Neston & Beyond: The Sacrifice of Salary Sacrifice? Plus MON£Y Mouse by Alison.

There is a bit of a worry and a wobble going on in 11 Downing Street, and it is more than the mystery of how Freya, (the Chancellor’s cat) managed to cross the Thames last week. (Don’t panic, she’s has been returned, crisis averted, worry not.)

During a moment of altiloquence, the Chancellor made a populist move in the March budget announcements on pensions, but in the same way he said free “advice” to all in the speech, but the word “guidance” was in the document, something else will have to change after the event. To explain the story, I am obliged to explain (as briefly as I can) two facets of the pension world. The story follows.

1. Salary Sacrifice.
This is a well established practice for employees and employers. What this means is if say, you have a contracted salary of £40,000, you and your employer can agree to pay you a reduced sum via the payroll, say £30,000, but pay the rest into your pension. Either side can cancel the arrangement. Why is this popular and well established? Well the employer doesn’t have to pay National Insurance (NI) on the amount going into the pension, the contribution is deductible against corporation tax, the employee only pays tax and national insurance on the reduced salary, plus they get a chunk of money into their pension pot. This is very popular with some of the worlds largest employers with UK operations such as Shell & Mercedes Benz running this system almost uniformly.

2. Pension Options at age 55.
Well as you know, before the budget, if you had a personal pension or ‘money purchase’ pension, at age 55 or older if you wanted to, you could draw 25% as tax-free cash, and with the rest, your options were:

Leave it invested.
Draw on it as income, but with an annual limit.
Buy an annuity.

Following the budget, your options are from April 2015, or just before the next general election (quelle surprise):

Leave it invested.
Draw on it as income, but with no annual limit.
Buy an annuity.

Why are these two items now a story? Well it could cost the Treasury, or rather you and me as taxpayers, many billions, some estimate as much as £20bn a year. How so?

Well the thing is, there is nothing wrong, based on the current rules of salary sacrifice if they remain as they are after April 2015, for the employer and employee agreeing to pay the full £40,000 into a pension policy, but immediately, if aged 55 or older, the employee draws 25% tax free cash (£10,000) and then takes an income from the fund of £24,866, set against personal tax allowance.

The employees ‘take home’ is the same as taking taxed salary but only £5,133 is paid in tax, as opposed to £10,107 in Tax & NI, plus he or she has still got £5,000 in the pension pot, and the employer saves around £4,700 in NI payments.

This is a loss to the treasury in our example of a little under £10,000 per annum per employee.

There are a large number of people aged over 55 working in the private sector, and thanks to the failings of successive governments, precious few are in final salary pension schemes, so why wouldn’t they do this.

As you might imagine, this has occurred to someone down that London, and there are some scare stories beginning to do the rounds about the removal of the tax free cash portion, or cash limits on drawings, but these are completely politically unpalatable. My foolish prediction is the salary sacrifice rules will be changed to limit the amount that can be sacrificed to say, no more than 10% of salary. If I am right, remember you heard it here first.

If I am wrong, forget I mentioned it.

Bye for now,

John.

MON£Y Mouse Kitnapping

P.S. I haven’t forgotten (Edit by Alison; yes he had) proposed future topics are making use of your ISA allowances, pensions, life assurance rates, income protection, ‘Auto Enrolment’, Contango and Normal Backwardation.

Disclaimer: ‘Neston & Beyond’ and similar articles written by me are my personal views and the sole aim is to where possible inform, sometimes amuse, occasionally entertain and hopefully, if all else fails, at least be interesting. In no way can any of what you read here be taken as advice of any form, be it parental, lyrical, electrical, prognosticative, desirable, ichthyological, astronomical, factual, governmental, statistical, financial, legal, marital, occupational, political, philatelogical, sociological, incidental, accidental, fiscal, zoological physical, biological, medical, dental, accidental, haberdasherial, cosmological, or tangential.

Neston & Beyond – Get Time On Your Side Part 2 – Reality

Last time, we took a look at the financial ‘Catch 22’ that is the norm for many these days, particularly younger folk. This was if you saved from income for retirement, then you might not be able to afford to buy or rent a home. However, if you bought a house or rented, you couldn’t save enough to retire with. The main point I was trying to make is to get time on your side. If you start saving sooner, perhaps before buying or renting a home, then it will stand you in good stead later in life. The item was all a bit theoretical, and that was the intention, and you may recall I offered a possible solution for perhaps parents or grandparents to save for children or grandchildren. This week however, is the real thing.

The circumstances that gave rise to this plan may at first glance seem unique, but try and spot the principles at play, and it could be applied to a great many families I’m sure; just needs those involved to think about the longer term.

The names are fictional but the sums, procedures and timescales are accurate.

Uncle Albert had lived a modest life, and he and his wife lived within their means, which was the wages of a worker in a not overly prosperous part of the country. Although income was not high, Albert paid his rent and saved up what he could. For fun, he started buying shares. Very small amounts, a couple of pounds worth at a time to start with; he enjoyed the ‘sport’ of shares.

In the same way many follow football or cricket, and spend money to see their team play, Albert spent his spare money, as little as it was, on shares, and reading the financial papers about the ‘teams’ he was following. It was his hobby; his sport. When much older, he stopped buying, but held on to what he had.

Albert didn’t have children, but was close to his niece and her daughter and grandchildren. Following the loss of his wife, Albert willed his estate to his niece, and he passed away in 2002. After the usual estate costs, the value of his savings was around £130,000, and apart from a small legacy to another relative, this was left to his niece, Sylvia.

Sylvia and her husband were retired, owned their own home outright, had secure pension income and savings, although by no means wealthy. They felt they didn’t need this money, and enquired if some arrangement could be made to use the money to improve the lot of their daughter and grandchildren, but not allowing it to be spent too quickly. The three grandchildren were in their twenties at the time. This is the point at which I met the family.

There is much detail I will not bore you with but the upshot was the following plan was put in place. Sylvia instructed a deed of variation to Albert’s will. In effect, Sylvia renounced her entitlement under the original will, and instead arranged some immediate cash legacies to her daughter and her grandchildren, but also established a discretionary trust. After the legacies and costs, the sum of £82,000 remained. This sum was held by the trust and invested for modest growth in such a way as to require no annual tax returns. Each year, in memory of Uncle Albert, capital was appointed from the trust to each of the three grandchildren to fund a pension contribution. The differing ages and employments of the three meant use was made of ‘Stakeholder’ pension rules. This meant a gross pension contribution of £3,600 was paid to each of the three pension funds. Whilst held by the trust, the funds enjoyed good growth, and the payments to pension funds meant tax relief was obtained, and further growth was hoped for.

We can now fast forward to 2014. The last remaining funds in the trust have been distributed, the trust closed, and a final contribution made to each of the three pensions, with a small amount of cash left over to have a family meal out.

Following the final payment, the sum value of the three pension funds was £187,046. The grandchildren are in their thirties, all paying their own way, but now have around £62k each invested in a pension fund, and they cannot access this until they are at least age 55. Hopefully, the value will grow over time, and if death should befall one of them before accessing the funds, then it exists as a valuable form of life assurance for their own partners and children. If we had growth of 5%, over 25 years, each of the three funds would go on to be worth around £220,000. Allowing for inflation, in today’s terms this is around £133,000, a healthy sum towards a secure retirement, or indeed to pass on again to their children, and their children’s children…

I’m not suggesting blowing the family allowance on shares, but just give thought to the benefit of saving, however you do it, but for the long term.

It just takes time, (and the avoidance of football).

Bye for now,

John

Sunset Money Mouse

Disclaimer: ‘Neston & Beyond’ and similar articles written by me are my personal views and the sole aim is to where possible inform, sometimes amuse, occasionally entertain and hopefully, if all else fails, at least be interesting. In no way can any of what you read here be taken as advice of any form, be it parental, lyrical, electrical, prognosticative, desirable, ichthyological, astronomical, factual, governmental, statistical, financial, legal, marital, occupational, political, philatelogical, sociological, incidental, accidental, fiscal, zoological physical, biological, medical, dental, accidental, haberdasherial, cosmological, or tangential.

Neston & Beyond – Get Time On Your Side: Part 1 – Theory

A two parter for you, with a completely gripless cliff hanger in between.

Save a pound a day for million days and you’ll be a millionaire. Scratch that, owing to the wonders of compound inflation (“eighth wonder of the world”) it would actually take around 43,000 days, or 117 years.

Daniel Kahneman is a psychologist who paradoxically it may seem, won the 2002 Nobel prize for economics because of his study, amongst other things, behavioural economics. In a recent BBC documentary, he cited the example of New York taxi drivers. He had learned that the ‘typical’ driver knows how much he has to earn each day to make living, pay his expenses and so on. What Dr. Kahneman further observed is that when the weather was good, there was less demand for taxis, so the poor drivers had to do longer shifts to get their daily income. During the bad weather of course, when cold and wet as it often is in New York, taxis are in great demand, and so the daily threshold might be reached in half a day, at which point the driver goes home. At a glance, all seems reasonable, but Dr. Kahneman pondered why not do the longer shifts when the weather was bad, earn above the threshold, and spend the nice days relaxing in the park?

There is much of what follows that can be debated and subject to numerous variable and changing circumstances, but I am using a simplified set of examples just to examine what some might seem as illogical financial behaviour displayed by more than half the population.

In the UK, home ownership, as opposed to renting is higher than in many other European countries, and for most the process is much the same. Spend hours searching, find the place we can afford and if lucky like as well, then pay out a range of fees to set up the deal. Survey, mortgage arrangement fee, legal work, repairs removals, and so on. All in all an involving and expensive thing to set up, and not without significant risks. However, this is just the beginning. Homes bought by those in work using a mortgage, have the joy of monthly repayments to look forward to. Here are some numbers:

You borrow £150,000, and agree to pay it back over 25 years on a repayment basis. Let us say the interest rate on average is 5%, then the monthly repayments are around £877 and you will do almost anything to ensure those payments are maintained, understandably because you want to keep your house and enjoy a good credit rating. Assuming nothing else changes, the total amount repayable excluding the set up fees is around £263,000. This £263,000 is the money you have earned, so seeing as you pay income tax and national insurance, the true cost could be described as £375,000 of earnings for a basic rate taxpayer. Of course, we haven’t considered the costs of maintenance and insurance etc.

At the end of the 25 years, in the words of Al Pacino, as voiced by Rob Bryden, Whaddyagot?” A house, a place to live, hopefully a secure asset, that still needs insuring, maintaining etc. It may have increased in value, quite a lot as it happens if this had been over the last 25 years, and once paid off, a lower cost of living.

Let us play with another idea. You pay someone a fee to help you set up, or you can DIY set up, and pay into a savings plan of some sort; bank account, unit trust, whatever, the point is you regularly save, and somehow, that same motivation to maintain the payments no matter what is in place. So, you pay £877 per month into a fund of some description, and on average, you get 4% return. You’ve still paid in around £263,000, or £375,000 of your earnings, but “Whaddyagot?” Around £452,000. Had you paid into a pension plan, then you would have had around £565,000. In today’s terms, allowing for inflation, this is still over £330,000.

 

mouse house

So the obvious problem is if you only buy the house, you may have something to live in, but nothing to live on, unless you sell the house…

If you save, you have something to live on, but nothing to live in, plus you will have had some sort of housing costs for those 25 years. Is it then a fair conclusion that the correct solution is you do both? Well that would be nice but by and large unaffordable for most, particularly with the artificial house price inflation that governments and banks love so much.

Much is written of parents or grandparents helping young adult children with house deposits and, then the young adults hopefully can meet the repayments but often little else, certainly in the early years. Here’s a thought. Imagine an accepted practice would be for parents and/or grandparents to save a regular sum into two funds from the day a child was born until their age 25. Just for comparison, let us use the same monthly figure of £877. Pay one third into a fund accessible at age 25, and two thirds into a pension plan, tied up until their age 55. We invoke Mr. Pacino once more:

At age 25, the accessible fund is £150,000, or £90,000 if allowing for inflation.

The pension fund is £376,000 . Nothing else is paid into this, it is just left invested, and at the ‘childs’ age 55, the fund is £1.25 million, or £750,000 if allowing for inflation. Therefore, funds available for house deposit, no need to save into pension, the pension funds would be payable like a life assurance if the child died before retiring so life insurance premiums saved, and financially secure in retirement, ready to pay into their grandchildren funds.

Although not necessarily realistic, the benefits of using time to your advantage are clear. Save sooner, pay debt off quicker, and financially at least, life could be better. Next time, a real life example of a version of this that has been happily running for the last 13 years.

Bye for now.

John.

Disclaimer: ‘Neston & Beyond’ and similar articles written by me are my personal views and the sole aim is to where possible inform, sometimes amuse, occasionally entertain and hopefully, if all else fails, at least be interesting. In no way can any of what you read here be taken as advice of any form, be it parental, lyrical, electrical, prognosticative, desirable, ichthyological, astronomical, factual, governmental, statistical, financial, legal, marital, occupational, political, philatelogical, sociological, incidental, accidental, fiscal, zoological physical, biological, medical, dental, accidental, haberdasherial, cosmological, or tangential.