Moneyworks - Regular Saving

Regular Saving

Whilst the economy remains in a state of uncertainty, the basic financial planning premise that reliance on the State in retirement is not sufficient on its own continues to be true. If you already have an emergency fund in place and find that you have some net disposable income at the end of each month, now may be a good time to consider long-term savings with the aim of ensuring you do not have to rely wholly on the state and have a sufficient standard of living in later years.

You may be reticent about investing when stock markets suffer heavy falls, as has been the case over the past year however, by making regular contributions the risk associated with a fluctuating market could be reduced and could even be advantageous due to the concept of 'pound cost averaging'.

When looking for growth, the basic rule of investing is to buy low and sell high, but this is very difficult for private investors - and indeed for professionals to do, even with constant market monitoring. Hence, one of the risks of investing a lump sum is that this will be done when the market is high. One way to eliminate this risk is to make regular contributions to take advantage of 'pound cost averaging'.

The theory of 'pound cost averaging' is that by investing on a monthly basis, you effectively remove the short-term peaks and troughs that can have a negative effect on investment and smooth out the investment returns. This is because when the market is low your monthly investment will purchase more units, and when high your monthly investment will purchase fewer units.

This can be demonstrated in the following example: Two investments are made into the same fund - Eric invests £5,000 as a lump sum on the 1st May 2009, Ernie also invests £5,000, but via five monthly payments of £1,000. The price of the fund fluctuates over the period as follows:

Unit Price		Units Purchased
		Eric (£5,000 lump sum)	Ernie (£1,000pm)
1st May 2009	£1.00	5,000	1,000
1st June 2009	£0.90		1,111
1st July 2009	£0.80		1,250
1st August 2009	£1.00		1,000
1st September 2009	£1.25		800
Total Units Purchased		5,000	5,161

 

 

 

 

 

 

 

 

 

 

Final unit price on 1st December 2009 is £1.50

As can be seen, Eric's investment on the 1st May 2009 provided 5,000 units and the value of his holdings on 1st December 2009 is therefore £7,500 (5,000 units at £1.50 a unit). Ernie, having invested on a monthly basis now holds 5,161 units, valued on 1st December 2009 at £7,741.50.

The above ignores charges, interest earned and dealing costs. If the price had continued to rise over the above period, investing a lump sum would have produced a greater return. If the price had continued to fall, investing on a regular basis would have produced a loss that was less severe than that incurred through the single premium.

This concept can also be used to reduce the risk of investing a lump sum, as it is usually possible to spread the monies over a specified period.

If you are looking to start contributing to a plan, two tax efficient vehicles are an Individual Savings Account (ISA) and a personal pension plan. Both are similar in that any income or gains earned within the fund are free of tax, apart from being unable to reclaim the 10% tax credit on dividends. Where the two differ is in the rules on contributions going in and taking money out.

With a pension plan, personal contributions paid in can attract tax relief at the appropriate tax rates you have paid. This could mean that for higher rate taxpayers, for every £60 'effectively' paid by you £100 could be credited to your plan as long as you have paid sufficient tax at 40% (this would involve paying £80 net and claiming back £20 from HM Revenue & Customs, providing an effective net contribution of £60). For basic rate taxpayers every £80 paid would result in the same £100 being credited. The total amount that you can contribute personally to the plan and receive tax relief is the greater of 100% of relevant UK earnings or £3,600 per annum. This can be a complex situation and therefore advice should be sought before contributions are made.

The offset to this is that when you come to take your money out up to 25% can be taken tax-free, but the remainder will be taxed at the rate applying to you. It is also not possible to access the fund until age 50 at the earliest (moving to age 55 from the 2010/11 tax year).

Contributions paid into an ISA do not attract any tax relief going in and therefore the amount invested will be the amount paid by you from your account. There are restrictions on the amount that can be paid in each tax year, and the Budget article discusses the maximum subscription limits for an ISA and the changes to these announced in the Budget.

When you come to take the money out you should receive this taxfree. You are also able to access the money at any time, subject to specific provider restrictions, as there is no age restriction applied.

In summary, if you are considering saving for the future then there are many decisions to be made as to how, where and when you save. The decision can depend on what you are saving for, how long you can invest, and what access you need, but in the end, decisions do need to be made.

The value of investments and income from them can fall as well as rise and you may not get back the full amount invested. Investments in equities do not have the same degree of capital security as investments in deposits. The levels and basis of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor. 

 

Money Works is published by Moneyweb Limited Independent Financial Advisers.

Summer Issue 2009