Russell Bruce: What to do with the taxman’s largesse

In this second article I will set out some options on how you can manage a Self Invested Personal Pension (SIPP).

In the first article [How to get money out of HM Treasury] I argued that the main criterion for taking out a SIPP later in life was because the taxman added to your investment even if you no longer had qualifying income for a higher allowance.

Pensions, annuity income and investment income do not qualify, but everybody under the age of 75 still has an entitlement to invest up to £3600 a year whether they are tax payers or not.

This means finding £2800 from non productive savings or any windfall and the taxman adds £720 to take you up to the maximum for those with little or no qualifying income. (link to first article)

The main SIPP providers usually require a minimum amount to invest as a lump sum when you open your account. This is often around £1000 in the first instance (£800 from you £200 from the taxman). Any additional periodic payments in future years usually need to be around £500.

There is always a regular payment option alternative if you do not have easy access to a lump sum contribution if you want to commit regular payments to a SIPP a  £50 minimum is common with £40 from you and £10 from the taxman.

Because SIPPs, as with ISA’s, provide an envelope tax free of any interest and no further tax on dividends or any capital gains liability they are both tax efficient.

There is an on-going debate about which is best for your pension savings. The benefit of an ISA is you can use your ISA annual allowance to build up future savings but still have access to the money if you find you need to take money out.

The taxman does not add his 20% to an ISA as he does with a SIPP.

If you are over 55 the access argument moves in favour of a SIPP because you can take your 25% tax-free allowance and start to drawdown income if you need the money.

I am concentrating on the options for those near or already retired who are concerned about provision later in life as their existing pensions are eroded by inflation.

I will assume therefore than most people will be looking at a relatively short period for further pension investment. You can no longer contribute once you reach 75.

On a 5 year horizon, and assuming that you put in the maximum allowance with no qualifying income, you will each year be able to put in up to £2880.

Each year the taxman adds his £720. You will have contributed a total of £14,400 and the taxman £3600. So without doing anything you have an increased pension pot totalling £18,000.

If you were to invest the same amount each year in a cash ISA, probably earning an average of 2% per annum, if you are lucky, you would earn interest totalling £887.38 after 5 years and your ISA fund would then be worth £15,287.38.

Neither the tax rules or interest rates can be predicted with certainty for the next five years but this example shows that investing in a SIPP could return an additional £2712 due to the tax benefit.

So how should you invest this money in a SIPP?

Option 1 is the ultra safe option. Do nothing. Just let the money sit there benefitting from the taxman’s largess. You will probably be offered, from time to time, fixed interest rate deals to tie some of this money up for a year or two years. This is a safe way to spread a bit more icing on the cake.

Other options involve investing in stocks, shares and funds. This might improve your return but it may also put your capital at risk. The value of these investments can go down as well as up over any given cycle.

If you are comfortable investing then you have the benefit of the taxman’s cushion to protect you from risk to your own capital contributions. Most SIPP providers sell managed funds and will probably provide you with information on these in their newsletters.

There are about 2400 to choose from which is more than a little daunting. Hargreaves Lansdown select 150 for their Wealth 150 and also offer ready made selections depending on your requirement for income or capital growth.

The investors Chronicle publish a selection of those they consider to be the 100 best funds. If you are up for a bit of research you could whittle the list down by first finding out who is on both of these selections.

The advantage of these funds is that they have a spread over many investments in their chosen area, narrowing the risk of over exposure to a few individual stocks and shares.

Your SIPP provider earns commission if you buy these funds. In return they will normally waive the purchase fee.

Each year as you put more money into your SIPP you can decide to hold it as cash or invest.

Basic rules

If you are comfortable investing directly in shares it is important to set down some rules and stick to them.

I would suggest the following to help minimise risk and I stress ‘help’. Nothing is guaranteed when you are dealing with future values.

  • Start with the FTSE 100
  • Consider investing in companies that have a long history of paying dividends year after year.
  • Phase your investment purchases to help iron out the volatility in the market.
  • Avoid chasing shooting stars. They might continue to increase in value but you may be buying at a time when the upside is vulnerable to a correction
  • Invest in different sections; Pharmaceutical, Oil and Gas, Household, Industrials, etc,. The wider the spread the less you are exposed to violent sector corrections.
  • Beware the next big thing. It might not be. Use your own judgement
  • Beware the penny share that will make you a fortune. It probably won’t.
  • When deciding on good dividend payers select those with a low PE, low debt and a decent dividend cover. (These terms explained below).
  • Sell a share that has fallen in value by more than a percentage you are comfortable with. 10 or 15% is a reasonable guide.
  • Don’t get caught in the headlights. Watching a share you have bought increase in value can be mesmerising. Be ready to lock in profits by selling a part or all of a share.
  • Don’t panic. Try to buy when shares are a bit cheaper. May is a time when the market often falls. In 2012 the market fell steeply in May but they were two other less dramatic dips and these can represent a buying opportunity.

Lord Rothchild once said he usually did not manage to buy at the bottom or sell at the top. Probably though, you should be looking at shares that pay decent dividends and which seem to have a reasonable prospect of continuing to do so.

In other words you would be investing for the medium to long term and less concerned at volatility because those dividend cheques continue to roll into your account.

There is no reason not to look at smaller companies if that interests you, but make sure you understand the reasons why you are doing so.

The FTSE 100 offers a choice of the majors and as a whole, around two-thirds of their revenues come from outside the UK so you get international exposure and limit the risk of being confined to the economic performance of the UK.

In the next article I will look at the companies in the FTSE 100 with a history of paying good dividends.

Russell Bruce
6th March 2013. This article is for information and does not constitute personal financial advice

Some terms explained
PE or Price earnings ratio: If a share trades on a PE of 10 the price of the share is 10 times annual earnings. The FTSE 100 average is presently around 16.
Dividend: A payment to shareholders paid yearly, half yearly or sometimes quarterly. The final payment is usually the larger dividend
Dividend Cover Company: earnings are also expressed as an amount per share in issue. So if the earnings per share are 10p and the dividend is 5p for the year then the dividend cover is 2. If the cover is less than 1 then the company is partly paying the dividend from reserves and this is not sustainable unless attributable to non-recurring factors.

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