I’m off the planet, because every month they have more days left over than pay cheque.

That comes back to step 2 of my book The Money Plan: get financially well organised. You’ve got to know what you want in life and have a plan in place to get there. You’ve got to get your mindset right, which is why I spend about one-third of The Money Plan on financial mindset. It’s that important.

If you are miles away from your targets, go through your expenditure items and see if you can squeeze them down. Look at all payments coming out of your account and ask the holy trinity of questions about each: do I need this, do I want this, can I get a similar experience for less elsewhere?

You’ve got to plan for your future, and 12.5% is just the start; if you’re in your 50s or 60s with little in your pension pot, you’ve got to make big sacrifices to put more away so you can make your pension income last longer in your retirement.

With that said, I’m realistic. If your employer pays a significant contribution to your pension, say 10% or even 15%, then that can make a big difference. You might even decide to redirect your savings onto your mortgage.

The 40/40/20 principle

After all unsecured debts are repaid and the financial fundamentals such as emergency cash, a will and power of attorneys are in place, I refer to what’s left over between your income and expenditure as a snowball, a surplus.

A good way to be financially organised is to take that snowball and allocate it 40/40/20: 40% goes to overpaying your mortgage, 40% goes into your retirement plan, and 20% goes back to you to enjoy today. I repay 20% back to enjoying today because I strongly believe that although we need to plan to ensure we have sufficient income for when we decide to stop working and retire, we should not live our life for our retirement – for the last quarter of our life, the 40/40/20 rule helps us achieve this financial balance in life.

So while 12.5% might seem like a huge proportion of your income to start off with, what I’m trying to do is shift your mindset from 1% or 2% to a bigger figure. The 40/40/20 ratio allows you to change how you think about things, without missing out on enjoying the here and now.

Market unease

Stock markets have been in the news again, with some substantial drops around the world recently. It’s easy to think of the markets as a plaything for the rich, but the reality is that everyone with a pension is invested in them. Should you be concerned about a bigger market correction (fall) coming soon, particularly if you’re trying to increase your pension contributions?

It comes down to mindset again: we should only worry about things we can control. You can’t control the FTSE or other stock exchanges, but you can control your asset allocation – how your money is invested. That’s determined by your risk tolerance and your risk capacity.

Your risk tolerance is how much your investment i.e. pension could fall in value before you begin to feel uncomfortable, before you start to worry. Your risk capacity is how much can your investment can fall before it starts affecting your lifestyle, what you can afford, and whether you have time for the value to recover after a fall.

A 100% stock market exposure portfolio, which almost nobody has, will typically fall around 50% in value during a significant market correction (such as the dotcom bubble bursting in 2000 or the financial crisis 2007). That can happen more than once if you’re investing over the long-term, such as with a pension.

A 50% stock market investment portfolio is therefore likely to fall around 25% in value during a correction.

To work out your risk tolerance and capacity, put the numbers above into real pounds for your circumstances. If you have £100,000 saved in your pension and it dropped in value by 25%, do you have long enough left before retirement to wait for the market recovery and an increase in value again? Or are you going to be sick with worry and upset?

If the latter, you’ve got too much stock market exposure and you need to reduce it. When investing, time is your friend, you need enough of it to ride out the inevitable waves in the market.

As a very general rule of thumb, think 100 minus your age to work out the rough proportion of your retirement plan investment that should be allocated to the stock market. If you’re in your 20s, you could have 80% (100 minus 20) of your investment in the market, because you’ve got 40-plus years until you need access to it. If you’re in your 50s, around 50% exposure to the markets is likely more sensible, because you have less time to see out the peaks and troughs.

And remember, even if you’re in your 80s, this rule still leaves 20% exposure to the stock market. You don’t want to remove it altogether because it’s your engine for driving growth and returns.

The Budget

The Budget takes place on Monday 29 October. Pretty much every year since I’ve been in financial planning, there have been rumours that it will include measures to tinker with higher rate tax relief and how it works with pensions. This year is no different.

If you’re concerned about it, then make your pension contributions early if you can – squeeze as much in as you can before the Budget, don’t wait until afterwards.

I think politicians are more focused on Brexit at the moment, but they do need to find more money, so it’s worth keeping an eye out for any announcements on Monday.

Capital gains tax on second homes; liability & planning

October 10, 2018 1:20 pm Comments Off

More people are selling second properties. This could give rise to substantial CGT liabilities. How are those CGT liabilities calculated? Advance planning can reduce those CGT liabilities.

It would seem that some of the tax measures announced by George Osborne in his Budget in 2015 are beginning to take effect. More and more people are selling their buy-to-let investments. This naturally leads into considerations on potential capital gains tax (CGT) liabilities.

Capital gains tax is payable on the profit made from the sale of property that is not the taxpayer’s principal private residence, as well as assets such as shares (that are not held inside a pension or ISA).

Whilst no CGT is payable on the profits arising on the sale of a private residence, CGT is a reality on the sale of a buy-to-let property. After deduction of the CGT annual exempt amount, tax will be payable on the gain at 18% (to the extent it falls within the investor’s basic rate tax band) and 28% (to the extent it takes him or her into higher rate tax). It should be noted that the top rate of CGT on residential property is therefore 28% – even for 45% income tax payers.

And we can expect that HMRC is taking a keen interest in these transactions.

It has been reported that HMRC is apparently cracking down on those who sell a second home or buy-to-let property but fail to pay tax on the profits.

In this regard, apparently HMRC is to write to 1,500 people it has identified as having sold a property in the 2015/16 tax year but not declared a profit on which capital gains tax would potentially be payable. The letter will ask recipients to explain why they have not declared the gain and paid any tax. Failure to respond to the letter or provide an adequate explanation could result in a formal investigation and fines.

As mentioned earlier there has been an increase in sales of buy-to-let properties after a series of tax changes, that began to come into force in April 2016, reduced their attraction to investors.

The question is, is there any way in which the CGT tax bill can be reduced?

The tax is levied on the capital gain that arises on disposal – this is the difference between the purchase price of the property and the price at which it is sold.

Each individual has an annual capital gains tax exemption of £11,700 in 2018/19. This is £23,400 per couple where the property is in joint ownership. This, of course, is an investor’s total annual exemption and so, if the investor also has taxable capital gains elsewhere, these will count towards it. Losses from, say, the sale of shares or another property can be offset against gains.

Furthermore, the investor can deduct from the gross gain any costs incurred in the process of buying and selling the property, such as legal fees, agents’ fees and SDLT. It is also possible to deduct the cost of improvements, such as a kitchen extension or putting in a new bathroom.

It is not possible to deduct mortgage interest, repair costs or the cost of replacing items, (known as running repairs). However, in the case of buy-to-let properties, such costs will typically have been claimed against income in the year they were incurred. Matters can get complicated if an item is replaced with one of a higher specification, (in which case part of the cost can be offset against income and the other part against any gain.)

If a property has been the principal private residence of the investor for part but not all of the time it has been owned by the investor, in principle, CGT will only be charged on the pro rata gain for the period during which the property was not the investor’s principal private residence. It is also possible to claim an exemption for the last 18 months of ownership whether the property was occupied or not.

If a property that has been occupied as a private residence has been let out, it is possible to make use of lettings relief, which will reduce the gain by £40,000 — or the amount of the gain that is chargeable, whichever is lower. For investors who have more than one home that they have used as a private residence, they can nominate which will qualify for principal private residence relief. It does not have to be the one where they have lived most of the time.

Generally, it would make sense to nominate the one expected to make the largest gain when the property is sold. The problem here is that the investor needs to act quickly as they only have two years from when a new home is bought to make the nomination.

Unmarried couples can each nominate a different home as their main residence and therefore benefit from two “principal private residence” exemptions. This does not apply to married couples or civil partners.

When is the tax due

The deadline for paying CGT is the last day of January after the end of the tax year in which the taxpayer realises the gain. For example, if the taxpayer sold a property on 1 August 2017 (in the 2017/18 tax year) the deadline to pay the tax due would be 31 January 2019.

There are plans to change the rules to require tax to be declared and some paid on account on such properties within 30 days of sale. This is expected to come into force on 6 April 2020.

Example – Frank

Frank bought a house on 1 February 2006, for £120,000, lived there until 31 July 2010, and let it until it was sold on 31 January 2018 for £260,000. He will have made a profit of £140,000 over the 12 years he owned it.

He is entitled to the principal private residence (PPR) relief for the time it was his main residence — in this case, the initial 54 months. A further relief is available for the final 18 months before it was sold, allowing him to claim PPR relief for 72 of the 144 months of ownership.

Deducting £70,000 from the total gain of £140,000 (72/144ths) leaves £70,000 that is subject to capital gains tax (CGT) — assuming no other capital expenditure that could be used to reduce the gain further.

Because Frank had let the house, a further £40,000 letting relief can then be deducted, reducing the gain to £30,000. From this he can deduct the annual CGT exemption in the tax year the property was sold — £11,300 in this case — pushing the taxable gain down to £18,700.

If he were a higher or additional rate taxpayer, Frank would pay 28% tax, giving a bill of £5,236. If the gain kept Frank in basic rate tax, he would pay 18% or £3,366.10

The Longest Bull Run Ever

August 30, 2018 3:21 pm Comments Off

Last week the USA stock market established another record – the longest bull run ever.

On Wednesday of last week, the main US stock market index, the S&P 500, dipped marginally but still managed to set a new record. 22 August 2018 marked 3,453 days of bull market, which many commentators hailed as the longest ever for the index. That period topped the previous record, set between 1990 and 2000, when the US market enjoyed an internet-led technology boom, ending with the dot-com bust.

The latest bull market arguably started on 9 March 2009 when share prices bottomed out in the wake of the 2007/08 financial crisis and the demise of Lehman Brothers in the previous September. At its low, the S&P 500 hit the devil’s number – 666 – a memorable floor from which it has since risen to a new closing high of 2874.69 (as of last Friday). As the graph above shows, there were a few hiccups on the way, such as the 2010 flash crash, the drop caused by concerns about China in the second half of 2015 and the sudden return of volatility at the start of this year. Nevertheless, since March 2009 the S&P 500 has achieved annual growth of 16.7%. UK investors in the US market would have done marginally better, as the pound has fallen 6.6% against the dollar since March 2009.

The S&P 500’s record run has thrown up a number of interesting facts, which may (or may not) give comfort to those worried about the continued longevity of what has been described as the most-hated bull market of all time:

The generally accepted definition of a bear market, which puts an end to any bull market measurement, is a fall of 20% from the previous peak. However, the start date of the previous longest run (1990 to 2000) began after a market drop of 19.92%, not 20%. Stick precisely to the 20% threshold and the tech-bust of 2000 ended a bull market which started in December 1987 – a 4,494 day stretch.

To add a further twist, the market sell-off in 2011, prompted by political dispute over the US debt ceiling, was also over 19%, but under 20%.

The 1990-2000 run produced a higher gain over the shorter period – 417% over 3,452 days against 323% over 3,453 days for 2009-2018.

Look at the performance of the S&P 500’s components since March 2009 and three sectors stand out. Consumer Discretionary posted gains of over 610% and Information Technology over 530%. Together those two sectors cover the FAANGs (Facebook, Apple, Amazon, Netflix and Google/Alphabet). Coming up third was Financials, a reflection of the recovery of the banks from the 2007/08 financial crisis.

Studying just the index numbers does not give a full picture of market value. The price/earnings ratio for the S&P 500 is currently around 24 whereas at the peak of the dot-com boom it was over 46. However, the S&P 500 index is 85% above its March 2000 level.

For most of the current bull market, dollar interest rates have been ultra-low and there has been no shortage of cash, thanks largely to quantitative easing. The Federal Reserve kept its main rate at 0%-0.25% for seven years from December 2008 and only crossed the 1% barrier in June 2017. By the end of 2019 the Fed consensus is that the rate will be 3.25%-3.50% and quantitative easing is now running in reverse and accelerating.

The current dividend yield on the S&P 500 is 1.77%, whereas the drumbeat of rising interest rates means that 2-year US Treasury bonds offer a yield of 2.62%. Holding cash and near cash is now a viable alternative for income-seeking investors.

In global terms, the USA market appears expensive. As at the end of July 2018, MSCI’s World Ex USA Index had a price/earnings ratio of 16.29 and a dividend yield of 3.10%.

However you measure it, the US stock market has enjoyed a long, strong, run in this decade. How much further it has to go is a question which seems to have been around almost since the rally started, however Trump, love him or hate him, is fuelling the growth with tax reform and legislation simplification.

To Bit or Not to Bit: What Should Investors Make of Bitcoin Mania?

January 20, 2018 11:28 am Comments Off

Bitcoin and other cryptocurrencies are receiving intense media coverage, prompting many investors to wonder whether these new types of electronic money deserve a place in their portfolios.

Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it.

Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million,^[1] of which more than 16 million are in circulation.^[2] Transactions are recorded on a public ledger called blockchain.

People can earn bitcoins in several ways, including buying them using traditional fiat currencies^[3] or by “mining” them—receiving newly created bitcoins for the service of using powerful computers to compile recent transactions into new blocks of the transaction chain through solving a highly complex mathematical puzzle.

For much of the past decade, cryptocurrencies were the preserve of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. This niche appeal is reflected in their market value. For example, at a market value of $16,000 per bitcoin,^[4] the total value of bitcoin in circulation is less than one tenth of 1% of the aggregate value of global stocks and bonds. Despite this, the sharp rise in the market value of bitcoins over the past weeks and months have contributed to intense media attention.

What are investors to make of all this media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply, but that is the past. What about its future value?

You can approach these questions in several ways. A good place to begin is by examining the roles that stocks, bonds, and cash play in your portfolio.

EXPECTED RETURNS

Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.

Government bonds often provide a more certain repayment of promised cash flows than corporate bonds. Thus, besides the potential for providing positive expected returns, another reason to hold government bonds is to reduce the uncertainty of future wealth. And inflation-linked government bonds reduce the uncertainty of future inflation-adjusted wealth.

Holding cash does not provide an expected stream of future cash flow. One pound in your wallet today does not entitle you to more pounds in the future. The same logic applies to holding other fiat currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.

The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies.

With this framework in mind, it might be argued that holding bitcoins is like holding cash; it can be used to pay for some goods and services. However, most goods and services are not priced in bitcoins.

A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with possibly high transaction costs to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.

If bitcoin is not currently practical as a substitute for cash, should we expect its value to appreciate?

SUPPLY AND DEMAND

The price of a bitcoin is tied to supply and demand. Although the supply of bitcoins is slowly rising, it may reach an upper limit, which might imply limited future supply. The future supply of cryptocurrencies, however, may be very flexible as new types are developed and innovation in technology makes many cryptocurrencies close substitutes for one another, implying the quantity of future supply might be unlimited.

Regarding future demand for bitcoins, there is a non‑zero probability^[5] that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand).

Future regulation adds to this uncertainty. While recent media attention has ensured bitcoin is more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns.^[6] Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.

All of these factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input in the price of bitcoins today. That price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in bitcoin’s price today.

WHAT TO EXPECT

So, should we expect the value of bitcoins to appreciate? Maybe. But just as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today. They don’t entitle holders to an expected stream of future bitcoins, and they don’t entitle the holder to a residual claim on the future profits of global corporations.

None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.

When it comes to designing a portfolio, a good place to begin is with one’s goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of a portfolio should be allocated to that security.

Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash in fiat currencies, they don’t provide the means to plan for a wide range of near-term known expenditures. Because bitcoin does not help achieve these investment goals, we believe that it does not warrant a place in a portfolio designed to meet one or more of such goals.

If, however, one has a goal not contemplated herein, and you believe bitcoin is well suited to meet that goal, keep in mind the final piece of our asset allocation framework: What percentage of all eligible investments do the value of all bitcoins represent? When compared to global stocks, bonds, and traditional currency, their market value is tiny. So, if for some reason an investor decides bitcoins are a good investment, we believe their weight in a well-diversified portfolio should generally be tiny.^[7]

Because bitcoin is being sold in some quarters as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust dimensions of expected returns, has been helping investors effectively pursue their goals for decades.

[1]. Source: Bitcoin.org.

[2]. As of December 14, 2017. Source: Coinmarketcap.com.

[3]. A currency declared by a government to be legal tender.

[4]. Per Bloomberg, the end-of-day market value of a bitcoin exceeded $16,000 USD for the first time on December 7, 2017.

[5]. Describes an outcome that is possible (or not impossible) to occur.

[6]. “Investor Alert: Bitcoin and Other Virtual Currency-Related Investments,” SEC, 7 May 2014.

[7]. Investors should discuss the risks and other attributes of any security or currency with their advisor prior to making any investment.

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Archive: 2018