Case study: Financial Planning for a comfortable retirement

4th February 2009

Adding to these woes for savers is a general expectation that the Bank Rate still has further to fall.  It was cut by 0.5% to 1.5% on 8th January and many commentators are predicting further rate cuts in 2009.  Already at the lowest level in the history of the Bank, the rate could go to 1% tomorrow and as low as zero before the end of the year.

Savers, and particularly retired people who depend on the interest on their savings to supplement their income, need to carefully consider all of their options.  So, just what steps can savers take to boost their income from their cash during these unusual economic times?

The first step is always to consider your attitude towards investment risk, reward and volatility.  People who have their money in cash tend to have it there for a good reason.  Cash is typically a suitable asset class for very cautious investors.  You are unlikely to see a particularly good return on your money (particularly at the moment) but you can also sleep easily at night, not having to worry about risk to your capital.

Now that the Financial Services Compensation Scheme (FSCS) offers compensation of £50,000 per separately licensed financial institution (or £100,000 for joint accounts), most savers can rest assured that their capital is completely safe.  Even if income from interest has fallen, at least the capital value will not fluctuate.

There are alternative options to consider, but savers must take care to assess the additional risks involved.  There is, quite simply, not an identical alternative in terms of risk for cash.  

Shop around

Before getting depressed about low rates of interest on your savings, it still pays to shop around.  By using online price comparison websites you can ensure that you have your savings in the most competitive account.  Comparison tables are also published each weekend in the Sunday papers.

Banks and Building Societies profit from the apathy of savers who do not regularly review their interest rates.  You need to shop around at least annually, and more frequently given the current market conditions, to find the most competitive rates.  There remains a great deal of difference between the most and least competitive interest rates available.

When shopping around, always go back to your current Bank as well to ask them if they can improve the interest rates they are paying on your savings.  Take care not to be persuaded to buy a different financial product such as a 'Guaranteed' Bond as an alternative to keeping your money in cash savings.  

Immediate vesting personal pensions

One option to consider is making a pension contribution and immediately taking the benefits.  This can result in a very high level of income, as a result of the availability of tax-free cash, income tax relief on your contribution and reasonably high annuity rates.  You need to be between 50 and 75 years old to take advantage of this tactic.  Here is a brief explanation of how it can work.

It is possible to make a gross pension contribution of up to £3,600 each tax year without reference to earnings.  If you do have earnings then you can make a larger pension contribution, limited to 100% of your earnings in the tax year and the current annual allowance (£235,000 for the 2008/09 tax year). 

The cost of making a contribution of £3,600 before tax relief is added is £2,880.  From the £3,600 you can immediately take tax-free cash of 25%, or £900, making the actual cost of making the contribution £1,980.  So, for your £1,980 contribution you get a £2,700 pension fund with which to purchase an annuity.

The current annuity rate for a 65 year old non-smoking male is 7.32%.  It is 6.88% for a female of the same age.  This means a gross yield of 9.98% or 9.38% respectively.  

Admittedly, whilst it is a high return with low risk, it is limited in most cases to quite small sums of money.  You also have to factor in the loss of future access to your capital and the terms of the annuity. However, for savers who use this strategy every year or those with earnings to justify a higher level of contribution, it can soon add up to a reasonable level of income.

Repaying debt

An alternative to consider is using some or all of your savings to repay debt.  The cost of debt has also been falling, but to date it has not fallen as far as average savings rates.  Some forms of debts, particularly credit cards, continue to have double-digit interest rates.  Using savings (where you are receiving low and taxable returns) to repay debt (with high interest rates) can make a lot of sense from a financial perspective.

Some savers with mortgage debts could benefit from using an offset mortgage.  These result in any savings balance canceling out the equivalent interest charge on mortgage debt.  You don't receive interest on your savings but you don't have to pay interest on the equivalent mortgage balance either.  This type of mortgage has been particularly popular with higher rate taxpayers with savings, who do not then have to pay any income tax on their savings interest.

However, the suitability of an offset mortgage in the current economic environment will depend on the interest rates being paid on your mortgage debt.  Borrowers with a very low tracker rate mortgage deal may see little benefit from offsetting their savings.

Using an offset mortgage in this time when banks are looking shaky must also come with a health warning.  The terms of the Financial Services Compensation Scheme (FSCS) mean that any mortgage debt is offset against any savings balance within the same institution before calculating compensation in the event of collapse.  This means that if you have a £50,000 mortgage and £50,000 of offset savings, your compensation would be zero.  Technically you don't lose out, as your mortgage balance is also wiped out, but it does remove your access to the savings.

Go tax-free

Savers looking for higher returns on their cash need to ensure that they are doing all they can to shelter their savings from income tax. Using your annual Individual Savings Account (ISA) allowance each tax year means you can receive tax-free interest on this part of your savings, without taking additional risk with your money.

Every person (age 16 and over) can save up to £3,600 each tax year into the cash component of an ISA.  The overall annual limit is £7,200, with up to £3,600 in the cash component and the balance in the stocks and shares component.

Banks and Building Societies typically reserve their most competitive interest rates for ISA savers.  This is because money saved in an ISA wrapper tends to remain in the account for longer, as savers do not wish to lose the tax benefits for that tax year by making withdrawals.

Consider investing the money

Assuming you are comfortable with the additional levels of risk, you might consider investing some of your cash in a well diversified investment portfolio.  A professional independent financial adviser will be able to make recommendations for a portfolio suited to your risk profile, financial objectives, investment term and income requirements.

If you do consider this option then avoid investing in a single fund or asset class.  Diversification has always been important when it comes to investing money, but never more so that now when a single asset class investment is considered incredibly risky.

Corporate bond funds are currently being tipped as a suitable alternative for savers who are looking for a higher yield without significantly higher levels of cash.  There is a big difference between the risk profiles of different corporate bond funds, so make sure you understand where you are investing your cash and what risks are involved.

If you do invest your savings then you must be prepared to take the long term view and accept that there will be some volatility involved.  When you establish the investment portfolio you should agree a formal review strategy for your adviser.  This needs to occur at least annually but they should also be providing you with quarterly valuations of your holdings and regular commentary on financial markets.

Martin Bamford is a Chartered Financial Planner and Certified Financial Planner certificant for Informed Choice; an award-winning firm of Chartered Financial Planners working with individual and small business clients in Surrey and the surrounding counties to help them to build, manage and protect their wealth.  

To request a new client welcome pack and arrange an initial meeting with no cost or obligation, please call Informed Choice on 01483 274566 or email hello@icl-ifa.co.uk. 

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