Yellowtail Blog

Did you watch the Panorama programme on BBC1 last Monday? I did and was shocked at one particular (unscientific) approach to determining a person’s investment risk tolerance. It’s hard to believe, but one of the high street bank’s financial advisers claimed to know a client’s attitude to investment risk simply by looking into her eyes.

As a method it is as valid as using astrology. Using astrology all Librans would invest in balanced portfolios, and someone born under Taurus would be permanently bullish. It is of course ridiculous.  What would happen if Leo moved into Ursa Major?

The Financial Services Authority have also taken a recent interest in risk profiling tools, so we were pleased to discover that our risk profiling methodology is about as good as it gets. We didn’t expect anything else.  The research behind the tool we use is thorough and there is a continuous testing and validation process that goes on behind the scenes.

Assessing risk tolerance has been an Achilles heel of the advising industry for many years.  However the use of psychometric testing helps determine risk in more robust manner. Psychometrics is a mix of psychology and statistics, and was developed by psychologists in the late 19th century. Psychometrics underlies all testing of personality, skills, aptitudes, IQ, etc.

The system we employ is a scientifically validated tool for assessing risk tolerance.  It is used by a lot of leading advisers, from across 15 countries, and in seven languages. More than 400,000 risk profiles have been completed, and the results of these are regularly fed back into the system to ensure the accuracy of the conclusions.

Until recently the Financial Services Authority gave no guidance on how an investor’s risk profile should be measured, hence perhaps the bank adviser’s impersonation of Paul McKenna, the TV hypnotist. However, in January, the Financial Services Authority did release a detailed guidance paper. By and large, the FSA did a very good job. As it was, the FSA was very critical of industry standards and the paper is going to force most in the industry to rethink their current practices.

So are all psychometric financial risk profiling tests good tests? Unfortunately the answer is no. Most that we know of are OK but some would not meet international psychometric standards. Anyone who provides this type of psychometric test should publish a technical manual independently verified by a third party with expertise in the field. We believe that FinaMetrica is the world standard for risk profiling psychometrics.

Risk tolerance is often thought of as being a tick-box exercise.  However, a good psychometric test will provide you with a better understanding of, and commitment to, your investment decisions as part of your personal financial planning.

Have you noticed how the financial services industry works by developing products with names that resonate with your emotions?  Before the credit crunch it was all about boosting returns, with little regard for risk; now the focus is on minimising risk, with little regard for returns.

Just a few years back, people lined up for investments known as “structured” products. These were promoted as funds where investors could ‘have their cake and eat it’, seemingly earning an investor high returns without any risk. Yet in a post-crisis report by the Financial Services Authority it was pointed out that many of these products used terms like “safe”, “secure”, “protected” or “guaranteed” whilst hiding substantial risks.

In that period of investment hubris before the financial Armageddon, financial product makers also marketed created financial products that actively encouraged more risk taking in the belief that markets were ‘on a roll’. The problem was that these investments were based on the faulty assumption that market risk always remains the same. Many people are now living with the consequences.

These days, investors are more risk averse. The focus has turned to preserving capital and ensuring a “guaranteed” minimum return above what could be obtained from risk free deposits. So the financial services industry has come up with “absolute return” funds.

Sometimes called “all weather” funds, absolute return funds suggest they can deliver reliable returns in rising or falling markets. Describing themselves as highly diversified funds they bring together a dizzying range of asset classes – including commodity futures, swaps of various kinds, mortgages, currencies and other exotic financial instruments. They are a far cry from a traditional equity and bond portfolio.

Many add leverage, borrowing money to increase returns. They also use shorting, that is selling investments they don’t own, hoping to benefit from a drop in price of the investments – a speculative practice.

The intention with these products is to use a range of investments that are “uncorrelated” – meaning they behave differently at different points in the economic cycle – to traditional stocks and bonds. Consequently, they are supposed to lower your risk of a negative return by increasing the diversification in your portfolio.

That’s the theory. But there are a few problems in practice. For one thing, as we saw in the financial crisis, the past isn’t a good guide to what will happen in the future. During extreme stress, the markets tend to punish all risky assets, with prices dropping across the board. Distinctions are not made no matter how uncorrelated they are.

Secondly, investors are mistaken if they think volatility and correlations are the only measures of risk. Extreme events can occur. Some of those events can be blamed on the financial system; others not. Who would have thought, for instance, that Japan would suffer a catastrophic earthquake, a hugely destructive tsunami and a terrifying nuclear crisis at the same time?

A third issue is that a supposedly risk-free investment should really only expect the risk free rate of return, something like the return you can receive on a bond issued by the UK government.  That they don’t – and we shall see evidence of that in a moment – highlights the contrast between simulated track records and reality.

Despite all of this, the moniker ‘absolute return’ is a great marketing strategy. And it appears to have worked. In the UK, for instance, the absolute return sector was the second most popular among retail investors in 2009 and the third most popular last year, according to the Investment Management Association.

The sheer complexity of these funds and the vast differences in their underlying investments make comparisons difficult.

In the UK, research has found that 13 absolute return funds were set up in 2009 in the wake of the financial crisis. Only two were around in 2007. Far from offering returns uncorrelated to the stock market, by the end of 2010, the absolute return sector had moved in the same direction as the FTSE-100 in 29 of the previous 36 months. And in 34 out of 36 months, the absolute return funds had moved in the same direction as the balanced managed sector (funds with a maximum of 60 per cent in shares).

So it’s not clear from all of this that absolute return funds are living up to their names: In the meantime they have opaque strategies, a reliance on simulated returns, a large variation in fees, and returns that do not differ greatly from what can be achieved in underlying shares and bonds – so why invest in all the smoke and mirrors?

When risk appears again on the horizon and these “all weather” portfolios do not live up to expectations (and they won’t) their defenders may blame “the black swan”, the “six sigma” event or the once-in-a-century storm. What they’re really saying is that they couldn’t predict the markets. 

Straight bananas, metric measurement and now Europe wants to mess with your pension!  Most normal people, and I’m assuming you’re one of them, don’t wake up in the morning thinking about the Treaty of Lisbon. Neither do most people wake up thinking about annuities.  So I would be doubly surprised if anybody (apart from a few pension geeks) woke up today thinking about the Treaty of Lisbon and Annuities in the same thought.
But from 1st March these two seemingly separate things could have a significant and detrimental impact on retirement income. It looks as though men will be hit quite hard, but married couples, particularly where the majority of retirement income will come from the man’s pension, may also be affected. Before I get everybody’s blood pressure up I should point out that if you’re already retired and have purchased an annuity with your pension funds, this isn’t going to affect you. Relax and enjoy the rest of the day.

For everyone else, here’s the story. In September 2010 Dr Juliane Kokott, an Advocate General in the European Court of Justice argued that using a person’s gender when underwriting insurance policies was actually sex discrimination, and therefore did not comply with the provisions contained within the Charter for Fundamental Rights.

I’ll go back a couple of steps just to show how significant this is. When an insurance company wants to calculate how to charge for a life insurance policy, it will take into consideration a variety of different things, the age of the person, the medical history and the gender. The same happens when working out how much income to pay someone in exchange for their pension fund.

The older a person is the shorter their remaining lifespan, this means that a higher level of income can be paid. Likewise, if someone is in poor health they have a shorter lifespan, and consequently the more income that can be paid. Finally, because men are statistically likely to die at a younger age than a woman, they too receive a higher income because the pension fund does not need to last so long.

Age, health and gender have been legitimate factors in the calculation of insurance, risk and annuity returns but now an unintended consequence of the Treaty of Rome will mean the majority of people will be worse off.

Nature has little regard for the Treaty of Lisbon so unfortunately men, we’re still more likely to die at a lower age than women. This means that if insurance companies are compelled to offer same sex annuity rates, the age expectancy for men will rise, and their annuity income will decrease. That will hit their pockets with a reduction in income of around 5% being talked about, though some commentators have suggested there will be a 13% difference. Put another way, a £100 income payment could fall to between £87 and £95, neither of them a favourable outcome.

The ruling will be announced on March 1st, but many insurance companies have already started to withdraw their current annuity rates in favour of unisex rates. This is because the 14 day acceptance period for annuities would take them beyond the 1st March.

One problem we help our clients tackle is the hassle of managing their cash through savings accounts.  It can be a struggle to earn more than a miserly interest rate, without the grind of wasting your free time on opening and monitoring a number of bank accounts.  Here are some steps you can take to reduce the stress and continue to earn a decent rate of interest on your savings.

Savings accounts topping the best buy tables in the newspapers and paying the highest rate of interest may seem attractive.  Many of these accounts offer enticing interest using a high bonus rate for a period of time, typically up to a year.  But maintaining the accounts can be a lot of work.

One good thing about these bonus accounts, especially where the bonus makes up a large chunk of the overall interest rate, is you know the interest rate won’t fall very far.  Don’t rely on the banks to let you know when it’s time to move your money because the bonus has expired though. Make sure you make a note to start looking for alternatives a month before the end of the bonus.  At that time you’ll have to be prepared to move your money to an account paying a better interest rate.

If you don’t want the work of keeping on top of the best buy savings accounts another strategy is to open accounts with a bank or building society that pays consistently good rates.  Moneyfacts regularly run a consistency survey which shows building societies offering the most stable interest rates.  Over the long-term most savers probably end up with more interest earned this way than by chasing the best rate.

Once you’ve chosen a good account you probably want to be able to safely deposit a large amount of money.  From 31 December this will get a little easier.  The compensation payable under the Financial Services Compensation Scheme, or ‘FSCS’, is going up from the current £50,000 to £85,000 per person, per authorised firm.  This means joint account holders can put £170,000 into one institution and still be fully protected under the scheme.

The FSCS would pay out if a UK regulated financial services firm is unable to pay claims against it. We never recommend clients put more than the compensation limit with one institution.  You can check if your savings account is covered under the scheme by asking the institution or looking at the list provided on the FSA website.

The bottom line is there are a few things you can do to make sure your money is safe and earning a good rate of interest.  The least hassle do-it-yourself method is to find an account paying a consistent rate of interest rather than a best buy.  Use a joint account to take advantage of the higher amount that will be protected by the FSCS.

Are you worried about having enough money for later in life?  Financial Planning Week could be for you.

You may have family members, friends or colleagues looking for some free information to help them take control of their lives by planning what they want to achieve and taking some simple steps to help them to get there. Financial Planning applies to everyone regardless of their financial situation; it’s not just for the well off.

Financial Planning Week is organised by the Institute of Financial Planning and its members (Dennis Hall is Chair of the London region), but also involves a number of other organizations (such as National Savings & Investments), keen to share their expertise and resources to help promote awareness of the need for and benefits of Financial Planning.

There’s no jargon, no product pushes, and definitely no sales gimmicks – just good useful information and guidance to help people. The overall aim of Financial Planning Week 2009 is simple. It is to get as many people as possible to take some positive action during the week in respect of making their own financial plans and improving their financial “fitness” by taking some simple steps. It does not matter how small those steps might be. They will help people to identify what they want from life and then to map out how they get to where they want to be from where they are now.

You can visit the Financial Planning Week website for more information.

Giving up smoking last month will save Mandie Martin as much as £3,500 a year, but the 25-year-old radio worker is still struggling to build a savings cushion and get on to the property ladder.

She says: “I used to withdraw £10 from the cash machine every morning to buy cigarettes on the way to work — and I’d spend the change on coffee and a banana. I’ve stopped that now, so I should be able to start saving for once. Now seems an obvious time to review my finances.

Financial CV

Income £774 a month, after rent, phone and gym bills.

Rent £200 a month.

Objectives To get into better financial habits and start saving. Also wants to get on the property ladder with her boyfriend, possibly using the Government’s HomeBuy scheme, provided that the timing is right.

Dennis Hall gives Mandy advice in this Times Money Makeover.  You can read the rest of the article on the Times website.

Cara Martin, 28, is a qualified social worker and works full time in adult mental health for the Belfast Health and Social Care Trust. She lives at home with her parents in the family home in the south of the city. “My financial goals include increasing my personal savings and working towards buying my own home within a year,” she says.

Besides getting a foot on the property ladder and increasing her savings, Cara would also like some investment advice. “I am sceptical of the risks of making a bad investment and would like to have solid advice to help me make the correct choice when investing my money.”

Case notes

Income: £22,000 per year
Monthly outgoings: £400 rent, £134 for a car, £15 for private health insurance, £15 for mobile phone.
Debt: £20,000 student loan
Savings: None

Read the rest of the article on the Independent website, with advice given by Dennis Hall of Yellowtail Financial Planning and two other advisers.

What is a Power of Attorney and how does it work?

A power of attorney is, generally speaking, a document where you give another person (your attorney) the authority to manage your affairs and act on your behalf. There are different types of powers of attorney. This briefing relates specifically to those residing in England & Wales.

Lasting power of attorney (LPA)

A Lasting Power of Attorney is designed to be used in cases where you lack capacity to act, due to such factors like illness, accident or the onset of dementia.

You must create your power of attorney whilst you still have the legal capacity to do so. By planning ahead and making an LPA, you are able to give your instructions whilst you are of sound mind, in anticipation of the possibility of not being able to do so in the future.

It makes sense to give consideration to establishing an LPA at the same time as you create your will as much of the required activity is very similar. Like not creating a will, if left too late, friends and relatives who need to administer the sufferer’s financial affairs must nominate a receiver through the courts. This can be a long and expensive procedure. Having an LPA in place will provide you with the peace of mind that your financial affairs will be in order should you be unable to manage them yourself.

Types of LPAs

The new lasting power of attorney comprises two documents, one for your financial affairs and one for your personal welfare. These documents are called Lasting Power of Attorney – Personal Welfare and Lasting Power of Attorney – Property and Affairs. They are described below in greater detail.

Personal Welfare LPA

The Personal Welfare LPA deals with matters relating to your personal welfare, i.e. your social and health care needs – it’s like a living will. If in the future you lack the ability to look after your own personal welfare, this document will entitle your personal welfare attorney(s) to do the following types of things:

• Deciding where you live.
• Making day-to-day decisions, what you will eat or what clothes you will wear.
• Making decisions about what medical care you will receive, including (if you agree to it in the LPA) whether or not you will receive life-sustaining treatment.
• Deciding when and where you will go on holiday.
• Deciding what social activities you might participate in.

Your attorneys are restricted from doing any of the following:

• Consent to place a child up for adoption or consent to the adoption of a child
• Consent to sexual relations
• Give you medical treatment for a mental disorder or consent to you being given medical treatment for a mental disorder if your treatment is regulated by Part 4 of the Mental Health Act 1983
• Decide to vote on your behalf
• Consent to marriage or civil partnership
• Consent to a decree of divorce or dissolution of a civil partnership on the basis of two years’ separation

When it comes into effect?

Your Personal Welfare LPA must be registered before it can be used. However, after the document is registered, your attorney(s) cannot begin to act on your behalf until you have lost capacity to make decisions for yourself. It is wise therefore to register the document as soon as possible so that it will be ready for use when your attorneys need to use it.

Property and Affairs LPA

The Property and Affairs LPA deals with matters specifically related to your finances. For example if one day you lack capacity to look after your own financial affairs, this document will enable your property and affairs attorney(s) to do the following types of things:

• Opening, closing or operating bank accounts
• Claiming and receiving on your behalf, for example, all pensions, benefits, allowances, services, financial contributions, repayments, rebates
• Making all tax returns and adjusting and settling any claim for tax
• Paying your household expenses
• Buying, leasing, selling property
• Paying for private medical care and residential care costs

When it comes into effect

The Property and Affairs LPA comes into effect as soon as it is registered with the Public Guardian unless you specify in the document that you don’t want it to come into effect until after you lose capacity. This is different from the “Lasting power of attorney – Personal welfare” which can only be used after you have lost the capacity to make decisions on your own.

Safeguards

It is very important that you trust the person(s) whom you appoint to act as your attorney(s). A lasting power of attorney is a very powerful document. However, you should be aware that there are a number of safeguards in place to help prevent abuse of the system by any of your attorney(s). These safeguards are the following:

• Your LPA must be registered. This registration process acts as a safeguard because certain people have the right to object to the registration.
• You, the donor, or your attorneys have to give notice of intention to register your LPA, giving all the ‘named persons’ in your LPA the chance to object
• Your attorney(s) must follow the Code of Practice which provides guidance on the Mental Capacity Act 2005. If they do not, and neglect their duties toward you, they can be found guilty of a criminal offence, with possible imprisonment
• If any evidence is presented to the Office of the Public Guardian of your attorney(s) not looking after your best interests, the Public Guardian will look into the matter and decide what action should be taken
• You have the option of placing restrictions in the LPA about what you want/do not want your attorneys to do

The only conclusion that I can draw from the proposed change to pension tax relief for high earners, is that it kills pension planning stone dead. The likelihood is that after paying a top marginal rate of 50% on their earnings, most will be paying 40% on their retirement income, yet tax relief on pension contributions will be restricted to 20%. This hardly seems equitable given that pensions generally only defer taxation. The tax pendulum has now swung so far in the government’s favour high earners need to find other retirement funding strategies.

So what do these proposals actually mean, let me take a look in detail. From April 6th 2011 the Government intends that individuals whose income is £150,000 or more will no longer receive tax relief at their full marginal rate of tax (currently 40%) on pension savings/contributions. Of course, as with the pension simplification exercise, it’s far from straightforward.

It has been outlined that the relief is to be reduced by a tapering mechanism so that those earning more than £180,000 receive relief at the basic rate only (currently 20%). This doesn’t only apply to personal contributions, as the budget papers refer to Pension Savings, which includes pension contributions (employer or employee) to money purchase arrangements, as well accrual of final salary benefits. Although the budget talked about the introduction of the reduced rate of tax relief taking effect from April 2011, in a surprise move the chancellor announced measures designed to pre-empt the reduction in tax relief.

Restricting relief before 2011

Legislation is being introduced designed to undo any tax reliefs that would be received by high earners trying to accelerate their pension contributions (or final salary benefits) prior to 2011. These restrictions are effective immediately – i.e. from 22nd April 2009.

High earners who have already made (or expect to make) contributions greater than £20,000 in the 2009/10 tax year, need to act quickly to avoid incurring a tax charge as a result of this “anti-forestalling” legislation. This is especially important if contributions have historically been made at irregular intervals.

With immediate effect the budget introduced a new “special annual allowance” of £20,000 maximum. For high earners, tax relief on pension savings above this allowance will only be at the basic rate of tax. The Revenue will recover any tax relief given at a higher rate than basic rate through a “special annual allowance charge” via self-assessment tax returns.

The special annual allowance charge will apply only if an individual:

• has “relevant income” greater than £150,000 in the tax year of the savings or the previous two (so for savings assessed for 2009/10, any tax year from 2007/08);

and

• the individual increases the level of their pension savings beyond their normal regular ongoing pension savings.

This means that an individual who is earning (or has earned) more than £150,000 yet simply maintains their level of regular pension savings as it currently stands should not be affected by the anti-forestalling legislation.

Pension savings greater than the normal regular ongoing pension savings made between 6th April 2009 and 21st April 2009 are not subject to the special annual allowance charge but will reduce the special annual allowance available in 2009/10.

Further clarification

“Relevant income” is defined as total income for the tax year less any normal deductions for reliefs (including pension contributions up to £20,000). Importantly, any salary sacrifice in respect of pension contributions or benefits must be added back to the income figure if the agreement took place on or after 22nd April 2009.

“Normal regular ongoing pension savings” for money purchase arrangements it refers to the level of payments that have been made before 22nd April 2009 which are at least quarterly; and for a final salary arrangement, it includes all benefits provided they are calculated under scheme rules that do not change on or after 22nd April 2009.

Calculating Pension Savings For the special annual allowance the basis of calculating the value of pension savings is similar to the existing Annual Allowance calculation. Brief this means that for money purchase arrangements, the value is the total contributions made in relation to that individual, including any from the employer, in the tax year;

And for final salary arrangements this means the increase in accrued rights over the tax year multiplied by 10. If an individual triggers the special annual allowance charge, the law will allow (subject to the pension scheme’s own rules) the member to unwind the pension savings that gave rise to it.

Note: This is a very short summary that aims to cover the broad implications of the budget proposals. The technical notes run to approximately 100 pages and we have barely covered the basics.

The big hurrah that greeted Alistair Darling’s increase to ISA limits is worth just £10.40 for those saving in a cash ISA, and even less if you’re a basic rate tax payer.  So the widely reported big incentive to encourage savings turns out to be marketing over substance – for now that is.

He (the chancellor) announced that the limit on ISA savings will be raised to £10,200, for the over 50s in the current 2009/10 tax year and for everyone else from April 2010.  But buried in the fine print was the news that the increased limit won’t be available until 6 October for the over 50s.  In keeping with the existing ISA rules half of the annual allowance can be invested in cash or the entire amount in Stocks & Shares based ISA.

So, what does it actually boil down to? Well the best ISA rates we could find right now will pay 3.5% interest, whether they are still paying that in October is another matter, but let’s press on.  The additional £1,500 invested in an ISA from October 6th would generate interest of £26.02 in the current tax year.   For a 40% tax payer the tax saving is a mere £10.40

Of course it’s better than nothing, yet the amount of newspaper column inches given over to a £10.40 tax saving this year is disproportionate to the size of the tax benefit.   Yet, if as we predict interest rates and inflation begin to rise, the tax benefits will become substantially higher in the coming years.