Following last week’s UK budget, guest blogger David Crozier reflects on the government’s assault on pension savers and on the return of tax arbitrage.
So that’s it, then; the beginning of the end, the thin end of the wedge, the death knell for pensions in the UK. What? Did you just think it was a few high earners that will be affected by Dunce Darling’s removal of higher rate relief? Think again – some serious commentators believe this is the final straw for final salary pensions in the UK.
As far as personal pensions and their self-invested siblings are concerned, I’ve applied a general rule for a long time: if one is not benefiting from an employer contribution, nor enjoying tax relief at 40%, there is little point in making pension contributions.
If one is going to restrict oneself in the way that pensions do, giving up income today in return for income at some indeterminate future date, there must be an incentive to do so. The changes in the budget are a positive disincentive for high earners: most of them will continue to be high earners in retirement; why would they make pension contributions at 20% to generate pension income which will be taxed at 40% or 50%?
Given that alarm bells were raised in the weeks leading up to the budget, I suppose the changes came as no great surprise; possibly we were even relieved that higher rate tax relief wasn’t removed entirely. But then that has been New Labour’s genius – to remove our wallets, while we thank them for giving us back a fiver.
What, you ask, has all this got to do with index funds & ETFs? Nothing – and everything!
What will our high earners do, now that they are not saving in pensions? Save in a bank account? Not likely, with interest rates at (literally) an all-time low, and with a strong dose of inflation on its way in the not-too-distant future, once the effects of fiscal easing and prolonged low interest rates eventually work their way through the system.
What high earners will do, if they have any sense, is swap income-producing assets – bonds, gilts, cash, property, high-yielding equity funds – for capital growth. And divert funds previously destined for pension contributions into capital-growth assets. Cue ETFs and index funds. In my book, it doesn’t matter where the return comes from; income or capital, it’s all the same when it hits the pocket. But what you would rather pay – 40% or 50% on income, or 18% on capital growth? No contest, really.
And with ETFs and index funds it’s fairly easy to pick a basket of widely-diversified asset classes, targeted as broadly or as narrowly as you wish, and keep the yield really low.
Note the phrase “widely-diversified”; one must never allow the tax tail to wag the investment dog. Investors will probably have to accept some level of income yield (and therefore income tax) in order to be properly diversified. It is most definitely not a case of seeking out the lowest-yielding funds, regardless of underlying asset class. Rather, choose the correct basket of asset classes and then be clever about how each is populated.
As an aside, don’t fall into the trap of assuming that holding the accumulation units of a fund is the same as having a fund with no yield. The yield is still there, and you will be taxed on it, even though the income is used to increase the fund price, rather than being paid out.
Of course, all this is possible with actively-managed funds too, but I feel that one is in much more control using asset-class funds and ETFs, than if one derogates the responsibility to a fund manager. Not to mention the evidence that the substantial extra cost incurred is not reliably repaid in higher risk-adjusted return. One pays one’s money and takes ones choices and chances.
The moral of this rather grumpy piece has to be – if you can’t escape from the higher rate tax net by retiring or leaving the country, then do what you can to exchange income for capital growth. Tax arbitrage is alive and well and living in Mr Darling’s United Kingdom.
David Crozier CFP is a director of Navigator Financial Planning, which is founder-member of the Evidence-Based Investment Group