UK Discount Brokers

The last task in the exercise to remodel the portfolio of a UK relative, described in yesterday's post, was to find an easy way and low cost way to purchase and administer the required new holdings of Exchange Traded Funds and OEICs. The list of factors I considered:

• account administration fees
• interest rate on cash balances as a minor factor due to the intended buy and hold strategy
  
• trading cost as a secondary factor since the intent is to buy and hold over the long term, and making purchases only to re-balance the portfolio once a year
• online trading and account access in a self-managed (no advice) relationship with the broker
  
• ability to hold ISAs, PEPs and regular with one company to simplify statements and facilitate transfers amongst accounts (since the move of investment funds into the tax-exempt ISA will take several years due to the annual £4000 contribution limit)
• account closure and transfer fees in case a change might be needed
• customer service - tested by phoning and asking for details; here there was a pronounced difference between the best and the worst (HSBC); another factor was the ease of finding info on their websites
  

In doing my investigation, all of it initiated through the Internet, one useful source for the traditional brokerage firms was the website of The Association of Private Client Investment Managers and Stockbrokers, which has a search / selection tool to narrow the list to brokers. However, it doesn't cover all possibilities - I discovered the Motley Fool and Etrade UK. Who knows there may be others.

The result came out in favour of Selftrade by a hair over E*trade and Motley Fool, which actually have lower trading fees of £8.95 and £10 per trade, respectively, vs Selftrade's £12.50. However, Selftrade has a single annual £25 account admin fee for any number of ISAs and PEPs, the lowest going and lower transfer out fees. Motley Fool pays nothing on cash balances and has higher transfer out fees while the killer for E*trade was poor customer service - being disconnected on one call, ring-no answer on another call and a long wait to finally get through on the third call. Selftrade phone answering was prompt, the phone triage menu tree short and the person who answered was knowledgable and patient. The big banks and brokerages like Barclays, Lloyds TSB and HSBC all were a bit more expensive on both trading and account admin fees.

If anyone has any experience, insights or other sources of info, your comments would be most welcome.

Remodeling a UK Equities Portfolio

For the past week, I've been pre-occupied in reviewing a UK relative's investments and it is a familiar story. This person is not at all interested in managing investments day to day but does want to save money in the long term. The result has been a hodge-podge of assets that are inefficient and poorly diversified despite owning a number of different funds. The chart on the left, taken from Trustnet, shows the various holdings. Despite the variety of names, all are essentially composed of UK equities and when one delves into the funds, one discovers the same major companies such as BP, HSBC, Royal Dutch Shell, and Barclays. The funds display the familiar under-performance relative to the index, the FTSE in this case, as four out of eight failed to beat the FTSE All Share gain of 44.3% over the past five years. For comparison, I added into the chart an index tracking fund - the M&G Index Tracker A Accumulation. As is typical of index funds, the M&G tracker also under-performs the index, gaining only 40.6% over the five years.

One thing that has surprised and disappointed me is the small number of Exchange Traded Funds available in the UK. iShares offers only a FTSE 100 (the 100 largest companies) and a FTSE 250 (the next largest companies after the 100) ETF but no FTSE All Shares tracker at all. Perhaps that is because the iShares ETFs are registered in Ireland and so do not qualify for dividends tax exemption when held within the tax-free ISA (similar to RRSP in Canada). That gap led me to search among the regular funds (called OEICs in the UK) for index trackers such as M&G's. Their management fees and expenses are thankfully not too high, as one would hope: M&G's comes in at 0.3% annually. It is interesting to note the uniform 1.5% management fee applied by all the other OEIC funds, no doubt as the result of adhering to the FSA's Stakeholder program whose aim is to ensure fair conditions for fund investors. In addition, the above returns do not account for the initial charge or front end load on the OEICs that vary from 4% to as much as 6.25%. To put it another way, making up the initial lower amount invested takes about five years at 1% return more per year. Can the winning funds continue to out-do the market or is it likely they will revert to the mean? All this is to say that I've suggested getting out of OEIC into market tracking funds.

The other major change is to suggest to my relative to take advantage of the ISA program under which one can contribute up to £7000 annually in a non-taxable account. Why was that tax advantage not used? It's just not knowing about it in this case.

There is a huge number of funds available in the UK and it is a big chore sorting through and comparing them. I found a number of useful sources like the website of the UK regulator, the Financial Services Authority, which has comparative tables for all types of investments and shows all the charges (why can we not have something similar from our Canadian regulators?). There is also the Trustnet website, for performance tables and charts that allows one to enter and track a portfolio with updated values.

The lack of diversification beyond the UK also needs to be corrected. Therefore, IUSA (iShares S&P500), IAPD (iShares Asia Pacific Dividend Plus), IEEM (iShares Emerging Markets) will be substituted for the UK holdings where these can be put either into ISAs or PEPs (another UK tax-free plan - it was the pre-cursor to the ISA and can still be held as a "grandfather" type of account). For regular taxable holdings, about a third of the total equities will still be in the UK but as the M&G FTSE All Shares Index Tracker. The last chunk will go into M&G European Index Tracker, a broad based OEIC fund with 0.5% annual fees and no initial charges.

It has been instructive to see how a typical passive investor can evolve a portfolio by accident that can be improved with such simple measures as better diversification, lower fee funds and use of tax-free accounts.

The next stage was to find a place to buy and hold these new assets, a big job in itself and worthy of a future post.

Lessons from an Expert on Annuities

Moshe Milevsky is one of leading experts, if not the leading expert, on retirement finances and annuities. A professor in Finance at York University, he has written a number of consumer advice books and many research articles. He also heads the non-profit, public-service Individual Finance and Insurance Decisions Centre.

I have just finished reading his paper on variable payout annuities, charmingly titled How to Avoid Completely Outliving Your Money, and would highly recommend this very readable paper to all those who like me are preparing to transition from the financial accumulation phase to the consumption phase, aka retirement.

Some of the bullet points of note in this paper:

• the value of annuities stems from the dispersal of the financial assets of the deceased amongst the survivors (but don't worry, or make nasty plans to bump off other annuitants, your benefits don't go up or down if people die sooner than expected ;-)
  
• the longer you wait to buy an annuity, the more you will get per month
• people who purchase annuities live longer than the population average; no, buying an annuity doesn't cause you to live longer, it's just those who do purchase them are healthier and wealthier than average and these people do have a tendency to live longer (PS insurance companies know this and price it in)
  
• fixed payout annuities are very vulnerable to inflation, just like bonds; even at 2% annual inflation, there would be a 1/3 loss in purchasing power after 20 years; at 4% inflation it's down by more than half; the following words, written in 2002, are still true today "in today’s close-to-zero inflation environment, surprises can only be in one direction"; of course, insurance companies do offer fully or partially inflation-indexed annuities.
• annuity quotes vary considerably among financial institutions so it is important to shop around
  
• the greater your estate creation of bequest motives, the lesser should be your interest in annuities
  
• with variable payout annuities the optimal age to annuitize is much earlier - about ten years; Milevsky shows one scenario in which the optimum age to buy an annuity for a single woman is 80 years old for a fixed annuity but 70 years old for a variable annuity; for a single man the same fixed vs variable annuity optimum is 70 years old vs 60. Milevsky points out these ages would change for different individuals
  
• variable payout annuities enable one to construct an underlying portfolio of stocks and bonds that funds part of the annuity payment; this better matches financial theory that states one should be diversified between these asset classes and not just dependent on fixed rate / bond-type investments as is the case for a fixed annuity.
• variable payout annuities also allow one to shift the payout proportion to either earlier or later years in retirement e.g. this can suit those who anticipate they will be more active and want to spend more early in their retirement and to tail off later on ... in fact, don't the round-the-world tours tend to diminish once people hit their 80s?
• the greater the emphasis on consumption versus bequest motives, the greater the role of payout annuities in the optimal retirement portfolio

The IFID website has many other research and popular press articles on annuities. More to relish reading!

The More You Learn, the Less You Know

One of the pleasures of handling one's own investments and finances is the continual learning and the intellectual challenges that come from really understanding how various products work and especially the background theory, since that is what enables going beyond rote advice or partial, non-integrated solutions. However, it is a big challenge that just seems to grow as I learn more! Long ago, I learned the differences between common and preferred shares, bonds and treasury bills, ETFs and mutual funds. Many years ago, I did an MBA in Finance at the best (at the time, is it still? can you guess which one?) school for finance in Canada, and learned how to derive the CAPM and the Black-Scholes option pricing formula. Later I successfully passed the Canadian Securities Institute course. Yet as I write this blog, it seems the new stuff I need to know, both theoretical and practical, is growing without limit! On top of that, to actually manage my financial affairs, taking in the huge volume of news and data spewing forth each second could occupy every waking hour.

And yet, decisions must be taken and investments made. Tempus fugit. In the words of Scotland's bard Rabbie Burns (not Robbie!! though Robert is acceptable, as I have been reminded numerous times by Scots), "Nae man can tether time or tide". I suspect that's why so many people who have less interest and time to spend on this stuff can get taken in by idiots and crooks. Or, they succumb to the bane of too many DIY investors, shortcut the investigation process, going with their instinct or changing their approach every other day, depending on what they read last. Oh well, isn't the beginning of enlightenment the recognition of one's own ignorance?

Canada's High-Taxes vs the UK

When I decided to come over to Scotland, I investigated the tax consequences, expecting to find myself paying more tax over here in the UK. I was surprised to find the opposite, in fact, quite the opposite. For my fellow Canadians out there, here's the shocking news - the excess rate of taxation is considerable and across the board in all types of income and investment taxes.

Refer to the chart for all the numbers. I've used Ontario as my benchmark province.
The UK advantages start with the personal exemption of about $11,500 vs only $8839 in Canada. Take your marginal tax rate and compute the savings on the difference.

On income and interest, treated as the same in Canada but taxed at a slightly lower rate on interest in the UK, the Canadian rate is higher in every single tax bracket and the difference is the worst for middle income earners. For example, in the blue highlighted line for taxable income in the $60k range the Canadian marginal rate is 33% vs 22% in the UK. Ka-ching, another difference that could reach into the four figures.

On dividends, the UK has a zero effective rate due to an offsetting dividend tax credit until a person has more than about $76,000 taxable income.

On capital gains, the rate is actually higher in the UK throughout the tax brackets but everyone is given an annual exemption of about $20,150 in net gains. That should suffice to ensure a tax-free existence for most investors of modest means.

Not shown in the chart are the comparable retirement savings vehicles, the RRSP in Canada and the Individual Savings Account (ISA) in the UK. An ISA offers the same tax-free accumulation/compounding as the RRSP. An ISA does not allow a tax deduction as does the RRSP. Instead, any withdrawals are tax-free as opposed to the RRSP where withdrawals are taxed at the rate for marginal income. The RRSP advantage of saving taxes by withdrawing after retirement when one's tax rate would be less is not there for the ISA ... but the UK tax rates are lower in the first place and more uniform up to high levels. In addition, the ISA doesn't create artificial incentives to keep interest bearing securities inside the RRSP and dividend or growth investments outside. For anyone who has struggled with portfolio balancing across both RRSP /LIRAs and regular accounts while minimizing taxes, this ISA feature would be a big boon. Perhaps the biggest plus of the ISA is that the £7,000 annual allocation that is not reduced by contributions to a regular pension plan and thus allows a much high tax-free savings rate if desired.


Though such differences are and were not the motivation for my move to the UK, nor would I advocate moving to another country just to save taxes, it does lead one to ask those people who make our taxes why they are so high.

Key Decisions that Affect Future Wealth

While we often focus on the stock market and our investment decisions as those that will most affect our future wealth, as I look back and around me, it seems that two other decisions we make during our lives have far more influence. I note in advance, to avoid getting into trouble at home, that neither of these decisions should be made exclusively or even primarily as financial decisions. It is true however that they both inevitably have a very large lifelong financial impact. My comments are descriptive, not prescriptive!!!

1. Career Choice - over a lifetime, the difference in income between a Zeller's cashier and a dentist adds up to quite a lot. Without going into the details of which career pays best, suffice it to look at the simple arithmetic of a lifetime of earnings, which has conveniently been made into a neat table by the Fiscal Agents website. Of course, choosing a career simply for the pay is likely to lead to stress, burnout and eventual abandonment. On the other hand, you get the opposite when your make a good choice - fun and fulfillment, which I would maintain is a non-financial form of wealth.
2. Spouse - pick the wrong person and you can have years, maybe a lifetime of misery, financial and otherwise. Think of divorce, its causes and its consequences. Pick the right person and it's the opposite - a lifetime of emotional happiness, of course, but this spills over into financial success. Not that the spouse brings a pile of money into the marriage but the support from a trusted advisor to not waste, to spend wisely, to invest wisely whatever money is earned makes a huge difference. Investing one's time, effort, love and attention in a marriage brings a very high rate of return. And a stock holding is just a number on a printed sheet, not very huggable. ;-)

In my case, the spouse element has been predominant in whatever financial success I have achieved. Would be interested to hear anyone else's views.

Taxes on Interest vs Dividends vs Capital Gains

A friend asked about how dividend taxation works and the difference in tax rates between the different types of investment revenue - interest vs dividends vs capital gains. He tried unsuccessfully to figure out the answer browsing through the Canada Revenue Agency's comprehensive but daunting website. Since he, being a smart guy, did not succeed, I figure this is worth a post for someone else's benefit.

I must acknowledge the excellent free Taxtips website, already linked under the Resources sidebar of this blog, for providing the calculators and information that produced the following results, though of course, if I've made any errors of interpretation that's not their fault.

The tax calculation of Canadian dividends goes through a grossing up process of the actual dividends we receive by cheque. Currently, this means adding 45% on top of the actual dividend, and the new higher amount is included in our taxable income. Yikes, you may say, that will raise my taxes! But through a clever tax credit calculation on the amount, the CRA gives it back and we all end up better off. Better even than interest or capital gains. (I'm referring to the most common type of dividends, those paid by companies listed on stock exchanges such as the TSX. See this Taxtips page for the nitty gritty of what is in this category termed "eligible" dividends.)

Use the Taxtips calculator to do your own numbers for your own province. I used Ontario for me and my friend. For almost every tax bracket, dividends have the lowest marginal tax rate, better even than capital gains, which may surprise some. The dividends tax advantage against capital gains diminishes progressively as you go up in tax bracket, being about 1% in the $72k-118k brackets for 2006. In the very top bracket, over $118k, the tax rate is higher on dividends. However, both dividends and capital gains have a significantly lesser tax rate - half or less - than interest or ordinary income (like salary) at all taxable income levels. (See this Taxtips chart, which shows both 2006 and 2007 brackets and marginal rates for Ontario.) That's why we are constantly told to put our bonds, GICs, CSBs and the like into our tax-sheltered RRSP.

Hmm, those banks stocks and utilities look better and better.