Investment Recommendations. Evaluation of Financial Situation, Ambitions and Products

Table of Content

1. Introduction

2. Current Financial situation
2.1. Annual income
2.2. Fixed annual expenditures
2.3. Assets
2.4. Liabilities

3. Future financial needs

4. Financial products available to Phoebe
4.1. Shares
4.2. Bonds
4.3. Investment Trusts and Unit Trusts
4.4. Index Funds
4.5. Tax efficient products

5. Proportion and amount of investments
5.1. Tracker funds
5.2. Bonds
5.3. Shares
5.4. Investment Trusts and Unit Trusts

6. Tax aspects

7. Use of information technology

8. Conclusion

9. References

10. Appendix

1. Introduction

The following report should provide Phoebe with an overview of her current financial situation by including net income, taxes, expenditures, assets, pensions and liabilities. Furthermore, financial products, appropriate to her current financial ambition, will be evaluated and recommendations about the sum to invest will be given.

2. Current Financial situation

2.1. Annual income

In order to estimate Phoebe’s annual net income, her total gross income for the tax year 2015/2016 is calculated and illustrated below. Besides the earning from her employment, dividend payments (Exhibit 1) and interest earned (Exhibit 2) needs to be taken into consideration (Gov.uk, 2016). Furthermore, personal allowances and pension contributions are tax deductible and can therefore be subtracted from her gross income (drawn form: Gov.uk, 2016a; Gov.uk, 2016b).

As her taxable income is within the basic taxpayer bracket, a 20% tax rate applies, but she receives the full amount of dividends (drawn from: Gov.uk, 2016a; Gov.uk, 2016c). Furthermore, 20% of the interest she earned is taxed (Exhibit 2) (Gov.uk, 2016d). Besides, she needs to pay council tax (The City of Edinburgh Council, 2016), National Insurance (Gov.uk, 2016e) and company pension contribution.

Figure 1: Annual net income for the tax year 2015/2016

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2.3. Assets

According to the assessments of the Lloyds Bank Group (2016) and Nationwide (2016) the estimated value of her property is approximately £270,451(Exhibit 4). Furthermore, she owns 5000 shares of Standard Life, which have a value of £17,460 (4th May 2016) (Exhibit 5) (Yahoo Finance, 2016). Besides her balance of £10,500 on her two bank accounts, she inherited £300,000, which amounts to a net value of 212,500 after deducting inheritance tax (Exhibit 6).

Figure 3: Overview of Phoebe’s assets

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Furthermore, Phoebe is entitled to receive state pensions at her retirement age of 68. As the increase in pension entitlement is subjected to several economical factors, estimations about her future state pensions are imprecise (Gov.uk, 2016f). The current regulations ensure a yearly minimum increase of 2.5%, which leads to a minimum pension of £19,261.03 in the year 2051 (Exhibit 7). Assuming she works at her current employer until an age of 60, she is entitled to receive an annual pension of £21.275 from her company’s pension fund and a one-off tax-free lump sum, which amounts to £63.825 (Exhibit 7).

2.4. Liabilities

The outstanding amount of the mortgage is 95,000, however the outstanding principal amounts to £80,641 and the outstanding interest to pay amounts to £14,359 (Exhibit 8). As in 2006 the official interest rate of the Bank of England was 4.75% (effective date: 3th of August, 2006) (Bank of England, 2016), Phoebe’s mortgage interest rate of 2.84% is advantageous, as she borrowed at a lower rate than she could invest in (Exhibit 9).

3. Future financial needs

Due to the currently low official bank interest rate of 0.5%, it is recommendable that Phoebe pays off the whole outstanding mortgage. As taking on a new loan to leverage new investments does not seem to be consistent with her risk adversity, this will not be discussed in more detail. It is assumed that she pays off the outstanding principal, which amounts to £80,614 (Exhibit 8).

As Phoebe is not too bothered about a wedding, it is assumed that she spends 50% of the average cost of a wedding in the UK, which leads to a price of £15,055 (Brides, 2015). Putting aside £15,055 Phoebe ensures that she can pay her wedding and also that she has an appropriate sum of money in the case of unforeseen expenditures. The remaining liquidity will be spread over products with lower risk (lower return) and higher risk (higher return). Earnings from her future investments should be added to her savings account and reinvested at some point in the future.

4. Financial products available to Phoebe

Phoebe’s current financial products (current account, saving account) have been evaluated as sufficient and necessary for her financial ambition and will not be discussed in more detail.

Figure 4 illustrates that the interest rates are at a historically low value and cannot compensate the inflation. Therefore, investments in the stock and bond market have become more interesting in comparison to placing funds in deposit accounts.

Figure 4: Development of UK interest rate and FTSE All Share index

Source: Stevenson, 2011

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4.1. Shares

By acquiring a share of a company investors become a co-owner. Share prices are determined by supply and demand and are commonly traded at the secondary market. When the company perform successfully, share price increases and investors share the success. In an optimal scenario Phoebe receives dividend payments and benefits from a gain by selling the shares at a higher price in the future. If the company performs badly, no dividends are paid out and the share price decreases. In a worse case, the company goes bankrupt and the whole investment is lost (Mike Patton, 2015).

Buying shares of small and recently formed companies tends to be riskier, as the performance is difficult to evaluate and the share price volatility is higher. However, such companies have a higher potential for large return than well-settled companies. Large companies often have a large market capitalisation and a steady but unspectacular return can be expected (Adrian Lowery, 2009). In addition to account management fees, provider of share dealing accounts commonly charge fees per trade (Money Supermarket, 2016).

4.2. Bonds

Bonds refer to debt investments, whereby the investor lends money to a company or government. Phoebe can expect a fixed amount of interest at regular periods, as well as a repayment of the principal investment on maturity, as long as the company does not go bankrupt. Consequently, bonds tend to be less risky than shares. The term to maturity varies from one to more than ten years. Bonds with a higher default risk commonly offer higher interest (Yahoo Finance, 2013).

As bonds are tradable before maturity, prices will change with regard to market demand and supply. When the prices increase during the lifetime, Phoebe could sell the bonds for a higher price and generate a gain. Convertible bonds may be of particular interest for Phoebe, as they offer an additional possibility to generate income by converting the bond into a predetermined number of ordinary shares in case the company’s share price increases.

Phoebe could either invest in bonds via funds or via direct investments. While funds have the advantage of a spread portfolio, it is notable that the whole investment is lost when the fund manager speculates badly. Commonly, investors need to pay annual fund management charges of approximately 0.75% (Which?, 2016).

4.3. Investment Trusts and Unit Trusts

The objective of Investment and Unit Trusts is to make lucrative investments into an entity or an asset by buying shares, bonds and other financial products on the secondary market. The advantage of such investments is a diversified portfolio, which spreads and therefore lowers the risk for the investor. Furthermore, investment funds offer the opportunity to invest in particular sectors, such as real estate, technology or healthcare, which are exposed to different risk factors. Shares of Investment Trusts are traded on the secondary market, and share prices depend on supply and demand; whereas Unit Trusts do not offer shares at the secondary market. Assets of Unit Trusts are valued based on the actual share prices of the portfolio and can therefore be considered less risky than Investment Trusts, because shares cannot be traded at a premium or discount of the actual value. Research however shows that Investment Trusts generate a higher return (Lambert, 2010). Investment Trusts only raise money at the IPO or Second Public Offering (SPO), while Unit Trusts continuously raise new money from investors. While Investment Trusts pay out dividends if they perform well, Unit Trusts returns are paid out through distributions. The annual management charges in both investment funds are between 0.5 and 1%, depending on the fund and the sector they are investing in (Drawn from: Lambert, 2016; Petroff, 2013). While Investment Trusts may charge a performance fee, Unit Trusts may charge a one-off initial payment. The website vanguard.com offers an online fee comparison of different investment fonts.

4.4. Index Funds

Index funds, also referred to as tracker funds, are a form of mutual fund, by which Phoebe attempts to replicate the performance of a given index of stocks. Index funds own all shares of the particular index and therefore no picking winners or losers exist. As they are commonly managed by computer systems, Index funds have significant lower fees than other funds (Lambert, 2016). Besides that, tracker funds are a relative simple financial product whereby no selection of single companies is necessary to have a diversified portfolio.

4.5. Tax efficient products

As the Stock and Share ISA is particularly interesting for higher taxpayers it will not be considered as a potential saving option at this point in time (Gov.uk, 2016g).

A Cash ISA is comparable to any other savings accounts but have the advantage that interest does not get taxed. Every individual is allowed to open one Cash ISA per tax year, whereby the limit is £15,240 (Tax year 2015-16) (Gov.uk, 2016h). Phoebe could invest in an instant access ISA or a fixed term ISA, whereby the interest rate can be variable or fixed. The UK Government announced that from the tax year 2016 onwards, basic taxpayers do not have to pay taxes on interest up to £1,000 on any saving account. As interest rates of ISA accounts may rise from that point, they should still be considered (Morris, 2015).

5. Proportion and amount of investments

By putting aside £10,500 from her bank accounts and £4,555 of the inheritance, Phoebe would be able to have instant access to a sufficient amount of money in case she celebrates her wedding or unforeseen expenditures arise. She should invest this money in an instant access Cash ISA in order to save taxes. After paying her mortgage off, she has a remaining sum of £127,303 for investments in different financial products (Exhibit 10). It is recommended to split this investment as illustrated in Figure 5.

Figure 5: Proportion of investments

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5.1. Tracker funds

It is recommendable that Phoebe invests 30% of her investment into tracker funds, as they appear to be a relatively uncomplicated financial product with lower volatility. Furthermore, Phoebe does not need to deal with the strategy nor the financial situation of single companies. One of the biggest advantages of tracker funds is that they have low fees, which leads to a high net return. Phoebe should consider diversifying her tracker fund portfolio and investing in several industries in order to spread the risk. As it is almost impossible to perfectly time investments, Phoebe should make use of pound-cost-averaging. By doing so, she would not invest all in one go, but spread the investment over time, which averages the costs of buying and investing (Morningstar, 2007).

5.2. Bonds

As bonds often have higher interest rates than bank accounts and a lower risk than most other investment products, Phoebe should invest 30% of the remaining sum into bonds. It is recommendable that she manages the bond investments by herself, and thereby reducing the risk of loosing the whole investment. Furthermore, Phoebe should diversify the portfolio, for instance, by investing in government bonds (lower risk) and company bonds (higher risk). Besides, Phoebe should consider the ratings of external rating agencies (Exhibit 11). Convertible bonds may be profitable, if the company is expected to perform well in the future. Effective bond prices correlate with unpredictable market interest rates; therefore, the timing of buying bonds is not schedulable.

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