What the panel advise: Danby Bloch

We asked Danby Bloch Editorial Director of the publisher Tax Briefs, what he would have advised the mystery shopper to do. He said:

The process

Making recommendations based on other people's inadequate interviews of a client is always tricky.

There are lots of gaps of factual information and in terms of the client's aims and attitudes.

The Mr X's risk profile was the biggest area of uncertainty as usual and should have received the most attention.

But there were lots of other gaps. What about Mrs X's views, for example?

It is usually best to see couples rather than one partner alone.

The company pension scheme

The pension scheme is crucial to this client.

He is thinking of retiring in two years' time - or possibly in seven years.

So it is essential to find out more about the scheme and any other pension benefits. In the meantime we are forced to make some educated guesses.

Mr X seems to be confident that he can afford to retire, but seems to know very little about the pension scheme.

In particular, he is under the almost certainly mistaken impression that there will be no early retirement penalties.

Many people who are members of their employers' schemes have a frighteningly vague idea of the likely value of the benefits and typically overestimate them.

If we assume that the pension is a fairly good final salary scheme based on 1/60th for every year of service, he will have 25/60ths at age 60 - £18,750 based on his current salary of £45,000.

If his normal retirement date is 65, then there could be an early retirement penalty that would reduce this by just under a third.

So if these assumptions are anywhere near accurate, the idea of retiring at 55 sounds pretty unwise.

What should Mr X do?

Start saving part of his current income and invest it for retirement income.

He is a higher rate tax payer now and will probably be a basic rate tax payer in retirement.

Pension investments would be worth looking at: in house AVCs - possibly buying back years; personal pension/stakeholder pension contributions of £3,600 gross for him if he has any freelance earning whatsoever; maybe the same for her - though the contribution would only benefit from basic rate tax relief.

Next year, or more probably the year after, the new Inland Revenue rules on pensions and tax are due to come into force.

It looks as though these new rules would allow Mr X to invest a very substantial amount into a pension at that point - as much as his annual earnings under the proposals announced a few months ago.

That could turn out to be something worth considering for a person in Mr X's tax position.

He also needs to think in terms of the gap between ages 60 and 65 during which he will not have any state pension.

That income gap - probably about £6,500 a year - may need to be plugged somehow.

We would need to choose the appropriate funds for the pension plans. We'll come to that under the general investment recommendations.

Tax position

Mr X is currently a higher rate tax payer and his wife is a non taxpayer and could have an income of up to £4,615 tax free before she pays any tax.

He can transfer cash or assets to her and instead of paying tax on the income at 40%, she would pay no tax at all. There would be no tax on the transfer between them.

He will probably cease to be a 40% taxpayer when he retires; so it makes sense to make pension contributions now and get 40% tax relief and pick up tax free cash in retirement and income that will only be taxed at 22% or so.

Capital gains will probably be tax free by keeping them below the annual exemption - £7,900 this year.

Depending on how their wills are written (if they exist) they could have a potential inheritance tax liability on their joint estate of £388,000 after both have died of just over £50,000.

The mortgage

Repaying the mortgage sounds like the most obvious course of action for someone of his age and generally cautious approach to investment.

It is equivalent to getting a tax free return equal to the rate of interest on the mortgage with no risk to the capital.

He would be doing well to get 4.75% gross from a deposit account, so getting the equivalent of 4.75% net is attractive. And most people like to pay off debt.

The trouble is that there is probably an early redemption penalty for the next three years.

If so, the approach might be to reserve £32,000 from the lump sum he has inherited and invest it in the highest safe return he can get for a three year period.

Held in his wife's name, the income would be tax free (because she is not using the amount of her personal allowance), so the difference between the interest paid out and the interest received might not be all that great.

But of course Mr X might not be happy about putting money in his wife's name.

Mrs X as the sole or main investor

Mrs X has no income and no assets to speak of - other than half the house, presumably.

So she is not using her income tax personal allowance of £4,615.

She could take the whole of the £76,000, invest it in her name and all the income would be tax free.

If they reinvested the interest each year, a deposit account yielding 4.5% would generate £3,420 a year compound.

They might be happy to have a term deposit for six months or a year if it gained them an extra return.

The big question is whether Mr X is prepared to give Mrs X all or any of this large capital sum.

If the marriage is fine, then he might be prepared to give her the money to save the tax.

Otherwise, he might feel that the tax advantages are not worthwhile. I am going to assume that Mr X is happy to pass all of the £76,000 to Mrs X on the basis that this ploy would save a significant amount of tax.

Liquidity

Mr and Mrs X probably would like to have some of the money available to spend in a safe and accessible form such as a bank or building society deposit.

They might have planned needs for the next two or three years - holidays, car etc - and they might want a safety reserve in case he lost his job or the roof needed an emergency repair.

They would need to think hard about this - but let's assume they feel that they need to have £15,000 for this purpose.

All of this should be in Mrs X's hands, and the chances are that they would want to be able to access the funds pretty quickly - so no more than a week's notice for most of it and perhaps £5,000 or so on overnight terms.

Investing the rest

That leaves around £29,000 to invest plus £6,000 in the building society joint account.

There is also an existing PEP and ISA, which seems to be worth another £6,000. So there is a total of £41,000 to invest or at least consider, of which £35,000 is cash.

At this point it is essential to consider the timescale for these investments - not easy, because this discussion does not seem to have taken place.

If Mr X is planning to retire in two years or less, the bulk of the investment will need to be directed towards providing an income almost immediately.

But assuming he decides to go at 60, there is scope for some growth or at least income accumulation for about seven years.

Then, once they retire, the ideal income would be one that grows or at least keeps pace with inflation.

The overall timescale is pretty long. There is a fair chance that at least of them will another 30 to 40 years, so long term capital preservation and if possible some growth would be an objective to discuss.

1. The simple answer is to keep all the £35,000 in the bank and get 4.5% tax free.

That is a 2% real return above inflation. The bigger the sum on deposit, the greater the chance of getting a higher rate.

Remember there is all that other cash as well. The capital is safe in sterling terms and if interest rates rise, their income will go up as well.

Investing in a cash ISA, would allow Mr X to hold onto a small proportion of his cash, rather than give to his wife - £3,000 this year - and pay no tax on it.

The chances are that the rate of interest would be very slightly higher than from a deposit account outside the ISA framework.

Every little counts, I suppose.

But there are drawbacks to putting virtually all the eggs into the cash basket.

Interest rates make go down further; inflation might just conceivably return.

If sterling depreciated, foreign holidays could start to look rather expensive.

Maybe it would be worth considering a slightly higher level of risk or possibly more accurately a different type of risk.

The question is whether the extra return is worth the additional risk. 2. The next possibility is to consider fixed interest investments for at least some of the money. There is quite a choice.

(a) Gilts provide a yield that is not much greater than deposits and less for short dated stock - though the investor is protected against falling interest rates.

(b) Permanent Interest Bearing Shares or their equivalent from former building societies might be worth a thought. They yield between 7% and 8% gross.

They are issued by pretty secure organisations like the Halifax or the Bradford and Bingley - which might not pay their dividend, but probably will. And they are not very easy to buy and sell. (You get them from a stockbroker).

If interest rates fall further, they continue to pay out the fixed rate and the capital value goes up. If interest rates rise, the capital value falls.

They could be held in an ISA, but this would add to the costs for little or no advantage.

(c) Some split capital investment trust zero dividend preference shares (zeros) have proved very solid investments despite the justifiably bad publicity for about half of them.

Many are completely untainted by the problems that afflicted the high risk trusts. They have fixed maturity dates and the returns for this couple would be tax free at about 6% a year.

The fixed maturity date would mean that if they were kept to maturity, the return would not be affected if interest rates rose. (d) Then there are fixed interest funds.

The risks are spread between different companies, but the managers of the fund can make quite a difference to the relative performance in terms of both volatility and return.

Fixed interest funds might be worth putting in an ISA if the costs are no greater. As with other fixed interest investments, they are vulnerable to interest rate fluctuations - and they do not have the potential haven of the maturity date. 3. I think the adviser would be negligent if he or she did not raise the subject of equity - stock market - investment if the potential timescale for holding investments is long enough.

In the long term, 10 years or more, stock market based investments have almost always performed better than cash or fixed interest.

The last three years drop in share values has made investment now more attractive even if the bottom has not been touched.

Their very long term timescale is several decades - so it is important to think in these terms for at least some of their funds, if they can.

In any case, Seven years to retirement is probably long enough for markets to recover from a low - although it might well take longer, if some periods in the past are any guide.

There are some funds that are based on derivatives that provide no income, and the return on the capital is linked to a stock market index such as the FTSE 100 over a fixed period of say five years.

These funds vary according to market conditions - but if the stock market falls, some of them guarantee no loss.

The advantage is that the investor can get the growth (if any) in the stock market with no possible loss or very limited loss.

The potential drawbacks are inaccessibility over the investment period and the chance of losing out on the interest that might have been earned elsewhere.

These funds also have a relatively low cap on the amount of growth that can be achieved by the investment.

I would prefer a simpler and more straightforward investment into unit trusts or possibly traditional investment trusts.

The funds should be spread round various stock markets - not just UK - for diversification and the period they expect to hold them would be at least seven years and quite possibly more.

The existing PEP and ISA would need to be looked at to see if they should be switched.

Single premium investment bonds - for example, with profit bonds - are not tax efficient for non-taxpayers and are not attractive at the moment in view of their declining bonus rates.

Property might have been considered, but the amount available would probably rule that out in most parts of the UK.

This might not be a good moment to buy property for letting. Commercial property funds look rather expensive.

Asset allocation

Asset allocation is the current buzz phrase - how the investments should be spread between the various asset classes of cash, fixed interest and shares.

This would need to be discussed, but the starting point might be to split the £41,000 balance of the investments roughly between more cash, fixed interest and stock market investments.

We would also consider whether to phase the investment, buying them at six monthly or annual intervals over the next year.

The asset allocation would therefore be:

Cash - £30,000 (54%) Fixed interest - £13,000 (23%) Equities - £13,000 (23%)

Estate planning

The potential inheritance liability on the estate is not negligible, but the chances are that they would not want to reduce their long term security to save their children tax - at least not yet.

But there are actions they should consider to avoid elementary mistakes.

Having a will and enduring power of attorney makes sense.

Summary

The money would be deployed as follows:

Cash bequest - £76,000
Building society - £6,000
ISA and PEP - £6,000
Total - £88,000

Pay off mortgage - £32,000
Cash reserve - £15,000
Investments - £41,000
Total - £88,000

BBC Radio 4's Money Box Investigates was broadcast on Tuesday, 22 April, 2003 at 2000 BST.