06 May Journalist heroesRead Time: 6 minutes
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In any field of human endeavour there are good, mediocre and bad practitioners and I’m sure journalism is no different. Even medicine, which consistently tops the table in terms of public trust, has had a few dodgy representatives over the years. Certainly financial services has had its share of them, as the recent death of Bernie Madoff reminds us.
Yet as in all professions, there are some who stand out from the crowd. Several of those have influenced my own modest career, so I feel that they deserve credit for contributing to improving various aspects of the market that we experience today.
In the 1980s, when I started working in the sector, UK financial services was a very different environment to how it is now. Indeed, it probably wasn’t very different to the ‘wild west’ that still exists in certain parts of the world such as the middle east. The Financial Services Act came into effect in 1988 and was pretty well the first major regulation affecting the field of financial advice. Indeed, even once it was in force, there wasn’t a huge amount of effective regulation of the behaviour of those who worked in it, at least from where I was observing. In those days, going to see many advisers meant being recommended to purchase an insurance-based savings plan known optimistically as a ‘maximum investment plan’ or MIP.
This was a regular savings vehicle into which you agreed to pay contributions for at least 10 years (some ran for as long as 25 or even longer). The insurer then invested the contributions into one or more funds, generally linked to the stockmarket. After the earlier of seven and a half years or three quarters of the original term, it was possible to stop paying into it and withdraw the money, either as a lump sum or gradually over time. The investor did not pay any tax on the withdrawn amount and on policies started before March 1984, contributions had also attracted a limited rate of tax relief. When income tax had been at 60% and more in the 1970s, this was an attractive proposition but by 1988 the basic rate had fallen to 25%, which somewhat reduced the impact of the tax benefits. Capital gains tax (CGT) had remained at 30% until April 1988, when it was aligned with income tax rates.
Of course, a substantial reason behind the ‘popularity’ of these plans was that they paid a pretty decent commission to the firm arranging them. The longer the contract term, the larger the proportion of the first year’s contributions was paid out to the adviser. Inevitably therefore, less of it was available for the investor’s benefit. The adviser and the investor were not the only beneficiaries though. The insurer also collected an attractive stream of charges throughout the term, which only the mathematically minded could discern from the small print in the policy wording. Finally, the Inland Revenue (as it was then) also collected tax on the funds as they grew, at a rate up to that of corporation tax (although usually lower).
An alternative to MIPs for someone interested in investing regular amounts was the unit trust or investment trust savings plan (UTSP or ITSP). These were offered by investment groups and allowed typically £25 or more to be invested monthly into a fund. The charges, while still higher than those that we see for such funds today, were considerably lower than those of a MIP and since they were not part of the Byzantine cost structure employed by insurers, investors could stop and start at will and without any adverse impact on their investment.
Then in late 1988, I came across an article in one of the Saturday newspapers, I think ‘The Independent’, which looked into the returns available from the two similar vehicles. It was assisted by the fact that at the time, there were many more insurers than there are now, so there were many more of these contracts available to study. Furthermore, many of those insurers also owned subsidiary unit trust companies which handled the investment management for them. This presented the journalist, whose name regrettably escapes me, with a great opportunity to compare like with like as it was possible to invest in some funds via either the MIP or UTSP route.
The article looked at two hypothetical groups of investors. One group had invested £50pm over 10 years in around a dozen MIPs offered by companies which also had the same fund (a UK equity one, as I recall) available via a UTSP. The other had invested the same amount over the same period directly into the same underlying funds via the UTSP. Over the full 10 years, both would therefore have invested £600 each year, so £6,000 in total. The results were illuminating.
The MIPs, on average, turned the £6,000 into around £12,000 over the 10 years. Because the minimum term had been passed,the proceeds were tax-free, which would seem to be a respectable annualised return of around 12%.
The UTSPs meanwhile, investing in the same underlying funds, returned around £18,000 each for the same input. Admittedly, these proceeds were not tax-free as disposals of units in a unit trust attracted capital gains tax in the year of the disposal. From that year, CGT had been aligned with income tax so would be either 25% for basic rate taxpayers or 40% for higher rate taxpayers. Our UTSP investor could therefore look forward to paying up to 40% tax on his gain of £12,000, namely £4,800.
Figures are approximate and intended for illustrative purposes only
However, even today the proportion of taxpayers who pay CGT is tiny, at around 1%. Most of those do so because they realise a large gain (from selling a business or a property, for example) rather than a few units in an investment fund. Most investors in funds realise gains within their annual exemptions and up to that figure, no tax is due. In 1988/89, the annual exemption for an individual was £5,000, so only £7,000 of the gain would have been taxable, so the maximum tax for most investors would have been only £2,800. For a basic rate taxpayer, this falls to £1,750. None of this assumes any even basic tax planning, such as gifting to a spouse who paid a lower tax rate or staggering the disposal across two or more tax years.
Even in the worst case, the UTSP investor therefore ended up with net proceeds of around £13,200, compared to the £12,000 of the MIP investor in exactly the same fund, equivalent to an annualised return of around 14%. In the best case, which would have applied to a substantial proportion of investors in this scenario, this rose to around 19%. The UTSP investor also had the option to reduce, increase or stop contributions without penalty and to add or withdraw lump sums at any time.
Clearly the major part of the return will have come from the performance of the underlying assets in the fund and in 1988, it will have been the beneficiary of the 1980s bull market, so such returns are not necessarily representative. The big lesson from the article for me though was that the various hidden (in most cases, extremely well hidden) costs of insurance-based savings plans had a huge impact on the investor’s final return. It encouraged in me a desire to poke around in the product terms to determine just what was being extracted, to consider the insidious impact of annual taxation drag and to avoid products where the reward to the investor was often subordinated to that of others.
Costs are (generally) not the principal determinant of the outcome for investors but while investment returns vary from month to month and year to year, costs are a constant and they continue regardless of how well the fund’s underlying assets are performing. They make the assets work harder to achieve a given return and that can impact on the investment’s ability to deliver the return expected from it, as we saw with many endowment policies (which were similar to MIPs in terms of structure) in the 1990s when investors faced shortfalls in paying off their mortgages. Every pound that goes out in costs or taxes is one that the investor cannot spend as they choose.
I’m not privileged to know for certain what is responsible for the fact that recommendations to buy insurance-based savings plans have declined rapidly in the last couple of decades and there are probably several reasons. Better qualified advisers, more regulation, the abolition of most commissions and reductions in the rates of tax are all probably contributory factors. But I hope that the article I read in 1988, which certainly had such an impact on me that I can recall the key numbers from it more than 30 years later, was also a contributor. To whoever wrote it, as my ex-Royal Marine colleagues of the time would say, “Good effort”.