3.5 Reduce fees and taxes

fees matter
Click to read the FT article about fees

Chapter Overview
Tax-efficient investing is rule #1

Thoughts on fund and IFA fees
The book consistently makes the case for low-cost index trackers beating actively managed funds 95% of the time.  In Europe, that figure is closer to 90% according to independent research – but, even so – a definite no-brainer.

I’ve spent the last couple of weeks speaking with IFAs to figure out what kind of an investing approach I should take.  Guess what? Some think index trackers are a good idea as part of an actively managed allocation of assets.  Many replayed a version of ‘paying fees means bigger returns’ so index tracker savings are irrelevant.

After speaking with the fourth or fifth IFA, it occurred to me that they were ALWAYS going to suggest a way of investing which meant me paying fees – to them.

This worked out to be between £2-5K up front and between 0.4-0.7% of assets under management (AUM) to operate the scheme.

Even forgetting about the initial payment, losing 0.5% in fees each year is enough to make any investment outperform or underperform inflation.

Remember, 90% of actively managed funds will not outperform the index.  So what pay 1% extra in underlying fees + 0.5% to an IFA to end up with a substandard investment?

After speaking to the third or fourth IFA, I realised I was doing the equivalent of asking a butcher whether I should have meat for dinner.  Of course, his answer is utterly predictable, just as an IFA will never suggest an investment plan that doesn’t involve the involvement (and fees) of an IFA.

How about using an IFA to set up a sensible asset allocation via index trackers?  Unfortunately, this is the worst of all scenarios.

Using an IFA to set up an actively managed portfolio means that at least you have a slim (10%) chance of recovering the IFA and fund fees by out-performing the market.  Index trackers cannot, by definition, out-perform the average – and paying an IFA to set up a portfolio using them means there’s no way to break-even on the deal.

I’ve yet to figure out my own asset allocation via index trackers, but I’m pretty sure that it doesn’t make much sense to incur ongoing fees in this regard.  Maybe the initial fee might be worth it – but I’m reserving judgement.

Taxes
In the UK we have two main vehicles for making tax-efficient investments: Pensions and ISAs.

ISAs are pretty straightforward. You put a maximum of £20K per year of your tax-paid money into an ISA – and all of its growth is tax-free.  So if your £20K ISA grows to £30K over a period of time, you can spend all of that £30K whenever you cash it in without handing over a chunk of it to the tax man.

The downside is that you’ve already paid tax on the income which you then invested into the ISA.  The upside is that you know exactly how much you’ll have to spend in the future (barring fluctuations in the value of the investment).

An ISA is just a tax free wrapper for many kinds of investments.  You can have an equities-based ISA (stocks and shares) or a cash-based one – but in reality it can hold a wide range of stuff you want to invest in.

For example, the Alliance Trust platform (truly dreadful and I’m looking for an alternative) allows you to fill your ISA with stocks and shares, bonds, index trackers etc.

Let’s say you’re married and you have 20 years to go to retire and you can afford the maximum ISA contribution of £20K each per annum.

Over the course of 20 years, assuming an average return of 5%, your joint investment pot would grow to be in excess of £1.3M according to this compound interest rate calculator.  At a SWR of 3% pa, that’s enough to give you an income of £39K pa or £3,250pm.

Is that enough or not?  Only you can decide – and remember to take inflation into account because assuming 2% inflation for the next 20 years, that £3,250 pm will actually have the buying power of £2,000 in today’s money.

So, ISAs can be a useful way to save for the future, but what about pensions?

Pensions
No thanks at all go to our accountants for explaining this clearly to me! There are various different kinds of pension with weird sounding names but they’re all governed by a few simple rules.

There’s an annual limit of how much you can contribute to a pension in a tax-efficient way.  In 2015 that’s £40K pa, previously, it was £50K.  This is a total limit, so if both you and your employer are making contributions, you cannot exceed the £40K max in total.

In reality, you can exceed this maximum – but all the tax benefits are lost because the ‘extra’ is taxed at 55% – and pensions are only interesting because of the tax breaks.

On the plus side, the £40K you put into a pension is not taxed at source, so all of your contributions are made before deducting tax. The downsides are that when you are eventually able to draw on your pension (after age 55), you pay tax on the income at whatever the current rate is at the time.

As of April 2015, there’s greater flexibility in how you can use your pension – but who knows what the laws will be by the time you can eventually access it?

There’s a (current) lifetime limit of £1.25M per person across all pension funds.  So, hurrah, if you have that problem.

There’s also a thing called carry forward whereby if you didn’t use all of your pension allowance for the previous year, you have three years to catch up and make those payments.

Again, ‘pension’ is just a tax-efficient wrapper for many kinds of investment – similar to the ISA wrapper.  Again, via a platform such as Alliance Trust, you can decide what actual underlying investments will go in to your pension pot.

What happens after ISAs and Pensions?
So, you’re lucky enough to have more that £60K a year to save (£20K ISA + £40K pension) – what else is available in the way of tax-efficient savings?

As far as I can tell – nothing.

Schemes such as EIS or VCT do exist but they tend to be a much riskier way of tax-efficient investing.  The advice I’ve been given and read online is to only invest money you can afford to lose completely.

Don’t let the tax-efficient tail wag the investing dog.

Take your tax-paid spare cash and, after maxing out your ISA and pension allowances, invest more into the same underlying investments that you already hold in your ISA and pension wrappers.