Long Term Savings – the need to start early

Saving for income in retirement can be a daunting thought for most people – the problem they face is that they simply don’t know how much they need to save between now and retirement.

In this article we consider the time value of money, and in particular, the benefits to be enjoyed from “compound growth”. In later articles we consider just how you go about working out how much you need to invest to plan for your own retirement income.

The Rule of 72

In the article “The Rule of 72 – the Time Value of Money” we discussed a simple technique for calculating how your money grows over time whereby dividing the rate of growth you are enjoying on your money into 72 shows the number of years it takes for your money to double in value.

For example – if you were lucky enough to receive 6% annual interest on your money in a savings account then this would double in value every 12 years (72/6=12).

Compound Interest

The principle of compound interest is simply one of “money makes money”. An example of this would be investing £100 in a savings account at 10% interest – after one year your money would have grown to £110 – after two years, £121 – you have earned an extra £1 interest in year two as not only have you earned 10% on your original investment of £100 but you have also earned 10% interest on the £10 interest you made in year one and this continues for as long as you leave that money invested.

Over time, as the proportion of “interest earned” grows then the rate at which your overall investment grows also increases – it’s like a snowball effect – when you roll a small snowball down a hill at first it grows slowly – the more it rolls, the more snow it picks up on each rotation and the faster it moves…….

The following chart shows how £500 per month, enjoying a simple return of 5% per annum, grows over a 30 year period –

The above chart shows that in the earlier years the rate of growth on the funds invested is relatively low, and as the benefits of compound growth accumulate over time the curve of the graph becomes steeper as each and every £1 of interest earned subsequently earns its own interest!

It’s not how much you save, but how long….

The principle of compound interest therefore brings us nicely into the subject of pension planning, saving for retirement or any other form of long-term saving.

For the sake of this example we will consider that you wish to retire at age 60 and you are now aged 30.

You have calculated that to provide income in retirement of £20,000 per year, ignoring inflation for the time being, and assuming a return of 5% after charges for both the growth on your money being invested BEFORE retirement and for the annuity income you receive AFTER retirement, that to provide £20,000 per annum you need a fund of £400,000 (£20,000 per annum divided by 0.05).

So to achieve this income goal you need to build up a fund between now and retirement of £400,000. Logic says that we simply divide the fund needed between the number of years to retirement and this tells us how much we need to save each year – in this example £400,000 over 30 years requires a saving of £13,333.33 per year (£1,111.11 per month)

This however doesn’t take into account the growth that you would enjoy on each contribution being paid into the investment vehicle – the contribution made in month 1 would have the longest time to grow – 29 years and 11 months, the contribution made in month 2 – 29 years and 10 months and so on…….

Compound Growth and Regular Savings

Saving on a regular basis into an asset-backed investment, such as a pension fund, or a unit trust held under an ISA umbrella, can benefit from “pound cost averaging”. In a volatile stock market, such as the one we are currently in, investing on a regular monthly basis means that you effectively have 12 chances each year to invest some of your money into the stock market on a day when the market is lower than on other days. The benefit of this is that it brings down the average cost of the units you hold, and ultimately leads to a larger potential profit at the end.

In our example above we calculated the monthly contribution required to build a fund of £400,000 assuming no growth

If we add in say net annual growth of 5% after charges (which should be achievable over the medium to long term) then the monthly investment actually falls to £480.62 per month.

If the rate of growth increases to say 6% per year, the monthly investment falls to £398.20 per month.

If the rate of growth again increases to say 9%, the monthly investment required to hit £400,000 falls to £218.49.

The Cost of Delay

Above we calculated that £480.62 invested at 5% net per annum will grow to £400,000 over a 30 year period. If we reduce the term to 29 years, then to achieve the same fund value, the monthly investment needs to be £512.77 per month – an additional monthly investment of £32.15 or an additional total investment of £11,188.20 over the life of the investment. This shows the cost of delay.

So by waiting one year, an additional £32.15 per month needs to be invested, each and every month for the whole 29 year period, to provide the same £400,000 fund at age 60.

If the individual were to delay their regular savings by 2 years then a monthly investment of £547.63 would be needed – delay by just 5 years and the monthly contribution rises to £671.69 which is probably beyond the means of most families with average income and outgoings.

Starting Early

We have now calculated that the regular saving to build a fund of £400,000 over 30 years, at 5% net return per annum, would be £480.62 per month – but what if you were to start earlier?

If you had the foresight to have started last year, and therefore have a period of 31 years over which to make this investment then this monthly investment would fall to £450.90 – start 5 years earlier and the monthly investment would need to be £352.08……………….

Conclusion

In conclusion then it is vitally important that you start saving as soon as possible for retirement income – whether that be through a personal pension, stocks and shares ISA, a deposit account…….

Start as soon as possible!

Ask yourself this question – how many more paydays until retirement? – 30 years – another 360 payslips – it’s later than you think!

Related Article:

The start of the new tax year yesterday signalled changes in some of the main tax rates, reliefs and allowances and summarised below are the main rates, reliefs and allowances based on our own research: –

Capital Gains Tax

No change to personal allowance for Capital Gains Tax – remains at £9,600 for the 2009/2010 tax year

Note:

Tax allowances, rates and reliefs are subject to change. These figures are for guidance only and are correct to the best of our knowledge at the date of publication. Please check the HMRC website for current rates before making tax planning decisions.

ISA Allowance 2009/2010

Yesterday, 6th April 2009, marked the beginning of a new tax year – all last year’s planning is now closed and we each start the new tax year with a clean slate and the opportunity to make positive changes in our personal finances.

With the dawning of a new tax year comes the ability to contribute to another ISA allowance.

Our article “ISA’s – Individual Savings Accounts” gives more information on what an ISA is – the different types available, the tax treatment etc.

New ISA Allowance – 2009/2010

In the current 2009/2010 tax year the investment allowance into an ISA remains the same at a total investment allowance of £7,200.

This can be broken down into two constituent parts – up to £3,600 can be invested in a Cash ISA (a little like a savings account with a bank or building society, only with interest paid with no income tax deducted) – with the remaining amount up to a total subscription of £7,200 across both ISA types being available.

For example, if you invested £2,000 into a Cash ISA you could still invest £5,200 into a Stocks and Shares ISA.

22nd April 2009 – In the budget today, Chancellor of the Exchequer announced changes to ISA allowances which come into effect on 6th October 2009 for over 50’s and for the rest of the population from 6th April 2010 – click here for more details.

I didn’t utilise my full allowance last year, can I top it up?

No, once the clock strikes midnight on 6th April a new tax year starts and all subscriptions to last year’s ISA are complete – no more money can be paid in. In practice, if your Cash ISA is administered in the traditional way through a passbook with a bank or building society, you will more than likely continue to pay money into the same book – it is just your allowance for the current tax year which limits the amount you can pay into the account.

Can I have my Cash ISA and Stocks and Shares ISA with different companies?

Yes – you are free to hold your Cash ISA with a different institution to your Stocks and Shares ISA.

Are they expensive?

Typically when investing in an ISA you will incur an “initial charge” – usually in the region of 4%-6% depending on the fund you are investing in, together with an “annual management charge” of between 0.75% and 2.25%.

Many people invest through a discount “supermarket” where the investor may benefit from a discount on their initial and annual management charges.

Can I invest in more than one Cash ISA in the current tax year?

No – once you commence saving into one Cash ISA all contributions in that tax year must be into that Cash ISA with that institution.

Can I Transfer Previous Cash ISA’s and Stocks and Shares ISA’s to another bank or investment house?

Yes, you are free to transfer previous years ISA’s to another provider.

A word of warning here though – you need to TRANSFER your ISA – ask the new company for a TRANSFER form – they are the ones who must contact your previous provider and arrange the transfer. Under no circumstances simply close the existing ISA and take the proceeds to a new institution – it won’t be accepted as a transfer!

Stocks and Shares ISA’s – aren’t they risky?

Yes they can be – a normal course of action would be to invest in a unit trust shielded through an ISA wrapper. A unit trust will normally invest in a range of stocks and shares depending on what that fund is trying to achieve. In these types of fund your money is not guaranteed, you could lose money, you could get back less than you originally invested.

These types of ISA should be viewed as a medium to long term investment – minimum of 5 years although it would be wise to work on a minimum 10 year investment horizon.

Before investing in any asset-backed investment such as a Stocks and Shares ISA it is prudent to ensure you have saved sufficient “rainy day” money into a savings account – this is money you can access easily and they should ideally be invested in a savings/deposit account were the value of your account isn’t susceptible to falls in the value of underlying investments.

How much Rainy Day Money?

Everyone is different – some people may be comfortable with say 6-12 months net income plus all likely expenditure over and above your normal expenditure which you feel may be incurred over say the next 2 years. Others would wish to save considerably more.

The yardstick for any decision to invest in a Stocks and Shares ISA must therefore be – how long are you prepared to invest this money for and are you prepared to lose some or all of it if your investments don’t perform well.

For example, if you need a new car next year it would not be wise to invest these monies in a Stocks and Shares ISA because of the risk of your money falling in value over the short-term.

It can sometimes seem impossible for first-time buyers to get a foot on the property ladder, especially considering property prices in the UK today.

Here are 5 tips for first-time buyers to help them with their search for a new home: –

1. Save as large a deposit as possible.

In the current credit crunch the days of 100% mortgages seem long gone. To give yourselves a fighting change in the current market you need to aim for a good deposit. A minimum 5% is a starting point, 10% is much better.

What is the reason for this? Any lender wants to see that you are willing to share the burden of risk inherent in buying a property. By putting down a deposit you are opening up the market of mortgages available to you. For example, the choice of mortgages available to a first-time buyer with 10% deposit is far wider than for someone with just a 5% deposit.

When you apply for a mortgage the lender will carry out a “credit check” and also possible calculate a credit score for you. A credit check will be carried out with one of the 3 main Credit Reference Agencies in the UK. The lender is looking to see what your credit history has been like in the past. Are you good at meeting your financial commitments? Are you a safe bet?

We recently wrote an article on checking your credit record – How to Check your Credit Record

3. Are you a good bet?

The other area which a lender will want to consider is your ability to repay and service the mortgage going forwards. To this end they will be concerned with your employment position. How long have you had your job?

Are you self-employed (if so, do you have accounts showing the levels of income and profits you have generated?) Are you currently in the probation period with a new employer? Are you on notice of redundancy?

All these are areas and questions which you should ask yourself. For example, if you’re considering moving to a new employer could you wait until AFTER you have obtained your mortgage – you are more likely to receive a mortgage offer today if you have worked for the same employer for say 2-3 years than if you have recently moved to a new job and are within a probationary period.

Likewise, if you’re considering self-employment, can this not wait until you are settled in your new home, having obtained mortgage funding etc?

These are all lifestyle choices you need to consider carefully before taking action.

The lender will be interested in ensuring you are a “real person” – therefore when you check your credit records make sure you are currently registered on the Electoral Roll at your present address.

To register on the Electoral Roll you need to register with your Local Authority – more information here.

5. Do you have a credit history?

One problem many first-time buyers face is that they do not have a credit history – making it difficult for a lender to check whether they have been able to manage their finances in the past. Banks and credit card companies report account activity to the Credit Reference Agencies.

One tip I have heard many times is for young people to take out a credit card and use it on a regular basis – ensuring they pay of the balance each month in full to avoid interest charges – the credit card company will then report that this account has been maintained well on your credit record and this may increase your chances of being offered a mortgage.

Warning – you must remember that your home is at risk if you fail to keep up payments on any mortgage or loan secured on it.

Always seek independent financial and legal advice before committing to a mortgage or any secured debt.

As most non-taxpayers will know, interest on bank and building society accounts is paid net of tax at 20% – savings rate tax.

Unless you complete a Self-Assessment tax return the only way to ensure that you are not paying unnecessary income tax on your bank or building society accounts is to register for payment of interest on their savings accounts without any tax deducted.

How do I register for gross interest with no tax deducted?

You can either ask the cashier at your local bank or building society branch to register you for gross interest – to do this you need to complete form R85.

The Inland Revenue also have a helpsheet on this subject.

Am I eligible for gross interest on my bank account?

Those helpful people over at HMRC (the Inland Revenue) actually have a tax checker on their website here. Use this tool to see if you are eligible for gross interest payment.

I think I may have paid tax on my savings interest in previous years – can I claim it back?

If you were previously a non-taxpayer and you inadvertently paid tax on some interest received then you can complete form R40 – Tax Repayment Form and reclaim this tax from HMRC.

Waiver of contribution is one of those options usually available under a life insurance or critical illness plan which many people may not be aware of.

It may be mentioned by the financial adviser when the sale is being made but often it is not included for one reason or another.

What is Waiver of Contribution?

Quite simply it allows the premiums (or contributions) to be “waived” on a life insurance or critical illness plan in the event of the life assured not being able to work through accident or sickness.

There is usually a “deferred period” before this option kicks in – normally in the order of 3 months. After this period, if you are still off work then the benefit of the waiver starts and you no longer need to make regular payments into the plan.

This benefit continues until one of the following events occurs – return to work, make a claim under the policy or the policy ends.

So why is Waiver of Contribution so important?

Consider the situation – you have not worked for a long period of time due to ill health – it must be serious to keep you off work for such a long period of time.

It is at times like this that you actually need the life insurance or critical illness cover more than ever – it is also at times like this that you may not be able to afford to continue paying premiums, either through an increase in expenditure (medications, treatment, partner losing time from work to look after you etc) or a decrease in income.

Waiver of contribution gives peace of mind that your protection arrangements can remain in place at the time that you most need them to be in place.

Shrewd Action

Always consider the benefits of adding waiver of contribution to any life insurance or critical illness plan you take out.

Have you made a claim under waiver of contribution? If so, please let us know of your experience below.

We are receiving a steady stream of contacts from people asking various questions, and although we cannot specifically provide “advice” in the regulated sense, we are keen to ensure that our articles are relevant to the topics you are interested in reading about.

We will then take into account requests and suggestions when planning and writing future articles.

Hope you’re finding the site useful!

Simon

Credit Referencing – When you Apply for Credit

Many people don’t realise but whenever you apply for credit, whether it is a mortgage, credit card, monthly contract mobile phone etc, part of the application process is that you give permission for the lender to check with a Credit Reference Agency (CRA) into your credit history.

Based on the information stored there, together with the information in your application, they make a decision as to whether to offer you credit or not.

Shrewd Tip – it is shrewd to check your credit records before applying for large loans such as mortgages, car loans etc – to be refused credit as a result of an error on your credit record can be heart-breaking – it could mean losing the purchase of a new home – check well in advance to make sure there are no nasty surprises lurking in your credit record.

What is a Credit Record?

Most adults in the UK will have a credit record – this credit record contains information such as

Name
Electoral Roll listing
Details of individual agreements – e.g. credit cards, loans, mortgages, current accounts etc.

In respect of each “entry” it will contain information on the name of the lender, the credit limit, the current balance, whether the monthly payments are up to date, whether there have been any arrears on the account etc.

Why should I be interested in this?

As with all things, information stored in these credit records can be incorrect and therefore it is wise from time to time to obtain a copy of your credit records to check that no errors are showing which could be detrimental to any future application for credit.

How do I obtain my Credit Report?

There are 3 main Credit Reference Agencies in the UK and they are required by law to provide you with a copy of your record – a statutory report – on request.

They can currently charge a fee of £2 and access to your report is available under section 7 of the Data Protection Act 1998.

Some of the companies offer additional services such as allowing you to access your records on line – for this they charge additional fees – but if you only wish to check your current report then you need to apply for a copy of your statutory report for which the current fee is just £2.

Below are details of how to request a copy of your credit report from each company:

Experian

Equifax

You can obtain a copy of your credit report by visiting their site here. Again, download their application form, complete it and send off with your cheque for £2.

Call Credit

Visit their site here.

Remember – to just obtain a copy of your credit record you need to request the statutory report for which the fee is currently £2. We have not linked to their application forms as the version or location may change – you need to search their sites for the application forms.

What should I do when I receive my report?

IMPORTANT!

Firstly read through it and the accompanying booklet explaining about your credit record. Then go through it to check that all the entries are correct.

If any of the entries are incorrect then you can either contact the Credit Reference Agency or the originator of the information (e.g. credit card company) and explain what is wrong, why it is wrong and ask them to correct it.

If this fails to correct the situation then it would be shrewd to make a second request for the information to be corrected – and it would also be shrewd to send this request by recorded delivery to prove they have received the request.

In the event that they fail to correct the mistake then you are entirely within your rights to make a complaint to the  Office of the Information Commissioner.

We would welcome your comments on this article, together with an hints or tips you could pass on to other readers in respect of your own experiences with credit reports, credit report agencies and the Information Commissioner.

Trusts – An Introduction

What is a Trust?

A Trust is any arrangement whereby one person(s) manages and looks after assets for the benefit of another person or people. It is a legally binding agreement and is covered by various Trust and Taxation laws as well as judicial precedent.

Who is involved?

There are three classes of person involved in the setting up of a Trust – a Settlor is the person who sets up the trust, normally to receive their own assets – the trust assets are looked after by the Trustees for the ultimate benefit of the Beneficiaries.

During the term of the Trust, the Trustees are the legal owners of the Trust assets but the Beneficiaries are the beneficial owners. It is the Trustees legal responsibility to ensure that all decisions made in respect of Trust assets are made in the best interests of the Trust’s Beneficiaries.

It is normally good practice to have more than one Trustee and in the majority of cases the Settlor will also be Trustee. In line with this, it is also possible to name direct individuals to be Beneficiaries under a Trust or this could be written into the Trust to cover a group of people – for example, “all my children who survive me by 28 days”.

How is a Trust set up?

A Trust is generally set up by completion of a Trust deed. This deed sets out the nature of the Trust, the Beneficiaries of the Trust and the powers and obligations of the Trustees.

In respect of life insurance policies generic Trust wording can usually be supplied by the life office to help the Settlors’ legal representative ensure that a correctly worded Trust is put in place.

Are there many Different types of Trust?

Yes – there are a number of different types of trust and they all have different purposes – further information on the different types is available from your Solicitor – the purpose of this article is to introduce you to the topic of Trusts and how they can be used in relation to your own personal financial planning. In future articles we will deal with some of the more common Trust arrangements in more detail

How are they used in financial planning?

Two of the most common uses for Trusts in financial planning are to protect assets from taxation or creditors or to ensure that assets pass to the correct beneficiary in the event of the death of the Settlor.

The majority of people reading this article may come into contact with a Trust arrangement through taking out a life assurance policy.

The Settlor, who is also usually the life assured, sets up the Trust using a standard wording provided by the life office (which it is advisable to get checked by a suitable qualified Solicitor) to leave the benefits from the policy (the sum assured) for the benefit of specific individuals.

A normal course of action would be for a parent to effect a life policy and place it in Trust for their children. There are several benefits to this course of action:

1. The sum assured on death is outside of the deceased’s estate and is therefore not normally subject to Inheritance tax.
2. The proceeds from the plan can normally be paid out quicker as there is no need to wait for probate to be obtained to allow release of funds. Usually provision of the death certificate and a copy of the Trust is all that is required.
3. It stops third parties accessing the funds which may not be what the life assured intended – it’s amazing who can “come out of the woodwork” when someone dies and there is money to be shared out!
4. It stops the sum assured being used to repay debts of the life assured in the event of the life assured dying whilst being insolvent or having large debts.
5. If the Beneficiaries are young children then the money can be held within the Trust and the Trustees would usually have the ability to make advances of the funds for the welfare and benefit of the children, whilst retaining the monies until the children are older and better able to manage their own affairs.
6. Grandparents could utilise a Trust to allow their assets to effectively “skip a generation” and be passed to grandchildren which is a particularly popular arrangement where their children are already wealthy in their own right.

Yes, Trusts can also be used for tax planning and in later articles we will discuss the various Trust planning tools available in the UK today. Gifts can be made into specific Trusts which provide an immediate saving against Inheritance tax; other Trusts exist to remove growth of investments outside of an Estate whilst still allowing the Settlor access to their capital.

In this article we will compare income protection insurance to critical illness cover and consider how they can be used together to protect your financial position.

Critical Illness Cover or Income Protection?

Many people ask whether it is more appropriate when considering insuring against ill health to take out income protection insurance or critical illness cover.

We think the confusion arises as many people seem to believe that the two types of insurance do the same job and fulfill the same need. Before considering this in more detail lets just recap on what each type of insurance is and how it works.

Income Protection Insurance

Income Protection Insurance, previously known as Permanent Health Insurance (PHI), is designed to provide the person covered with a replacement income in the event that they are unable to work through accident or ill health. It is not to be confused with ASU (Accident, Sickness and Unemployment) which generally pays out a benefit for a maximum term of 12 months.

After a deferred period (period between telling the life company about the illness and the cover commencing payout) the regular tax-free income is paid to the life assured until the earlier of return to work, death or retirement.

The income can be level or indexed, i.e. it increases each year, either in line with RPI or a fixed percentage, to maintain the real value of the policy.

Critical Illness Cover

Critical Illness Cover (CIC) pays out the sum assured when the life assured is diagnosed as suffering from one of a range of critical illnesses.

Cover is normally provided for a “core” range of illnesses as set out by the Association of British Insurers Statement of Best Practice – covering such illnesses as cancer, stroke, heart attack, kidney failure, major organ transplant, multiple sclerosis and coronary artery bypass surgery.

In addition to this, the majority of policies also cover “additional” conditions such as blindness, coma, loss of limbs, loss of speech, Parkinson’s disease, benign brain tumour, paralysis, terminal illness, third degree burns to name but a few.

The policy can be taken out for a fixed term or whole of life on a single or joint life basis

Income Protection and Critical Illness Cover – complementary policies

To put this into context we need to consider the following basic points of each type of cover: –

1. Income protection = regular income if unable to work through accident or sickness
2. Critical Illness Cover = lump sum payment on diagnosis of one of a number of critical illness conditions.

It is therefore possible to see that depending on the nature and severity of the illness it might be possible for the policyholder to claim one or both policies.

Off work sick – but not critically ill

An illness may be severe enough to prevent you from working (thereby making a claim under the income protection plan) but not one of the listed conditions for claim under the critical illness plan.

An illness may be critical e.g. cancer, but not such that in the event of successful treatment of the condition it is feasible that the life assured could return to work after a period of time maybe a year or so – but not long enough to really benefit from making a claim under an income protection plan.

The income protection plan may also provide proportionate benefit in that if the life assured returns to work on a lower salary as a direct result of having suffered their illness they may be entitled to continue receiving some of the benefits payable under the income protection plan

Summary

In conclusion, we would consider critical illness cover and income protection insurance to be complimentary in their nature and therefore it would be wise to consider taking out both types of insurance.

Naturally you should consult an Independent Financial Adviser before purchasing either of these types of insurance as they will be able to research the marketplace for you and make suitable recommendations based on your own particular circumstances.

We would welcome any comments you wish to make below.