Cefap 2016-17 Online Full
Cefap 2016-17 Online Full
Cefap 2016-17 Online Full
Claire Bateson
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The London Institute of Banking & Finance is a registered charity, incorporated by Royal Charter.
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Claire Bateson MBA BA (Hons) is a Fellow of The London Institute of Banking &
Finance and a chief examiner and moderator. Having worked in the financial services
industry for over 20 years, Claire now runs her own consultancy, Cobalt Advantage
Ltd, providing specialist training solutions and management development.
Carl Burlin BA Hons has worked in financial services for over 20 years. He started
his career as an adviser on protection, investments and retirement planning and
moved into training in 1994. Since 1994, he has specialised in the training of financial
advisers and sales managers, providing both technical and skills development.
Having worked for a large bancassurer until 2011, Carl is now a freelance training
consultant.
Carl has worked closely with The London Institute of Banking & Finance since 1997
and produced a number of study materials to support students across a range of
qualifications. He has achieved two Level 4 qualifications in financial services and
also holds CeMAP®.
Contents
Learning objectives
The purpose of this topic is to enable you to understand the key influences in
the UK financial services industry. It sets the scene for the remainder of the
study text and, to help you keep up to date, it is an area in which you should
undertake your own reading.
After studying this topic you should be able to:
u explain the function of the financial services industry in the economy;
u classify the main institutions and markets;
u explain the role of the UK government and the European Union;
u explain the purpose and position of clearing and settlement organisations.
1.1 Introduction
This topic begins by providing a broad introduction to the functions of the financial
services industry and to the institutions that make up the industry.
The government has a huge impact on the financial services industry, one of the
reasons for this being the requirements of the European Union, of which the UK is
a member state. Regulation of the industry is considered in later topics.
In the final part of this topic you will consider the role of organisations that are
responsible for ensuring that money flows around the financial system. This flow
is known as ‘clearing’, and it is ‘settlement’ organisations that enable it to happen.
provide services that they could, in theory, trade with others for the things they
need. The complexity of life, however, and the sheer size of some transactions
make it virtually impossible for people today to match what they have to offer
against what others can supply to them.
What is needed is a separate commodity that people will accept in exchange for
any product and that forms a common denominator against which the value of all
products can be measured. These two important functions (defined technically as
being a medium of exchange and a unit of account respectively) are carried
out by the commodity we call money. In order to be acceptable as a medium of
exchange, money must have certain properties. In particular it must be:
u sufficient in quantity;
Money also acts as a store of value. In other words, it can be saved because it
can be used to separate transactions in time: money received today as payment
for work done or for goods sold can be stored in the knowledge that it can be
exchanged for goods or services later when required. To fulfil this function, money
must retain its exchange value or purchasing power, and inflation (considered in
Topic 7) can, of course, adversely affect this function.
Notes and coins are legal tender, ie they have the backing of the government and
the central bank, but money comprises much more than cash. It includes amounts
held in current and deposit accounts, and other forms of investments.
The financial services industry exists largely to facilitate the use of money. It ‘oils
the wheels’ of commerce and government by channelling money from those who
have a surplus, and wish to lend it for a profit, to those who wish to borrow it, and
are willing to pay for the privilege (this is described in more detail in section 1.2.1).
Financial services organisations want to make a profit from providing this service
and, in the process of so doing, they provide the public with products and services
that offer, among other things, convenience (eg current accounts and payment
cards), means of achieving otherwise difficult objectives (eg loans and mortgages),
protection from risk (eg insurance) and peace of mind (eg provision for retirement).
1.2.1 Intermediation
In any economy there are surplus and deficit sectors. The surplus sector comprises
those individuals and organisations who are cash-rich − ie they own more liquid
funds than they currently wish to spend. They want to lend out their surplus funds
in exchange for a profit. The deficit sector comprises those who own less liquid
funds than they wish to spend; these are prepared to pay money (interest) to
anyone who will lend to them.
In this context, a financial intermediary is an organisation that borrows money
from the surplus sector of the economy and lends it to the deficit sector, paying
a lower rate of interest to the person with the surplus and charging a higher rate
of interest to the person with the deficit. Banks and building societies are the
best-known examples. An intermediary’s profit margin is the difference between
the two interest rates.
But why do the surplus and deficit sectors need the services of a financial
intermediary? Why can they not just find each other and cut out the middleman’s
profit? Actually, there are some cases where this does happen and it is known as
disintermediation (the process by which lenders and borrowers interact directly
rather than through an intermediary). An example would be where friends lend
money to each other, rather than using a bank. There are, however, several reasons
why both individuals and companies need the services of intermediaries. The four
main reasons relate to the following factors.
u Geographic location: firstly, there is the physical problem that individual
lenders and borrowers would have to locate each other and would probably
be restricted to their own area or circle of contacts. A potential borrower in
Surrey is unlikely to be aware of a person in Edinburgh with money to lend, but
each may have easy access to a branch of a high-street bank.
u Aggregation: even if a potential borrower could locate a potential lender,
the latter might not have enough money available to satisfy the borrower’s
requirements. The majority of retail deposits are relatively small, averaging
under £1,000, while loans are typically larger, with many mortgages for £50,000
and above. Intermediaries can overcome this size mismatch by aggregating
(collecting together) small deposits.
u Maturity transformation: even supposing that a borrower could find a lender
who had the amount they wanted, there is a further problem. The borrower
may need the funds for a longer period of time than that for which the
lender is prepared to part with them. The majority of deposits are very short
term (eg instant access accounts), whereas most loans are required for longer
periods (personal loans are often for two or three years, while companies often
borrow for five or more years, and typical mortgages are for 20 or 25 years).
Intermediaries are able to overcome this maturity mismatch by offering a wide
range of deposit accounts to a wide range of depositors, thus helping to ensure
that not all of the depositors’ funds are withdrawn at the same time.
This means that individuals and businesses, in return for a payment, can protect
themselves against an unexpected loss. The insurance company employs actuaries
who work out the probability of the loss and the resulting financial impact, and
then are able to calculate premiums that ensure the likely number of possible
claims can be met and a profit made.
The insurance company may choose to insure some (but not all) of the risks that
they are exposed to with specialist reinsurers. The insurer can then recover a part
of the claims they pay out from the reinsurer. This reduces the risk of the failure
of the insurer in the event of a catastrophic event, such as a natural disaster, that
may produce a very high level of claims.
In addition to the functions described above, the Bank of England was previously
charged with responsibility for the supervision and regulation of those institutions
that make up the banking sector in the UK. This responsibility was transferred
to the Financial Services Authority (FSA) in 1998, but the FSA ceased to be in
April 2013, with regulatory functions being shared between the Financial Policy
Committee (FPC) (part of the Bank of England), the Prudential Regulation Authority
(PRA) (a subsidiary of the Bank of England) and the Financial Conduct Authority
(FCA) (accountable to Parliament).
u Proprietary organisations, which account for the great majority of the large
financial institutions, are public limited companies. They are owned by their
shareholders, who have the right to share in the distribution of the company’s
profits in the form of dividends and can contribute to decisions about how the
company is run by voting at shareholders’ meetings.
u Mutual organisations, in contrast, are not constituted as companies and
do not, therefore, have shareholders. The most common types of mutual
organisation are building societies and friendly societies, each of which is
mutual by definition, and life assurance companies, of which only a small
proportion are mutual.
A mutual organisation is, in effect, owned by its members, who can determine how
the organisation is managed through general meetings similar to those attended
by shareholders of a company. In the case of a building society, the members
comprise its depositors and borrowers; for a life company, they are the with-profit
policyholders.
Since the Building Societies Act 1986, a building society has been able to
demutualise − in other words, to convert to a bank (with its status changed to that
of a public limited company). Such a change requires the approval of its members
and this approval has in practice generally been readily given, in large part because
of the ‘windfall’ of free shares to which members have become entitled following
conversion to a company.
The possibility of a windfall on conversion led to a spate of ‘carpetbagging’ − the
practice of opening an account at a building society that it is believed will soon
convert, purely to obtain the subsequent allocation of shares. Societies considering
conversion have, in response, sought to protect the interests of their long-term
members by placing restrictions on the opening of new accounts.
In the past some mutual life assurance companies, including Norwich Union (now
Aviva) and Standard Life, have also elected to demutualise.
Credit unions offer simple savings and loan facilities to members. Savers invest
cash in units of £1, with each unit buying a share in the credit union. Each share
pays an annual dividend, typically 2−3 per cent. These savings create a pool of
money that can be lent to other members; the loans typically have an interest rate
of around 1 per cent of the reducing balance each month (with a legal maximum of
2 per cent of the reducing capital). Recent legislation has meant that credit unions
will be able to offer interest on deposits, and to charge a market rate for providing
ancillary services to members.
A unique feature of credit unions is that members’ savings and loan balances are
covered by life assurance. This means that any loan balance will be paid off on
death, and a lump sum equal to the savings held will also be paid, subject to
overall limits.
In order to compete in today’s financial services marketplace, many credit unions
offer additional services, often in conjunction with partners, including basic bank
accounts, insurance services and mortgages.
end-users of retail services are normally individuals and small businesses, whereas
wholesale services are provided to large companies, the government and other
financial institutions.
Retail banking is primarily concerned with the more common services provided
to consumers and corporate customers, such as deposits, loans and payment
systems. It is largely the province of high-street banks and building societies
that deliver their products through traditional branch networks, call centres or
the internet.
The Wheatley report, undertaken in 2012, looked at the way in which Libor
was governed (previously an unregulated activity) following the Libor fixing
scandal. The report’s recommendations were accepted by the government to make
participation in setting Libor a regulated activity and to make manipulation of Libor
a criminal offence. The Financial Services Act 2012 (effective from April 2013)
brought these changes into effect. ICE Benchmark Administration Limited (IBA) was
established in July 2013 and the transfer of regulation by the IBA was completed
on 1 February 2014, following authorisation by the FCA (ICE, 2016).
Building societies are also permitted to raise funds on the wholesale markets: up
to 50 per cent of their liabilities (deposits from customers).
The distinction between ‘retail’ and ‘wholesale’ in financial services is much less
obvious than it used to be, with many institutions now operating in both areas. The
terms tend not to play a part in the day-to-day terminology in other financial areas
such as life assurance, pensions and unit trusts, but the concepts are present in
the background.
u Some organisations are clearly based at the wholesale end of the market, such
as life assurance companies and unit trust managers providing products to third
parties for onward sale.
u Product providers that sell direct to the public or through their own dedicated
sales forces are, in effect, operating in both a wholesale and retail capacity.
u Capital: a key issue here was that banking operations were potentially under
threat where a bank failed to hold adequate capital to ‘ride out’ difficult
economic conditions. Under the recommendations, it was suggested that the
largest ring-fenced UK retail banks would be required to hold greater levels
of capital in reserve, so as to provide greater protection in the event of an
economic downturn.
u Bail-in and depositor preference: the report recommends that the UK
resolution authority should have a statutory power of bail-in (to recapitalise
banks in resolution) and that insured deposits should have preferred creditor
status. Bail-in refers to investors, creditors and unprotected depositors taking
the financial consequences of keeping a depositor solvent, for example by
losing some or all of their deposited funds. This can be contrasted to
‘bail out’ whereby the government, and therefore taxpayers, pay a bank’s debts.
u Competition: the ICB called for improved processes for customers to switch
accounts and greater transparency so that customers can compare prices.
The proposals may also create opportunities for non-UK banks to compete
in the British retail banking market and could inhibit UK investment banking
operations in competing globally.
u Structural reform: under ring-fencing, banks will be required to create
separate standalone subsidiaries with their own governance arrangements,
referred to as ‘ring fenced bodies’ (RFBs).
At around the same time as the ICB was carrying out its work, there had also
been many concerns about the rewards provided to many senior managers in the
banking industry and the conduct of some of those managers.
Following the ICB, the government established the legislative framework for
changes to the UK banking system to be put in place through the Financial
Services (Banking Reform) Act 2013 (the Act). The Act will bring about the reforms
suggested by the ICB and also by a separate Parliamentary Commission on banking
standards, which was concerned with standards of conduct. The purpose is to
improve the resilience (ability to deal with adverse economic conditions) and
resolvability (how financial problems within an area of a bank’s operations are
dealt with so as to minimise impact on other areas of operations). The Act impacts
all UK banks with retail deposits of £25bn or more.
The Bank of England, through the PRA, has responsibility to implement changes in
respect of the ring-fencing of UK banks’ retail operations, the objective being to
ensure the continuity of core services for the bank’s customers. Core services
are accepting deposits and making payments from an account, facilities for
withdrawing money and making payments from an account and the provision of
overdraft facilities.
The system of ring-fencing is to be implemented by 1 January 2019, and the Bank
of England will publish final rules, to enable banks to make the necessary changes,
ahead of this date.
The Bank of England continues to consult on changes in respect of the capital levels
that banks are required to hold. It is proposed that UK ring-fenced banks should
hold reserves of capital equal to at least 11 per cent of their risk weighted assets.
There are likely to be more stringent capital requirements for ‘globally significant’
banks.
In respect of the conduct and accountability of senior managers, a new Senior
Managers’ Regime was introduced in March 2016. The regime overhauls the
approved persons regime and applies to UK incorporated banks, building societies
and credit unions and to UK incorporated and PRA designated investment firms.
The intention is to extend the regime to all banks operating in the UK. The regime
sees an approval process for senior managers and a certification process for more
junior employees. There is also a new conduct regime. Perhaps most significantly,
a new criminal offence of ‘recklessly leading a bank into insolvency’ has been
introduced, with a maximum punishment of seven years’ imprisonment. The aim of
the Senior Managers’ Regime is to enhance conduct and improve levels of individual
accountability.
A similar regime has been introduced for senior managers in the insurance
industry.
The Senior Managers’ Regime is detailed in section 2.2.3.
Companies quoted on the London Stock Exchange main market must conform to
the stringent requirements of the listing rules laid down by the FCA, acting in its
capacity as the UK Listing Authority (UKLA). For a full listing (ie a listing on the main
market), a considerable amount of financial and other information is required to
be disclosed. In addition:
u the applicant company must have been trading for at least three years;
u at least 25 per cent of its issued share capital must be in the hands of the public.
The London Stock Exchange, like most stock markets, is both a primary
and secondary market. The primary market is where companies and financial
organisations can raise finance by selling securities to investors. They will either
be coming to the market for the first time, through the process of ‘going public’
or ‘flotation’, or issuing more shares to the market. The main advantages of listing
include greater ease with which shares can be bought or sold, and the greater ease
with which companies can raise additional funds. The secondary market − which
is much bigger in terms of the number of securities traded each day − is where
investors buy and sell existing securities.
The AIM was established in 1995 and is an additional, separate market on the
London Stock Exchange. It is mainly intended for new, small companies with the
potential for growth. Its purpose is to enable suitable companies to raise capital by
issuing shares and it allows those shares to be traded. In addition to the benefit of
access to public finance, companies will enjoy a wider public audience and enhance
their profiles by joining the AIM.
Rules for joining the AIM are fewer and less rigorous than those for joining the
official list (the main market), and were designed with smaller companies in mind.
Gilts are sold at regular auctions held by the UK Debt Management Office (DMO)
on behalf of Her Majesty’s Treasury. The term gilt is short for ‘gilt-edged security’
and is a reference to their perceived safety as an investment. The government has
never failed to make a repayment on a gilt.
When a gilt is sold, the government guarantees to pay the holder a fixed interest
payment every six months until the maturity date, at which point the full value
of the bond is repaid. The majority of gilts are held by UK institutions, such as
pension funds, but a large proportion are also held by foreign governments and
investors.
See section 13.5 for further details.
These twin objectives of a free market for business enterprise and the protection
of the consumer are among the principles on which the European Union is
based. It is not surprising to discover that these objectives have been promoted
largely through European legislation, most of which impacts, either directly or
indirectly, on the UK. The force of European law can be seen in most recent major
developments in the regulation of UK financial institutions.
The role of the government in the UK in this context is to provide a framework
of regulation that stipulates how the financial services sector should be operated.
However, the regulation of the financial services industry is, broadly speaking, a
five-tier process.
u First level: European legislation that impacts on the UK financial industry. The
two main types of European legislation are ‘regulations’ and ‘directives’ (see
section 1.4.1).
u Second level: Acts of Parliament that set out what can and cannot be done.
Whenever reference is made to Acts of Parliament, it should be borne in mind
that the effects of the laws are often achieved through subsidiary legislation −
known as statutory instruments − which are made pursuant to (in accordance
with) the Act. Examples of legislation that directly affect the industry are the
Financial Services and Markets Act (FSMA) 2000, the Banking Act 1987, the
Building Societies Act 1997 and the Financial Services Act 2012.
u Third level: the regulatory bodies that monitor the regulations and issue rules
about how the requirements of legislation are to be met in practice. The main
regulatory bodies are the Prudential Regulation Authority (PRA) and the Financial
Conduct Authority (FCA).
u Fourth level: the policies and practices of the financial institutions themselves
and the internal departments that ensure they operate legally and competently
1.4.2.1 Basel I
Referred to as the Basel Accord. In 1988, the Basel Accord published a set of
minimum capital requirements for banks. The rules were adopted by the G10
group of countries, including the UK.
1.4.2.2 Basel II
Basel II was published in 2004 and superseded the original Basel Accord. The
objective was to establish an international standard for banking regulators in terms
of how much capital a bank should hold to provide protection against financial and
operational risk. An area of focus was ensuring consistency in the regulations so
as to provide a level playing field for banks when competing with those who fall
under a different regulatory jurisdiction.
Basel II details risk and capital management requirements so that banks are
required to hold appropriate levels of capital, given the risk presented by their
lending and investments practices; as risk increases so do the associated capital
requirements.
Basel II consists of three ‘pillars’, as follows:
u Pillar 1 details capital requirements in respect of three aspects of a bank’s
operations:
− credit risk;
− operational risk; and
− market risk.
u Pillar 2 gives banking regulators more effective supervisory tools and enables
regulators to deal with the individual components of risk.
u Pillar 3 contains a set of disclosure requirements so that the capital adequacy
of an organisation can be properly assessed.
In relation to supervision and disclosure, Basel II introduced the requirement for
banks to carry out ‘stress tests’, the use of computer simulations to understand the
effect of certain events on the firm. Stress tests ascertain the extent to which the
firm will have sufficient capital if certain unexpected adverse economic conditions
prevail.
as the umbrella organisation for the UK payments industry. It manages the major
UK payment clearing systems through three operational clearing companies.
u Cheque and Credit Clearing Company, which oversees the clearing of
cheques and paper credits on a three-day processing cycle;
u Bankers’ Automated Clearing Services Ltd (BACS), which is responsible
for the bulk electronic clearing (eg direct debits) operated on their behalf by
VocaLink Ltd; and
u CHAPS (the Clearing House Automated Payment System), an electronic
same-day interbank transfer system for high-value wholesale payments.
Payment services in the UK are regulated by the Payment Systems Regulator, a
subsidiary of the FCA.
References
Payments UK (2015) Payment statistics November 2015 [pdf]. Available at: http://www.paymentsuk.
org.uk/sites/default/files/Monthly%20Payment%20Statistics%20Nov%202015.pdf
[Accessed: 17 May 2016].
Peachey, K. (2015) Cashless payments overtake the use of notes and coins. BBC [online], 21 May
2015. Available at: http://www.bbc.co.uk/news/business-32778196 [Accessed: 17 May 2016].
ICE (2016) [online]. Available at: https://www.intercontinentalexchange.com/about [Accessed: 9
June 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
8. How does the European Union influence the financial services industry in the
UK?
9. What is the difference between an EU regulation and a directive?
Learning objectives
After studying this topic you should be able to:
u explain the objectives and role of the PRA;
u explain the objectives and role of the FCA;
u summarise the approach to the prevention of financial crime;
u interpret the FCA’s approach to supervision within the financial services
industry.
2.1 Introduction
During the latter part of the twentieth century, strong views developed in Western
societies concerning the rights of the consumer. The context for this was that,
as commercial organisations have grown through mergers and acquisitions, they
have become more remote from their customers and more concerned with their
own business performance than with customer satisfaction. This is reflected in
the emergence of both government organisations, such as the Competition and
Markets Authority, and consumerist bodies, such as Which? and Money Saving
Expert.
Perhaps because it deals with money − a vital common denominator both in the
lives of individuals and in the national economy − the financial services industry
has become one of the most regulated business sectors of all. Since the mid 1980s
there has been a raft of legislation relating to the financial services sector and there
is no sign of a slowing down in the trend for greater regulation of the industry,
often because as one problem is dealt with, another issue emerges.
Although governments try to foresee problems and to introduce legislation as
a means of ‘prevention rather than cure’, it remains true that most regulatory
legislation in the past has been reactive rather than proactive − ie it has been
passed in response to problems, rather than designed to foresee and prevent
them.
Much of this topic describes the current regulatory structure in the UK, presided
over by the PRA and the FCA. These bodies took over from the previous regulator,
the Financial Services Authority (FSA) in April 2013. This new structure was
introduced following implementation of the Financial Services Act 2012, legislation
that was introduced following the failure of the previous regime in the period
leading up to the 2007 credit crisis. The PRA operates as a subsidiary of the Bank
of England and has sole responsibility for the day-to-day prudential supervision
of banks and other financial institutions; prudential supervision is concerned with
the financial arrangements of a business, in particular, whether financial affairs are
arranged in such a way so as not to threaten the operation of the business. Within
the Bank of England, the Financial Policy Committee (FPC) looks at the economy in
broader terms to identify and address risks that may threaten economic stability.
The consumer protection aspects of the FSA’s former role were transferred to the
Financial Conduct Authority (FCA), which has responsibility for the conduct of all
retail and wholesale financial firms.
The FCA has responsibility for conduct regulation (ie the behaviour of firms and
individuals) for all firms, and prudential regulation for those firms not covered
by the PRA. This means there is some dual regulation by the FCA and PRA. The
following firms are PRA-authorised and so are ‘dual-regulated’ by the PRA for
prudential purposes and the FCA for conduct purposes:
u banks;
u building societies;
u credit unions;
u insurers (including friendly societies);
u Lloyd’s of London and Lloyd’s managing agents;
u certain systemically important investment firms designated by the PRA.
The FCA regulates all other firms, known as FCA-authorised firms or FCA-only firms
in respect of both conduct and prudential matters. The PRA and FCA are tasked
with co-operation and with co-ordinating their activities. The PRA has the power to
overrule or ‘veto’ decisions made by the FCA where it considers that action being
taken by the FCA threatens financial stability or is likely to cause the failure of a
PRA-authorised person in a way that could adversely affect financial stability.
Any financial services organisation conducting business in the UK must be
authorised by the PRA and/or FCA if it carries out ‘regulated activities’ in relation
to ‘regulated investments’. Both regulated activities and regulated investments
are detailed in the Financial Services and Markets Act 2000. Regulated activities,
for which firms must be authorised under the Regulated Activities Order (RAO),
include:
u accepting deposits;
u effecting and carrying out insurance contracts (including funeral plans);
u dealing in and arranging deals in investments;
u managing investments;
u establishing and operating collective investment schemes;
u establishing stakeholder pension schemes;
u advising on investments;
u mortgage lending and administration;
u advising on and arranging mortgages;
u advising on and arranging general insurance;
There are three key areas of prudential control for financial institutions relating to
their capital adequacy, liquidity and solvency. In simple terms capital adequacy is a
bank’s own funds (from shareholders), not money deposited by investors. Liquidity
is the speed at which cash can be acquired (borrowed or through the sale of assets).
Solvency concerns the amount of a bank’s own funds (short-term assets) in relation
to its longer-term assets (such as loans to customers). There are different rules for
deposit-takers, for investment firms and for life assurance companies. We will look
at prudential regulation for deposit-takers in more detail.
Solvency II has been adopted by all European Union (EU) member states, plus three
of the European Economic Area (EEA) countries. It aims to protect policyholders’
interests more effectively by making firm failure less likely, and by reducing the
probability of consumer loss or market disruption. Solvency II should also make it
easier for firms to do business across the EU.
The main aims of Solvency II are to:
u reduce the risk of an insurance company being unable to meet its claims;
u reduce losses suffered by policyholders should an insurer be unable to meet all
claims in full;
u establish a system of information disclosure that makes regulators aware of
potential problems at an early stage;
The new regime will apply to almost all EU insurance firms. Some insurance firms
will be out of scope depending on the amount of premiums they write, the value
of technical provision, or the type of business written.
The requirements of the Solvency II Directive became effective for supervisors
and the European Insurance and Occupational Pensions Authority (EIOPA) from
1 January 2016.
The PRA has made changes to its Handbook to reflect the new requirements.
2.2.2 Liquidity
Liquidity can be defined as the ease and speed with which an asset can be converted
into cash − and thus into real goods and services − without significant loss of
capital value. It must not be confused with insolvency, or with capital adequacy,
which are different issues.
The question of liquidity was at the heart of the issues arising in the lead up to and
the aftermath of the credit crunch in the latter part of the 2000s. The UK’s central
bank, the Bank of England, has had to operate in its role as ‘lender of last resort’
to rescue banks whose liquidity was inadequate.
In relation to banks, the definition of liquidity is a measure of a bank’s ability
to acquire funds immediately at a reasonable price in order to meet demands
for cash outflows. Liquidity risk can be defined as the risk that a firm, though
solvent (in terms of the level of assets held), does not have sufficient financial
resources available to enable it to meet its obligations as they fall due. This could,
for example, happen when a large portion of a bank’s assets have been advanced
as long-term loans and they face a situation when an unexpectedly high number
of depositors are seeking to withdraw their savings.
In assessing the liquidity risks that they may face, banks need to consider the
timing of both their assets and their liabilities, and endeavour as far as possible to
match them.
u Asset liquidity: a firm’s assets can provide liquidity in three main ways: by
being sold for cash, by reaching their maturity date and by providing security
for borrowing. Asset concentrations, where a large number of receipts from
assets are likely to occur around the same time, should be avoided.
u Liability liquidity: similarly banks try to avoid liability concentrations, where
a single factor or a single decision could result in a sudden significant claim. A
wide spread of maturity dates is one obvious way to achieve this.
the role is subject to significant change, the firm must have robust procedures to
ensure a smooth transition so as to equip the senior manager to carry out their
role effectively.
Each firm must maintain a ‘responsibilities map’ which details the way
responsibilities are allocated between the senior management team. Should
problems arise, the responsibilities map enables the FCA / PRA to more easily
identify which person is responsible.
The penalties for senior managers are wide and the regime enables the FCA /
PRA to instigate criminal proceedings against a senior manager whose action or
inaction has led their business to fail. If found guilty, the maximum punishment is
a prison sentence of up to seven years and / or an unlimited fine.
The regulators recognise that the actions of those in more junior roles, below senior
management level, could still cause major damage to a business and its customers.
The FCA / PRA define a number of ‘significant-harm’ functions. Individuals in these
roles are subject to a certification regime and each relevant firm must assess the
fitness and propriety of those in such roles on an ongoing basis, at least annually.
All those working for a regulated firm are subject to a Code of Conduct, unless they
perform an ancillary role. Where an individual breaches one or more of the rules
contained in the Code, then the FCA / PRA can take enforcement action against
them personally.
For insurance companies, there is a similar regime for Senior Insurance Managers.
One significant difference is that there is no scope for criminal proceedings.
Firms should have whistleblowing procedures in place to enable employees to
report serious inappropriate circumstances or behaviours within the firm that they
believe are not being addressed. Workers who wish to report their knowledge or
suspicions regarding, for example, a failure by the firm to comply with legislation
have a right to protection under the Public Interest Disclosure Act 1998. The firm’s
procedures should assist staff and not hinder them in the whistleblowing process.
The role of oversight groups is important. It is appropriate that all aspects of the
activities of financial services institutions should be kept under review to ensure
that the investments of both shareholders and customers are being handled safely
and honestly and that the institution is abiding by all the applicable laws and
regulations, in the best interests of all its stakeholders. This oversight of an
institution’s business can be carried out by different individuals and groups, such
as auditors, trustees or compliance officers.
2.3.3 Competition
In comparison with its predecessor, the FCA has greater powers and wider
responsibilities in respect of the promotion of effective competition. The FCA’s
statutory objective is to ensure that relevant markets function well, and one of its
three operational objectives is to promote effective competition. To understand
the role of the FCA in terms of competition, it is important to consider the broader
context of competition, and the promotion thereof, in the UK economy.
7. Communications with clients: a firm must pay due regard to the information
needs of its clients, and communicate information to them in a way that is clear,
fair and not misleading.
10.Clients’ assets: a firm must arrange adequate protection for clients’ assets
when it is responsible for them.
11.Relations with regulators: a firm must deal with its regulators in an open
and co-operative way, and must disclose to the FCA anything relating to the
firm of which the FCA would reasonably expect notice.
− criminal record;
− disciplinary proceedings;
There is a separate regime, the Senior Managers’ Regime, for those who hold
key roles in relevant firms, particularly banks and insurance companies (see
section 1.3.4.1 and section 2.2.3).
The FCA does not provide a definition of ‘fair’; its view is that fairness is a concept
that is ‘flexible and dynamic’, which can ‘vary with particular circumstances’. Firms
must decide for themselves what fair treatment means within the context of their
own business. What is clear is that the FCA intends fair treatment to apply at every
stage throughout the life cycle of financial products, such as:
u product design;
u administration; and
u post-sale activities, including claims handling and dealing with complaints.
The FCA has given some guidance on the types of behaviour it wishes to see and
has suggested a number of areas that a firm should consider. These include:
u considering specific target markets when developing products;
Responsibility for the fair treatment of consumers lies with a firm’s senior
management, which is required to ensure that fair treatment is ‘built consistently
into the operating model and culture of all aspects of the business’.
A key issue the FSA intended to address when it launched the original TCF initiative
was the extent to which customers are helped to understand the financial products
they are buying. Firms are expected to be clear about the services they offer and
about the true cost to the customer. Information must be provided to customers
in a way that is clear, fair and not misleading. Firms should always consider the
ways that the customer will assess their product against others in the market, and
ensure that a fair comparison can be made. This means not only that product
literature should be clear and appropriate to the customer’s expected financial
sophistication, but also that the advice given should be of a sufficiently high quality
to reduce the risk of mis-selling.
3. Consumers are provided with clear information at all stages, before, during and
after a sale.
4. Any advice given is suitable for the customer, taking account of their
circumstances.
5. Products perform as customers have been led to expect, and associated services
are of an acceptable standard.
6. There are no unreasonable barriers to switching product or provider, making a
claim, or complaining.
The FCA is clear that these outcomes are at the core of what it expects from firms.
Since 2009, firms have had to demonstrate to the regulator that they are
consistently treating their customers fairly. This can be done by using management
information that shows how they are delivering the six consumer outcomes or, in
areas of the business where outcomes are below standard, what action the firm is
taking to address the issues.
The concept of ‘conduct risk’ has developed from the TCF strategy and the FCA
places a lot of emphasis on the way firms in the financial services industry conduct
themselves. Firms will need to demonstrate how culture, retail strategies and
controls deliver fair treatment to their customers.
There is a strong focus on the culture and behaviours firms display − for example to
be less sales- and bonus-driven and deliver better customer service − and stronger
enforcement strategies when the rules are ignored.
5. ensuring firms act in the right spirit, that they consider the impact their actions
have on consumers and markets, rather than simply following the letter of the
law;
6. examining business models and culture and the impact they have on consumer
and market outcomes;
7. an emphasis on individual accountability, ensuring senior management
understand they are responsible for their actions and that they will be held
to account when things go wrong;
8. acting in a robust manner when things go wrong;
9. communicating openly with (financial) industry, firms and consumers so as to
understand the issues they face;
10.having a joined up approach to ensure that messages are consistent (FCA,
2015).
Before taking action against a dual-regulated firm the FCA will consult with the
PRA. They will decide whether a joint approach or single approach will be the most
appropriate. If a single approach is taken then information will be shared as the
investigation continues.
References
FCA (no date) Business plan 2015/16 [online]. Available at: http://www.fca.org.uk/static/channel-page/
business-plan/business-plan-2015-16.html?utm_source=businessplan2015&utm_medium
=businessplan2015&utm_campaign=businessplan2015#c1 [Accessed: 18 May 2016].
FCA (2013) The FCA sets out in detail how it will regulate consumer credit, including
payday lending, when it takes over responsibility in April 2014 [online]. Available at:
http://www.fca.org.uk/news/firms/consumer-credit-detail [Accessed: 18 May 2016].
FCA (2015) The FCA’s approach to supervision for fixed portfolio firms [pdf]. Available
at: http://www.fca.org.uk/static/documents/corporate/supervision-guide-fixed.pdf [Accessed: 18
May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
6. In respect of the fair treatment of customers, what does the FCA expect a
business to be able to demonstrate?
7. Explain the term ‘capital adequacy’.
8. List the types of financial crime.
9. What are the powers available to someone who has been appointed to
undertake an investigation on the FCA’s behalf?
Learning objectives
After studying this topic you should be able to:
3.1 Introduction
This topic examines the FCA’s Conduct of Business Sourcebooks, which are
important in the context of advising clients and customers. We saw in Topic 2
that these Sourcebooks are part of the Handbook published by the regulators,
setting out the rules for financial service providers to follow.
The four Sourcebooks covered in this topic are the ones that are most relevant
in the retail financial services environment, and therefore applicable in the adviser
and planner roles. We will also overview the regulation of payment service providers
as this links to the Banking Conduct of Business Sourcebook (BCOBS).
The Sourcebooks can be examined in much more detail on the regulator’s website;
the information contained in this topic is a summary version to provide a general
introduction.
There are 22 chapters to this Sourcebook. The information presented here relates
primarily to retail markets and concerns the sales process covered in Topic 18 and
Topic 19. Students are only required to be able to summarise the following details:
u COBS 1: Application This explains, in general terms, which firms and activities
COBS applies to and the territorial scope of COBS.
u COBS 2: Conduct of business obligations This explains that a firm must
act honestly, fairly and professionally with the best interests of its client
in mind. Clients must be provided with information that is appropriate and
comprehensible about the firm and its services, products and investment
strategies, costs and associated charges. This rule covers payments of fees
and commissions and when they are appropriate.
u COBS 3: Client categorisation A firm must notify a new client of
its categorisation as a retail client, a professional client or an eligible
counterparty (such as investment firms, credit institutions, insurance
companies, undertakings for the collective investment of transferable securities,
pension funds and national governments).
u COBS 4: Communication with clients, including financial promotions
This stipulates that communications of whatever sort must be fair, clear and not
misleading. Information must be presented in such a way as to be understood
by the average reader. Firms must not cold-call unless there is an existing
relationship with the provider and other criteria about the product can be met.
u COBS 5: Distance communication This covers the time to be allowed to
consumers before they are bound by contracts (conducted over the phone
for example) and that any e-commerce activities will have information easily,
directly and permanently accessible.
u COBS 6: Information about the firm, its services and remuneration This
covers the costs to be paid by the retail client, and that firms must disclose
commissions to retail clients.
u COBS 7: Insurance mediation Clients taking life insurance must be provided
with specific information about that product. The firm must specify the demands
and needs of that client and, if they have given advice, supply the client with a
suitability report.
u COBS 8: Client agreements Firms must enter into a written basic agreement
with a retail client setting out the rights and obligations of both parties.
u COBS 9: Suitability (including basic advice) This deals with the need for
firms to ensure that any personal recommendations are suitable for the client.
This includes gathering sufficient information and using pre-scripted questions.
Suitability reports must be provided.
u COBS 10: Appropriateness (for non-advised services) Where a client does
not wish to take advice the firm must ask the client to provide information on
their knowledge and experience so it can determine whether the product or
service is appropriate. If the firm does not consider the product or service to be
appropriate then it must warn the client.
u COBS 11: Dealing and managing This includes requirements for firms that
execute orders on behalf of clients, receive and transmit client orders or manage
client investment portfolios.
u COBS 12: Investment research This sets out the rules for managing conflicts
of interest relating to the production and distribution of investment research.
u COBS 15: Cancellation Firms must tell consumers about their right to cancel
life and pension policies, cash-deposit NISAs and certain non-life contracts. The
cancellation period is either 14 or 30 days depending on the type of product.
u COBS 16: Reporting information to clients This covers the need to supply
clients with reports on the services received, including any associated costs. It
includes regular statements for investments and deposits held.
u COBS 17: Claims handling for long-term care insurance This contains
rules on the information that must be provided to long-term care insurance
(LTCI) claimants and a rule on dealing with LTCI claims.
u COBS 18: Specialist regimes This contains provisions that modify COBS for
certain types of firm and activity, most of which are only relevant to non-retail
firms.
u COBS 21: Permitted links for long-term insurance business This relates
to policies where the benefits are wholly or partly reliant on the value of, or the
income from, property.
MCOB rules cover various activities including lending, administration, advice and
the arranging of loans. Banks, building societies, specialist lenders and mortgage
intermediaries need authorisation.
Mortgage sales, including those in respect of most variations of existing mortgage
contracts, are generally conducted on an advised basis. Execution-only sales are
only allowed in a limited number of circumstances; for example where a customer
is classed as being a high-net-worth customer or a mortgage professional.
Non-advised sales, where the customer is given information on a range of options
and picks one, are no longer allowed except for the most basic contract variations.
Advice is required where the sale has been conducted on an interactive basis,
with interaction between the consumer and a representative of the lender. Where
advice is given, the adviser must ensure the recommended product is suitable for
the customer.
The assessment of suitability must be based not only on a consideration of which
mortgage best suits the client’s needs and circumstances, but also on the initial
and ongoing affordability of the scheme for that client. This includes assessing
the impact of any possible increase in interest rates on a variable-rate mortgage
and considering the effect of the mortgage term running beyond a customer’s
retirement age. Responsibility for confirming the initial and ongoing affordability
of a mortgage sits with the lender, even where the mortgage has been introduced
by a third party, such as an intermediary.
Assessing the suitability of a mortgage involves three stages, as follows:
u assessing whether a mortgage is, in itself, a suitable product for the client;
u assessing what type of mortgage is suitable, in terms of both the method of
repayment (whether a repayment / interest-only or part and part mortgage is
suitable), the interest scheme (variable, fixed, tracker rate etc) and additional
features − the rules regarding interest-only mortgages have been tightened up
and a lender may now only grant an interest-only mortgage where the borrower
has a credible means of repayment;
u selecting the best mortgage and mortgage provider to meet the client’s needs
and circumstances.
Mortgage advisers, arrangers and lenders come under the scope of the Financial
Ombudsman Service and the Financial Services Compensation Scheme.
The structure of the Mortgages and Home Finance: Conduct of Business (MCOB)
sourcebook is as follows.
u MCOB 1: Application and purpose − this explains the scope of the rules, ie
to whom they apply and to what types of mortgages.
u MCOB 2: Conduct of business standards: general − this includes: the use
of correct terminology (‘early repayment charge’ and ‘higher lending charge’);
the requirement for communications with customers to be ‘clear, fair and not
misleading’; rules about the payment of fees/commissions; and the accessibility
of records for inspection by the FCA.
u MCOB 3: Financial promotions − this distinguishes between ‘real-time’
promotions (by personal visit or telephone call) and non-real-time promotions
(by letter, email or advert in newspapers, magazines or on television, radio or
the internet). Unsolicited real-time promotions are not permitted. Customers
must not be contacted during ‘unsocial’ hours (these are generally accepted
as 9pm to 9am, and all day Sunday) with due account taken of religious
beliefs and work patterns. Non-real-time promotions must include the name
and contact details of the firm. They must be clear, fair and not misleading, and
if comparisons are used they must be with products that meet the same needs.
They must state that ‘your home may be repossessed if you do not keep up
repayments on your mortgage’. Records of non-real-time promotions must be
retained for one year after their last use.
u MCOB 4: Advising and selling standards − this includes the information
that must be disclosed to the customer at the outset (the initial disclosures);
the content must include a clear explanation of whether advice is based on the
products of the whole market, a limited number of lenders or a single lender.
‘Independent’ advisers must be wholly or predominantly ‘whole of market’.
The nature of the way in which the firm is remunerated must also be made
clear, along with details of FCA regulation and coverage under the Financial
Services Compensation Scheme. Any mortgage recommended must be suitable
for the customer and appropriate to their needs and circumstances. Suitability
includes the requirement to ensure that the mortgage is affordable; records to
demonstrate this must be kept for three years. However, there is no regulatory
requirement to issue a suitability report to the client. Special requirements apply
if the mortgage will be used to consolidate existing debts.
u MCOB 7: Disclosure at start of contract and after sale − after the first
mortgage payment is made, the lender must confirm: details of amounts, dates
and methods of payment; details of any related products such as insurance;
the responsibility of the borrower to ensure that (for interest-only mortgages)
a repayment vehicle is in place; what the customer should do if they fall into
arrears. Annual statements must be issued, showing: the amount owed and
remaining term; the type of mortgage, and for interest-only a reminder to check
the performance of the repayment vehicle; interest, fees or other payments
made since the last statement; and any changes to the charges tariff since the
last statement. If a change is to be made to the monthly payment, the customer
must be informed of the new amount, revised interest rate and date of the
change.
u MCOB 8 and 9: Equity release − equity release are products used by older
customers to raise money using the equity in their property (the difference
between the value of their property and the debts secured on it) to raise
finance. Special rules apply to equity release (home reversion plans and lifetime
mortgages) in relation to advising and selling standards, and to product
disclosure.
u MCOB 12: Charges − ‘excessive’ charges are not permitted. Early repayment
charges must be a reasonable approximation to the costs incurred by the lender
if a borrower repays the full amount early. Similarly, arrears charges must be a
reasonable approximation to the cost of additional administration as the result
of a borrower being in arrears.
u MCOB 13: Arrears and repossessions − firms must deal ‘fairly’ with
customers who have mortgage arrears or mortgage shortfall debts. This
includes: trying to reach an agreement on how to repay the arrears, taking
into account the borrower’s circumstances; liaising with third-party sources
of advice; not putting unreasonable pressure on customers in arrears;
repossessing a property only when all other reasonable measures have failed.
Records must be kept of all dealings with borrowers in arrears. Customers
in arrears must be given the following information within 15 working days
of becoming aware of arrears: the FCA information sheet on what do when
in arrears; the missed payments and the total of arrears including any charges
incurred; the outstanding debt; any further charges that may be incurred unless
arrears are cleared.
Member states had until 21 March 2016 to implement the new requirements. The
system of regulation in respect of secured credit in the UK was already considered
robust and met many of the requirements of the MCD. Some changes have been
made to ensure full compliance with the MCD, as follows:
u The regulation of second charge lending was already within the remit of the FCA,
but the FCA has changed the nature of the regulation, moving its requirements
from the CONC (Consumer Credit) sourcebook to MCOB.
u Buy-to-let mortgages were regulated under CONC. Since 21 March 2016,
there has been a distinction between ‘consumer’ buy-to-let mortgages (now
regulated under MCOB) and ‘business’ buy-to-let mortgages (which are now
unregulated). Examples of consumer buy-to-let mortgages would be situations
where someone has inherited a property, or has moved house and is unable to
sell their previous property and so decides to raise a mortgage on the property
so they can then rent it out.
u In respect of second charge lenders, the switch from CONC to MCOB means
that their business processes have to become more robust, particularly with
u insurance mediation;
It also covers: communications (which must be clear, fair and not misleading);
inducements (managing conflicts of interests fairly, and not soliciting or accepting
inducements that would conflict with a firm’s duties to its customers); record
keeping; and ‘exclusion of liability’ (a firm must not seek to exclude or restrict
liability unless it is reasonable to do so).
u Name.
u Address.
Firms are free to offer more generous cancellation terms than this, provided that
they are favourable to the consumer. The right to cancel does not apply to the
following:
u travel policies of less than one month;
u policies, the performance of which has been fully completed;
u pure protection policies of six months or less, which are not distance contracts;
u pure protection policies effected by trustees of an occupational pension scheme,
or employers (or partners) for the benefit of employees (or partners);
u general insurance (which is not a distance contract or payment protection
contract) sold by an intermediary who is an unauthorised person.
On receipt of the cancellation notice the insurance company must return all
premiums paid within 30 days, and the contract is terminated.
u The (then applicable) ‘Treating Customers Fairly’ (TCF) principle, now fair
treatment of customers, did not have an equivalent for day-to-day banking
operations, which increased the risk of potential customer detriment. The FCA,
however, has the ability to fine and suspend operations of providers if it sees
fit.
u UK branches of credit institutions authorised in other EEA states are now subject
to BCOBS rules, which afford better protection for customers.
u There was increased pressure from government and the public for more controls
over the financial services sector due to recent regulatory failures. It has been
necessary to bolster public confidence in the UK financial services industry and
further regulation may go some way to doing this.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
7. What was put in place to cover areas of banking not dealt with in BCOBS?
8. What are the post-sale requirements under BCOBS?
9. Which firms are affected by the Payment Services Regulations?
Learning objectives
After studying this topic you should be able to:
u explain the regulatory requirements concerning complaints;
u summarise the role of the Financial Ombudsman Service;
u summarise the role of the Pensions Ombudsman;
u explain the Financial Services Compensation Scheme.
4.1 Introduction
This topic is concerned with the key elements of the rules for dealing with
complaints and compensation. There are various organisations that deal with
complaints and compensation. One of the main objectives of the FCA is to
‘secure an appropriate level of protection’ for consumers of financial services
and products. One step towards the achievement of this objective is to make it
easier for customers to know how to complain when they feel that they have been
badly treated by a financial institution or by an individual working in the industry.
Customers who are not satisfied with a firm’s response to their complaint can refer
the matter to the Financial Ombudsman Service (FOS), a dedicated independent
ombudsman bureau. In some circumstances, customers who have lost money can
receive compensation.
It must always be borne in mind, however, that consumers cannot be given
100 per cent protection, and they should take some responsibility for the
purchasing decisions that they make. Examples of this from the financial services
industry are that investors cannot be protected from falls in stock market values
(although it will attempt to educate consumers about the risks involved) and
that the Financial Services Compensation Scheme sets limits on the amounts of
compensation it can offer.
It is important for providers to identify the root cause of any recurring complaints
and their impact on other processes or products, even though they may not be
directly connected. These problems should be corrected where it is reasonable
to do so, as a failure to do so could lead to a reputational risk for the provider.
A firm is required to have appropriate management controls and take reasonable
steps to ensure it identifies and remedies any recurring or systemic problems. This
would include analysing the causes of individual complaints so as to identify root
causes common to types of complaint; considering whether such root causes may
also affect other processes or products, including those not directly complained
of; and correcting, where reasonable to do so, these root causes.
Recognising the importance of complaints to the industry and to customer
protection, financial services providers are required to identify a senior individual
who is responsible for complaint-handling within the firm.
Example 1
A shopkeeper goes in to his local bank branch at peak time to pay in some
takings. Whilst the branch is fully staffed and customers are being seen quite
quickly, it is not quick enough for him. When he gets to the cashier, he
expresses his frustration and that he is not happy at how long he has had
to wait.
Example 2
An elderly lady goes into her building society branch at a normally quiet time
to pay in a cheque. There is only one cashier working due to staff sickness and
there is a long queue. The lady is very worried as she needs to visit a friend,
who is very ill in hospital. She is worried that she will miss her bus meaning
that she will have to get a taxi, which she can’t afford. When she eventually
gets to the cashier she expresses her dissatisfaction and her worry that she
might miss the visiting hours.
These cases are both complaints. In example 1, the complaint may be able to be
dealt with relatively quickly and within three business days of receipt, as there is
no financial loss and there is no indication that the inconvenience is considered by
the customer as material. A simple apology may be all that is required to resolve
the matter to the customer’s satisfaction. In example 2, the consequences for the
customer are likely to result in financial loss and the distress would certainly be
material from the customer’s perspective. It may be that the matter can be resolved
within three business days, for example by adding the value of the taxi fare to the
customer’s account as compensation. However, the circumstances may require
careful investigation and if a solution cannot be agreed with the customer, ie if
the customer does not accept this, then the firm has eight weeks to try to agree a
suitable outcome.
4.2.5 Reporting
Six-monthly reports about the progress of complaints are required by the regulator,
showing:
u the total number of complaints received by the firm;
u the number of complaints closed by the firm (within four weeks or less of
receipt; more than four weeks and up to eight weeks of receipt; and more than
eight weeks after receipt);
u the number of complaints upheld by the firm in the reporting period;
u the root causes of complaints and corrective action taken to prevent recurrence.
As mentioned in 4.2 above, reporting requirements are simplified where a firm
receives fewer than 500 complaints in a six-month period.
The FOS service is free to customers and is open to eligible complainants described
in section 4.2. It bases its decisions on what is fair and reasonable depending on
the circumstances of each case. The FOS does not make the rules under which firms
are authorised, nor can it give advice about financial matters or debt problems.
Membership is compulsory for all firms authorised under the FSMA 2000. It is
funded by the firms that are members of the FOS. In addition to paying a general
levy, firms are charged a case fee for the 26th and each subsequent case, which in
2016/17 is £550 (maintained at the same level as for the previous two years).
As already mentioned, complainants must first complain to the firm itself; the FOS
will become involved only when a firm’s internal complaints procedures have been
exhausted without the customer obtaining satisfaction.
Complaints to the FOS must be made:
u no more than six months after the date on which the firm sent the complainant
its final response to the complainant; or
u within six years of the event that gives rise to the complaint; or
u within three years of the time when the complainant should reasonably have
become aware that they had cause for complaint, whichever is the later.
The maximum award that the FOS can make is £150,000 plus interest and the
complainant’s reasonable costs. Awards are binding on the firm but not on the
complainant, who is free to reject the FOS decision and pursue the matter further
in the courts if they wish. An award is not intended to punish the firm, but to put
the complainant back into the same financial position in which they would have
been had the event complained about not taken place.
u set out a timetable for regulatory action which would allow the FOS to consider
whether or not to place a hold or stay on complaints;
u explain how the FCA is already taking action to address an issue; or
u explain why it is not taking any action. It can also carry out wider enquires
with a view to testing the evidence like internal research, public requests of
information and carry out a review of the relevant regulated firms.
Compensation arrangements for customers who have lost money through the
insolvency of an authorised firm causing the firm to fail, comprise a number of
sub-schemes relating to:
u loss of deposited funds;
u investments;
u home finance;
u insurance business;
u insurance mediation.
Payment under the FSCS deposit sub-scheme is triggered when a firm authorised
to accept deposits by the Prudential Regulation Authority (PRA), such as a bank
or building society, goes out of business, for example if the firm goes into
administration or liquidation, and is unable to repay its depositors. FSCS can also
be involved if the PRA considers that an authorised firm is unable, or likely to be
unable, to repay its depositors.
In respect of loss of deposited funds, the protection is 100 per cent of the first
£75,000 (with effect from 1 January 2016). There is additional cover of up to £1m in
respect of ‘temporarily high balances’ that have been held for a period of less than
six months. This applies, for example, where a person’s savings are temporarily
boosted by certain life events such as receipt of an inheritance, sale of a property
or taking a lump sum from a pension. The majority of cases are paid within seven
days, with more complex cases taking up to 20 days.
The investment sub-scheme covers situations of loss due to insolvency of a
firm carrying out investment business regulated under FSMA 2000. Typically this
includes the insolvency of a firm advising on or arranging investments. Cover is
100 per cent of the claim up to a maximum of £50,000.
The home finance sub-scheme protects customers of authorised mortgage firms
in respect of business conducted on or after 31 October 2004. FSCS can provide
protection if a mortgage firm is unable, or likely to be unable, to pay claims against
it. FSCS is triggered when a firm authorised to advise on or arrange mortgages by
the Financial Conduct Authority (FCA), goes out of business, for example if the
firm goes into administration or liquidation. Where a claim is made against a firm
involved in home finance (mortgage) advice or arranging, the maximum claim is
100 per cent, up to a maximum of £50,000.
The sub-scheme for insurance business covers claims for compensation that arise
following the failure of an authorised insurer (life and general). The level of cover
depends on the nature of the policy.
u For all long-term insurance and for certain types of general insurance
compensation is 100 per cent of the value of the policy, with no upper limit
(policies with 100 per cent protection include long-term and general insurance
policies that provide benefits on death / disability only).
u Where a policy includes both a protection element and a savings element then
the protection element has 100 per cent compensation.
u If the insurance is compulsory (such as employer’s liability cover or some types
of motor insurance), the figure is 100 per cent of the whole amount.
u Annuities also receive 100 per cent cover should the insurance company
providing the income become insolvent and therefore unable to continue to
make payment under the annuity contract.
In respect of insurance mediation, the process of arranging insurance, the FSCS will
safeguard policyholders if an authorised firm is unable, or likely to be unable, to
pay claims against it, for example if it has been placed in provisional liquidation or
administration. Compensation is 90 per cent with no upper limit. If the insurance is
compulsory (such as employer’s liability cover or some types of motor insurance),
the figure is 100 per cent of the whole amount.
Claims cannot be made against the FSCS for other losses, ie those due to
negligence, poor advice or simply due to a fall in stock market values.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
4. What are the three different areas into which the Financial Ombudsman Service
divides complaints?
Learning objectives
After studying this topic you should be able to:
5.1 Introduction
In addition to the legislation already described in the topics concerning the PRA
and FCA, the interests of financial services customers are safeguarded by aspects
of a range of other laws and regulations. Some of these relate closely to financial
services, while others are aimed more broadly at the rights of consumers in general.
Many of these regulations are the result of EU directives and regulations − touched
upon in section 1.4.1.
This topic shows how a range of non-tax laws and regulatory schemes affect
different aspects of financial services including consumer credit, the terms
and conditions relating to customer agreements, pensions, advertising and
safeguarding customer information.
of safeguards under which potential borrowers must be made aware of the nature
and conditions of a loan, and of their rights and their obligations.
The Act affects most aspects of a bank’s lending activities, including personal
loans and revolving credit such as credit cards. Not all loans are covered by the
Act. Loans for the purchase of a private dwelling are exempt and further loans for
the improvement or repair of a private dwelling are also exempt, provided that
they are from the same lender as the original mortgage loan. Loans raised on the
security of a dwelling but used for other purposes are not exempt (unless on a first
charge basis).
Regulated mortgages are exempt from the Act but they are regulated by the
FCA. Therefore, further advances are exempt, regardless of their purpose. Second
charge loans are also now regulated by the FCA. A regulated mortgage contract is
one that is secured on land, at least 40 per cent of which is used, or intended to
be used, as or in connection with a dwelling. There is an exception for ‘consumer’
buy-to-let mortgages, which also fall under MCOB regulation even though they do
not meet the 40 per cent rule.
u Clients must receive a copy of the loan agreement for their own records.
u Prospective borrowers have a cooling-off period during which they can review
the terms of the loan and, if they wish, decide not to proceed with the
transaction. This applies to all loans regulated by the Act, unless the loan
agreement is signed on the lender’s premises.
u Undesirable marketing practices are forbidden: for instance, advertisements
must not make misleading claims.
u Credit reference agencies must, on request, disclose information held about
individuals and must correct it if it is shown to be inaccurate.
One of the Act’s most significant innovations was a system for comparing the price
of lending. This is the annual percentage rate (APR), which must be quoted for
all regulated loans. The APR represents a measure of the total cost of borrowing
and its aim is to allow a fair comparison, between different lenders, of the overall
cost of borrowing.
The calculation of the APR is specified under the Consumer Credit Act 1974 and it
takes account of two main factors:
u the interest rate − whether it is charged on a daily, monthly or annual basis;
u the additional costs and fees charged when arranging the loan, eg an
application fee.
The result is that the APR is higher than the actual rate being charged on the
loan. However, it gives consumers the opportunity to make comparison between
different providers with the ability to compare ‘like with like’ on the basis of total
cost rather than simply headline rates, which are often used to attract customers.
provided with adequate explanation of the credit agreement and the borrower
must be able to ask questions about the agreement or to request further
information.
u There are also a number of other changes mainly relating to information that
should be made available to the borrower.
The Pensions Act 1995 introduced changes to several aspects of pension provision
and supervision, not least of which related to concern about the security of
occupational pensions. Public confidence in the security of occupational pension
schemes had been severely dented by the Maxwell affair, where pensioners’ funds
were used to meet the general financial obligations of the company that scheme
members worked for. The government sought to restore confidence with measures
designed to prevent fraud and to improve the administration of occupational
schemes.
The later Pensions Act 2004 was, in part, a response to the worsening pensions
crisis in the UK. Two particularly important elements of the 2004 Act were the
establishment of the Pension Protection Fund and the transfer of regulatory
responsibility for occupational pension schemes from the Occupational Pensions
Regulatory Authority (OPRA) to the newly created Pensions Regulator. The Pension
Protection Fund provides a degree of security to the members of defined-benefit
occupational pension schemes in the event that the employer providing the scheme
becomes insolvent.
The Pensions Act 2008 built on these provisions and is aimed at enabling and
encouraging more people to build up a private pension income to supplement
the money they will receive from their basic state pension. A key element was
the introduction in 2012 of the process of auto-enrolment; this applies to many
employees and means that they will automatically become members of a qualifying
workplace pension.
The Taxation of Pensions Act 2014 introduced a range of new options in respect
of the way that members of money purchase pension schemes could take their
pension benefits. The stated objective was to provide greater freedom and choice
in respect of pension benefits.
Like the FCA, TPR has a set of statutory objectives, through the Pensions Acts 2004
and 2008.
u To protect the benefits and rights of members of occupational pension schemes.
u To protect members of personal (and stakeholder) pension schemes where
employees have direct payment arrangements.
u To promote, and improve understanding of, the good administration of
work-based pension schemes.
u To reduce the risk of situations arising that may lead to claims for compensation
from the Pension Protection Fund.
u To maximise employer compliance with employer duties and safeguards
under the Pensions Act 2008 (including the requirements in respect of
auto-enrolment).
u (In carrying out its duties) to minimise any adverse impact on the sustainable
growth of an employer.
TPR aims to identify and prevent potential problems rather than to deal with
problems that have arisen. It will do so by assessing the risks that may prevent
it from meeting its statutory objectives. These risks might include inadequate
funding, inaccurate record keeping, lack of knowledge or understanding by the
trustees, or even dishonesty or fraud. TPR will consider the combined effect of two
factors related to each risk: the likelihood of the event occurring and the impact
of the event on the scheme and its members. Schemes that are judged to have a
higher risk profile will be more closely monitored than those with lower risk.
TPR has a range of powers that enable it to protect the security of members’
benefits. These fall broadly into three categories.
u Investigating schemes in order to identify and monitor risks. All schemes
must make regular returns to the Regulator. In addition, trustees or scheme
managers must give notification of any changes to important information, such
as the types of benefit being provided by the scheme. TPR also demands
to be informed quickly if the scheme discovers that it cannot meet funding
requirements, so that remedial action can be taken at an early stage.
u Putting things right if they have gone wrong, which can include:
− requiring specific action to be taken to improve matters within a certain time;
− recovering unpaid contributions from an employer who does not pay them
to the scheme within the required period (by the 19th day of the month
following that in which they were deducted from the member’s salary);
− disqualifying trustees who are not considered fit and proper persons;
− imposing fines or even prosecuting certain offences in the criminal courts.
u Acting against avoidance, ie preventing employers from deliberately
avoiding their pensions obligations and so leaving the Pension Protection Fund
to cover their pension liabilities. The main actions TPR can take are to issue:
− contribution notices, requiring the employer to make good the amount of
the debt either to the scheme or to the Pension Protection Fund; or
− financial support directions, which require financial support to be put in
place for an underfunded scheme.
The Pensions Act 2004 requires TPR to issue voluntary codes of practice on a
range of subjects. The codes provide practical guidelines for trustees, employers,
administrators and others on complying with pensions legislation, and set out the
expected standards of conduct.
The Act also requires trustees to have a sufficient knowledge and understanding of
pension and trust law, and of scheme funding and investment. Trustees also must
be familiar with the trust deed and other important documents such as the scheme
rules and the statement of investment principles. These requirements came into
force in April 2006.
The PPF will ensure that, where a company with an eligible defined-benefit scheme
becomes insolvent, with an insufficiently funded scheme, members of that scheme
will still receive the core of the benefits to which they are entitled. The PPF will
provide compensation of:
u 100 per cent for scheme members who have reached the scheme’s normal
pension age, members already in receipt of a pension on grounds of ill health
and members in receipt of a survivor’s benefit (where the original member has
died);
u 90 per cent for current and ex-scheme members who are aged below the
scheme’s normal pension age, subject to an overall benefit cap.
The upper percentage limits outlined above are increased by 3 per cent per year
for long service members, ie those with more than 20 years’ pensionable service.
This is subject to an overall limit on compensation of twice the overall benefit cap.
To ensure that PPF compensation retains its value over time, pensions in payment
will be increased in line with the retail price index (RPI) up to a maximum of
2.5 per cent.
Compensation will be funded in two ways: firstly, by taking over the assets of
pension schemes with insolvent employers, and secondly by means of a levy on all
private sector defined-benefit schemes and the defined-benefit element of hybrid
schemes. The levy is split into three parts.
u A pension protection levy which is made up of a scheme-based levy and
a risk-based levy. The risk-based levy is based on risk factors, including
underfunding, credit rating and investment strategy. Eventually, this is expected
to constitute at least 80 per cent of the total amount collected by the PPF. The
5.5.2.1 Fairness
The main requirements are that all terms in regulated contracts should:
u be fair, with a contract or notice being deemed to be unfair if it causes a
significant imbalance in respect of the rights and obligations of the various
parties to the contract to the detriment of the consumer;
u adhere to the requirement of good faith (see section 5.5.2.3).
Any unfair term or notice will not be binding on the consumer unless they choose
to be bound by it. Where an element of the contract is deemed to be unfair then
the rest of the contract can continue to take effect, as long as this is practicable.
Terms that may be deemed as unfair include:
u disproportionately high charges where the consumer decides not to proceed
with services that have yet to be supplied;
u terms allowing the business to determine the characteristics or subject matter
after the consumer is bound;
u terms allowing the business to determine the price after the consumer is bound.
5.5.2.2 Transparency
The written terms of a contract should be transparent and expressed in clear, easily
understood language. If there is any doubt about the meaning of a written term,
the interpretation most favourable to the consumer will be adopted.
of the context of the advertisement, the medium used and the likely audience;
particular care should be taken with sensitive issues such as race, religion, sex
or disability);
u financial difficulty;
u customer vulnerability.
There is also a section on governance and oversight, which sets the framework
that registered firms should have in place to ensure effective implementation of
the standards.
The standards cover the following products:
u unsecured loans;
u credit cards;
u overdrafts.
Registered firms must at all times comply with the Consumer Credit Act 1974,
the Consumer Credit (EU Directive) Regulations 2010, the FCA’s Consumer
Credit Sourcebook (CONC), the Equality Act 2010 and other relevant legislation.
Compliance is monitored and enforced by the Lending Standards Board.
Overarching principles
The LSB details overarching principles of lending that registered firms should
adhere to when dealing with their customers. Registered firms will ensure that
their customers:
u are told about the products the firm offers, do not face unreasonable barriers
in accessing the products and are provided with clear information to help them
select a product;
u are assured that firms are committed to promoting their products responsibly;
u are provided with clear information about the application process, including
making customers aware of the impact of any application on their credit rating;
u are aware of the factors on which the firm will base their decision to lend and,
if declined, the main reason for this;
u are provided with clear and understandable documentation and information
that details both parties’ rights and obligations;
u will be supported if they anticipate, or the firm becomes aware, that they have
or are having difficulties in repaying their borrowing;
u Governance and oversight − firms are expected to put in place policies and
procedures that ensure customers receive a fair outcome when taking out a
consumer credit product and throughout all their dealings with the firm.
5.8.1 Definitions
The DPA 1998 uses a number of words and phrases that have precise meanings
within its terms. These include the following.
u Data subject: an individual whose personal data (see below) is processed.
u Personal data: the Act relates only to personal data, which is defined as
‘information relating to a living individual who can be identified from that
information or from a combination of that information and other information in
the possession of the data controller’ (see below).
u Sensitive personal data: this data can only be processed if the individual
has given explicit consent (in other words, it is not sufficient to claim that the
individual has never specifically withheld their consent). Sensitive data includes
information about an individual’s:
− racial origin;
− religious beliefs;
− political persuasion;
− physical health;
− mental health;
− criminal (but not civil) proceedings.
u Processing: this has a very broad meaning, covering all aspects of owning
data, including:
− obtaining the data in the first place;
− recording of the data;
− organisation or alteration of the data;
− disclosure of the data by whatever means;
− erasure or destruction of the data.
u Data controller: this is the ‘legal’ person who determines the purposes for
which data is processed and the way in which this is done. It is normally an
organisation/employer, such as a company, partnership or sole trader. The
data controller has prime responsibility for ensuring that the requirements of
the Act are carried out.
u Data processor: this is a person who processes personal data on behalf of the
data controller.
1. Data must be processed fairly and lawfully. This includes the specific
requirement for the data controller to tell the individual what information will
be processed and why, and whether it will be disclosed to anyone else. Data
must not be processed unless the data subject has given their consent or the
processing is necessary for one of the following reasons:
a. to perform the data controller’s contract with the data subject or to protect
the interests of the data subject;
b. to fulfil a legal obligation or to carry out a public function;
c. to pursue the legitimate interests of the data controller − unless this could
prejudice the interests of the data subject.
2. Data must be obtained only for a specified lawful purpose or purposes and must
not be processed in any way that is not compatible with the purpose(s) − this
includes the use of the data by any person to whom it is later disclosed.
3. Data must be adequate (but not excessive) and relevant to the purpose for which
it is processed. This should be borne in mind by advisers when determining how
much information it is appropriate to collect and retain in a factfind document.
5. Data must not be kept for longer than is necessary. This will be dictated to
some extent by FCA rules on how long information must be kept.
6. Data must be processed in accordance with the rights of data subjects. These
include:
a. the right to receive (on payment of a fee of £10) a copy of the information
being held (the information must be provided within 40 days of a written
request);
b. the right to have the information corrected if it can be shown to be incorrect.
5.8.3 Enforcement
The Information Commissioner oversees the application of the DPA. The
Commissioner’s responsibilities are:
The Commissioner can act as follows if the Commissioner believes that there has
been an infringement of the terms of the Act:
u serve information notices requiring organisations to provide the Information
Commissioner’s Office with specified information within a certain time period;
u issue undertakings committing an organisation to a particular course of
action in order to improve its compliance;
u serve enforcement notices and ‘stop now’ orders where there has been a
breach, requiring organisations to take (or refrain from taking) specified steps
in order to ensure they comply with the law;
u conduct consensual assessments (audits) to check organisations are
complying;
u serve assessment notices to conduct compulsory audits to assess whether
organisations processing of personal data follows good practice (data
protection only);
u issue monetary penalty notices, requiring organisations to pay up to
£500,000 for serious breaches of the DPA occurring on or after 6 April 2010 or
serious breaches of the Privacy and Electronic Communications Regulations;
u prosecute those who commit criminal offences under the Act; and
u explicit consent must be provided by the data subject before the details are
added to mailing lists and used for marketing purposes;
u businesses must be able to prove that the consent of both new and existing
subscribers has been gained;
u businesses need to advise their customers, in an easily understandable way,
how their data will be used;
u individuals are more easily able to access the data held about them;
u individuals have a right to be informed if their data has been ‘hacked’;
References
CMA (no date) [online]. Available at: https://www.gov.uk/government/organisations/competition-and
-markets-authority/about [Accessed: 19 May 2016].
European Commission (2016) Protection of personal data [online]. Available at:
http://ec.europa.eu/justice/data-protection/ [Accessed: 19 May 2016].
FCA (2015) CONC 3.4 Risk warning for high-cost short-term credit [online]. Available at:
https://www.handbook.fca.org.uk/handbook/CONC/3/4.html [Accessed: 13 June 2016}
Web Analytics World (2012) Summary of the proposed new EU Data Protection Regulation [online].
Available at: http://www.webanalyticsworld.net/2012/03/summary-of-the-proposed-new-eu-data-
protection-regulation.html [Accessed: 19 May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
7. The Standards of Lending Practice detail principles covering six main areas.
What are these areas?
8. What type of lending is not covered by the Standards of Lending Practice?
9. Under the Data Protection Act 1998 what does ‘processing data’ mean?
10. Explain the main rights that customers have in relation to factfind information
held by a financial services provider.
Learning objectives
After studying this topic you should be able to:
6.1 Introduction
Clients often have a range of financial needs, even when they approach an adviser
with one particular need in mind. In order to give the most appropriate advice,
advisers must be aware of the nature of all of the needs that clients may have
and must be able to recognise those needs even where clients themselves are not
aware of them. Some needs may be immediate, such as family protection, while
others, particularly retirement needs, may seem a long way off.
In this topic we will consider how an adviser can determine a client’s financial goals,
needs and objectives, which will be influenced to some degree by where they are
in their ‘financial life cycle’. Goals are a client’s non-financial future aspirations;
needs are the financial requirements that help them achieve those goals; and
objectives are the actions a client needs to take to help them achieve their goals.
Part of considering the client’s current circumstances will be to assess how they
manage their income and expenditure through budgeting. We can appreciate that
there are events in a person’s life which lead to a deficit situation in their monthly
income; this could be, for example, from the loss of a job. This deficit can be met
by the benefits from a financial protection product. If a person wishes to make a
substantial purchase, for example a house, then borrowing by way of a mortgage
loan would fill this need. The adviser has to ensure that the mortgage loan
repayments are affordable for the customer and must explore with the customer
how unforeseen events could affect their ability to repay. We will look at a range
of these issues in this topic.
u Few or no contributions being paid towards saving for retirement, which will
mean being dependent upon state benefits unless action is taken.
u People who have not made a valid will, whose assets on death may therefore
not be distributed as desired.
The adviser’s role is to define the client’s goals, needs and objectives accurately, to
enable the client to see the key issues facing them, and to recommend and discuss
a priority order for action.
Failing to establish a priority order with the client can result in a client ignoring
an adviser’s recommendations. The client’s priorities may well differ from those
that the adviser feels appropriate, and so the process is one of discussion and
agreement rather than straightforward selection by any single person. In the end,
however, deciding a plan of action and agreeing its priority order remains the
client’s decision, assisted by the adviser’s recommendations.
6.2.1.7 Retirement
Prior to retirement, most people’s financial planning is centred on converting
income into lump sums (or lump sums into bigger lump sums). At retirement,
when income from employment ceases, the focus changes: the requirement is now
to produce income from capital. Other factors also become more relevant: the need
to prepare for possible inheritance tax liabilities should be considered. Similarly
the cost of health care, and possibly of long-term care in old age, may become an
issue.
The above stages can be used by providers to categorise customers into ‘market
segments’ for marketing and promotional purposes. Age or time of life is not,
of course, by any means the only way in which market segments can be defined,
but it has been analysed in detail to give an illustration of the concept. Other
breakdowns are possible, for instance, by the level of annual income or by an
individual’s attitude to investment risk. Both of these characteristics can contribute
6.3 Budgeting
The need to budget underpins all other forms of financial planning. At its simplest,
it reflects the need to have sufficient funds to purchase the necessities of daily
living. It also encompasses the need to determine how much can be spent on other
items: on capital purchases; on leisure pursuits and holidays; on provision for a
secure retirement.
Many savings products can be used to budget for future capital and income needs,
but advisers must be careful not to put pressure on the client’s current and future
income when selling products paid for out of that income. An increase in mortgage
interest rates, for example, could push a family’s expenditure beyond its means.
It might be argued that the need to balance the budget on a weekly/monthly basis
is not as great as it once was: despite the credit crunch, credit is still more readily
available than it was for previous generations, but all borrowing must be repaid at
some point, and advisers should exercise caution when considering clients’ likely
future income and expenditure levels.
Conversely, the need to be able to budget is of great importance when a client is
being considered for mortgage finance, as affordability is one of the key factors a
lender will take into account when assessing a mortgage loan application. In this
situation it would not be acceptable for an applicant to make up any shortfall in
monthly income by relying on their overdraft. Advisers in this instance do have
to discuss with clients the impact of increases in interest rates, particularly when
lenders offer discounted rates in the early years of the mortgage term.
A budget can be prepared on a monthly or annual basis by totalling all of the
client’s income and subtracting all their regular outgoings. The clients may then
consider any large items of expenditure they wish to make. If expenditure is greater
than income then the client has to consider how they will close this ‘gap’, either by
reducing costs (say by downsizing their property) or increasing income (by taking
in a lodger, for example). This can be a useful exercise for the client as it prevents
them from ignoring problems of overspending.
Once the budget has been prepared the client will be able to see how much they
need each month to meet their regular outgoings. They should be encouraged to
start saving for an emergency fund, ie a pot of money they can use should the
unexpected happen, for example the loss of their job or a serious accident that
prevents them from working. As a general rule, the amount of the emergency fund
should be three times their monthly outgoings. There are several products where
this fund can be safely kept with immediate access, such as a deposit account (see
section 13.3.1).
When advisers make recommendations it is important that they assess affordability
to ensure that the client can maintain any financial plans they have taken out.
6.4 Protection
The need for financial protection comes from the fact that life can be uncertain
and it is not possible to avoid all the dangers and difficulties that it can bring. It is,
on the other hand, possible to take sensible precautions against the impact of the
risks that affect people, their lives, health, possessions, finances, businesses and
their potential inheritances.
Many people, however, make little or no provision for minimising the financial
consequences of death or serious illness. This may be because they are not aware
of the size of the risk or because they believe that they cannot afford to provide
the cover, not realising how cheap it can be, especially if taken out when young.
Statistics for the UK from the Office for National Statistics, based on mortality rates
between 1981 and 2014, and assumed mortality rates from 2014, suggest that, in
2015, a newborn male would expect to live to the age of 79.4 years and a newborn
female to live to the age of 83.4 years, which would suggest significant periods of
time in retirement (ONS, 2015).
In 2011 (the most recent year for which figures are available), 40 per cent of all
adults aged over 20 in the UK had a longstanding illness. In respect of males and
females aged over 20 with longstanding illness the percentages are as follows:
u 39 per cent of males;
u 41 per cent of females (ONS, 2016a).
In 2014 there were 296,893 newly diagnosed cases of malignant cancer in England
(ONS, 2016b).
It can therefore be seen that, for people of working age, the risk of illness is much
greater than that of dying.
Regardless of the risks, many people take an ‘it won’t happen to me’ attitude but,
the simple fact is, it might!
the remainder of the loan term, or by providing for a lump sum to pay off the
outstanding loan capital.
It is equally important for the life of a dependent spouse or homemaker to be
insured, even though they are not the family’s earner. In the event of their death,
the normal earner may have to give up work in order to look after the children, or
may have to pay the cost of full-time childcare.
a deceased shareholder to prevent the shares from going out of the close circle of
existing shareholders.
The exact nature of what constitutes suitable advice in a particular case will depend
on a variety of factors, including the term, affordability (at outset and on an ongoing
basis), any preferences for stability of payments or special features, and the client’s
employment status. Failing to protect the outstanding capital or the repayments
against sickness, death or redundancy can leave a client’s family destitute or lead
to their having to leave their home. Many clients are unaware of the magnitude of
the risk, or of the ease with which it can normally be mitigated.
A low level of interest rates coupled with strong house price inflation led, before
the credit crisis, to a large increase in individual and family indebtedness in the UK,
with many people increasing the proportion of their net income that they spend
on mortgage and other loan repayments. Increases in interest rates or a reduction
in income can leave people unable to service the high levels of debt that they have
taken on.
Borrowers can suffer from ‘over-indebtedness’, which broadly means that a
borrower has taken on too much debt, often from a variety of different sources,
and for some reason starts to have difficulty in repaying. As soon as the borrower
is late paying loan repayments (arrears) or goes over overdraft limits (excesses)
their credit rating is downgraded and they will have problems borrowing further
to ‘catch up’. Before the 2007/08 credit crunch, home owners in this position
were able to extend their mortgage loans, so using the increasing value of their
properties to fund their spending habit and clearing their outstanding overdrafts
and credit cards, only to start again.
The advantage of this refinancing is that the overall monthly repayments are
reduced, because the new loans are now subject to a lower rate of interest and
a longer repayment term. A serious downside to doing this is that the formerly
unsecured loan is now secured on the property, adding to the borrower’s problems
if they default on the repayments of the consolidated loan. Borrowers can then find
themselves in a position of ‘insolvency’, which means they are unable to pay their
debts as they fall due. They are no longer deemed creditworthy and have a number
of possible routes to take, the most serious of which is bankruptcy, which we
will consider in section 20.7. A further consideration is that, whilst monthly loan
repayments may reduce, the total cost of repaying the loan increases as a mortgage
generally runs over a much longer time period than an unsecured debt.
An adviser should also be prepared to counsel an individual on the risks of using
short-term ‘payday’ loans to overcome a temporary financial shortfall. The rates
charged are usually extremely high and there is a risk that borrowing on such a
basis becomes habitual, making getting out of debt more problematic.
From an adviser’s or planner’s perspective it is important to understand the total
picture in relation to a client’s past, current and future borrowing requirements,
and to link this to their life cycle stage. It would not be professional to make
recommendations that could lead a customer into financial hardship.
References
ONS (2015) Expectation of life, high life expectancy variant, United Kingdom [online].
Available at: http://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages
/lifeexpectancies/datasets/expectationoflifehighlifeexpectancyvariantunitedkingdom
[Accessed: 19 May 2016].
ONS (2016a) Proportion of people with a long standing illness and limiting long standing
illness and limiting long standing illness by age and sex 2011 [online]. Available at:
http://www.ons.gov.uk/peoplepopulationandcommunity/healthandsocialcare/disability/adhocs/
005477proportionofpeoplewithalongstandingillnessandlimitinglongstandingillnessbyageandsex2011
[Accessed: 19 May 2016].
ONS (2016b) Statistical bulletin: Cancer registration statistics, England: First release: 2014 [online].
Available at: http://www.ons.gov.uk/peoplepopulationandcommunity/healthandsocialcare/
conditionsanddiseases/bulletins/cancerregistrationstatisticsengland/firstrelease2014 [Accessed:
19 May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
4. In terms of family protection, which are the three main risks that customers
should consider insuring themselves against?
5. Why is it important to consider protection insurance for a dependent spouse
or homemaker?
6. Why is it good practice for business partners to arrange life assurance?
7. What is ‘over-indebtedness’?
8. Why did increasing house prices (pre-credit crunch) fund poor spending habits?
Learning objectives
After studying this topic you should be able to:
7.1 Introduction
This topic is about understanding the main priorities of customers in relation to
their need for future income. One of the key factors customers should consider
is how much risk they are prepared to take in order to gain future income and,
depending on their circumstances and experience, this will differ from person to
person. From a financial advice perspective it is important to ensure the customer
is realistic in their attitude to risk and is provided with appropriate products. We
will take quite a detailed look at risk as it can feature in a number of ways, all of
which affect the retail customer.
We will look in this topic at several areas that relate to future income. Investments
and saving are key activities for a customer who wishes to plan ahead − the
activities are subtly different, although some would argue they are the same.
Retirement planning is another key activity for providing future income, although
not one that many people consider soon enough. Tax planning, the final section of
this topic, is something that everyone needs to be aware of, whatever their levels
of current and future income.
Students should, however, be aware that there are some limitations to the advice
that can be given. It will depend heavily on the quality of the information collected
and how forthcoming the client decides to be with that information. It will also
depend on the quality of the historic data on the performance of financial products,
such as investments, and the organisations that provide them.
7.2 Risk
Risk is commonly understood in terms of the loss of the amount invested or of
making little return on the investment. We sometimes forget, though, that there is
the risk of lost opportunities − what might have been earned had the investment
been made elsewhere.
Time is an important risk factor. Consider an investor who has £1,000 to invest
for one year. If that £1,000 is invested in a building society account, the capital is
secure and the investor will receive interest at the rate applicable during that year.
If they were to invest the £1,000 in shares, the investment might fall in value and
the investor could not be sure how much dividend income they would receive,
if any.
If, however, the investor intended to invest for ten years rather than one, the risks
alter. Even though stock market investments are volatile, over the longer term the
stock market has consistently outperformed deposit accounts. Although shares
are still riskier in some respects, extending the time involved in the investment
changes the picture.
Generally, deposit accounts provide a more secure investment because interest is
added to the investment and the capital is not put at risk at any point. Even if
the provider were to pay no interest, the capital would be secure − but deposit
accounts pay interest at low rates, often not even equal to the rate of inflation.
Stock-market-linked investments are termed ‘asset-backed’ investments because
their value is backed by the value of the assets (or businesses) underlying the
shares. The assets themselves may increase in value; they may also lose value. Over
the longer term, asset-backed investments are more likely to provide protection
against inflation.
This is an important concept when making recommendations to clients.
Deposit-based investments may be more appropriate if a client’s investment
objectives are short term, but asset-backed investments will be more appropriate
for the longer term.
u Shortfall risk is a risk that an investment chosen for a specific purpose may not
meet expectations. For example, many investors who took out endowments to
support an interest-only mortgage loan have been warned that their endowment
policies are unlikely to match the mortgage amount on maturity. While riskier
investments might offer the potential for better growth, they also pose a higher
shortfall risk.
− Savers in variable-rate accounts run the risk that the interest rate will reduce.
This is a particular risk for those who have retired and who depend on income
from savings.
− Those with a fixed-rate mortgage loan run the risk that a reduction in
variable rates will leave them paying more than they would in the current
market. Many borrowers will take comfort in the security of knowing that
their mortgage payments will not increase over the fixed term and may be
prepared to accept the downside.
− Those saving in fixed-rate savings accounts may receive a lower rate relative
to the market if rates increase, but will be unable to withdraw their money
without penalty.
u Inflation risk − there is a risk that inflation over time will reduce the real value
of capital and reduce the buying power of the cash saved. Investors should look
for investments that are likely to provide a real return over time.
u Taxation risk − other than individual savings accounts (ISAs) and some
National Savings products, investments are taxed. It is possible, however, to
reduce the effect of taxation risk by choosing the right investment. Obviously,
tax-free investments should be considered first − providing they meet the
investor’s other needs. After that, the selection should consider how a product’s
taxation treatment might affect the investor. For example, a higher-rate
taxpayer might be better with a product that offers a lower return but has a
more favourable tax regime. Non-taxpayers would be best advised to avoid
products for which they cannot reclaim tax deducted. Changes in taxation rules
can also present a risk, and what may have been a good strategy could cease to
be so after government Budget announcements. Examples of this are changes to
the way in which death benefits from pension schemes are taxed, and changes
to the lifetime and annual allowances for pension contributions.
u Those who are in the early stages of working life may have little disposable
income from which to fund investment or savings. If they feel a need to invest
at all, it is likely to be to save for a house or to build an emergency fund. Both
of these objectives are best served by low-risk investments.
u Early married life brings with it a number of financial challenges. There may
be two incomes, but there is also likely to be a desire to build a deposit for house
purchase and/or to put money aside for future needs, particularly children. If
the couple manage to buy a house, their disposable income will be stretched
and investment will take a low priority. For this reason, much of the investment
focus will be on low-risk investments, providing easy access and capital security.
If children arrive, it is more likely that the couple will be dipping into savings,
rather than putting money aside for the future. Any cash they do manage to
save is likely to be kept on deposit for emergencies and short-term needs.
u Middle age often sees customers at their most affluent: they have more
disposable income and are more disposed towards saving. They may even have
built up some capital. In today’s society, as home ownership is common and
prices escalate, it is those in their 50s who are the largest recipients of inherited
wealth; much of this wealth will be invested. Those in middle age can often
afford to take a medium- to long-term approach to saving and are likely to be
interested in building up capital and income for retirement. This means that
they will consider investing in schemes that offer the prospect of capital growth
but increased risk.
u Those in retirement are unlikely to be able to invest from their income; in fact,
it is likely that they will use existing investments to supplement their retirement
income. This means that they may move existing investments to provide income
and that they will wish to protect their capital to ensure a continuing income.
The retired investor is likely to select low- to medium-risk investments to achieve
this goal.
In the case of a longer-term objective, even where meeting the target is imperative,
it may be possible to take a more speculative approach in the initial stages, with
a view to transferring some, or all, of the value into lower-risk investments nearer
the end of the term. This will consolidate the gains made to that date and provide
a greater degree of security when the funds are required. Where the main objective
is to provide income, the investor is likely to choose investments that produce
a relatively high level of interest or dividend income based on the profits of the
companies in which the shares are held. This might mean that capital growth is
sacrificed to some extent; this is a form of risk in itself. The customer should be
aware that low capital growth might reduce the real value of the income in future
years. If the investment is not for a specific purpose, then security may be less
important to the customer and more speculative investments can be considered,
particularly if they have other funds that are sufficient to compensate for any loss.
Establishing the customer’s attitude to risk, both generally and towards the specific
investment under consideration, is therefore an important part of the adviser’s role.
If the customer already holds other investments, they might hold a different view
of the risks to take with the new investment. Where it is their only capital, they
are likely to prefer a more safety-conscious approach. All of this means explaining
the relationship between risk and reward, and identifying the customer’s feelings
about the capital − are they prepared to take a degree of risk to achieve their target
or is safety the most important factor for them?
Another important factor that advisers should consider is a customer’s ‘capacity
for loss’. This can be described as the customer’s ability to absorb falls in the value
of their investment. If any loss of capital would have a materially detrimental effect
on their standard of living, this should be taken into account in assessing the risk
that they are able to take.
The customer’s attitude to risk may also be affected by previous experiences.
For example, a customer who lost money in a previous share investment may be
reluctant to take the same risk again. Conversely, a customer who made significant
gains through a high-risk investment may be keen to repeat their success. While
customer experience is an important factor in the risk decision, the adviser should
explore that experience and help the customer to understand what happened and
why.
saving and investment unless there is a specific need to differentiate between the
two.
by subtracting the rate of inflation from the interest / growth rate obtained on the
investment: an investment paying 1.5 per cent interest at a time when inflation is
1 per cent is providing a real rate of return of only about 0.5 per cent. If the rate
of interest is less than the rate of inflation, the real rate of return will be negative
and the purchasing power of the invested funds will fall in real terms.
Low inflation and low interest rates tend to go together, and one effect of this is
that people tend to suffer from the so-called money illusion − ie they tend to think
of interest rates in their nominal sense and not to adjust their thinking to allow for
inflation. Both savers and borrowers can be affected.
u Savers feel that the low interest rates currently being paid on savings are a poor
return for their money. They may, therefore, react to lower inflation by putting
their money into riskier assets in order to seek higher returns − demand for
high-yield bonds has certainly increased in recent years. However, if a large
number of people on average incomes lose their money because of opting for
riskier investments, they may not be able to afford to retire and social problems
will result.
u Borrowers (particularly those repaying mortgage loans) feel that they are
gaining from the lower monthly repayments that have resulted from interest
rate falls. This may persuade them to take out a larger mortgage since they feel
they can more easily afford the monthly repayments. This is a misconception as,
although less cash flows out in interest payments at the start of the mortgage
term, a higher proportion of cash flow will be necessary to repay the capital.
Again, problems may be stored up for the future as people take on debt
they cannot afford, especially if interest rates rise again. In the meantime, an
increased demand for houses can push up house prices and threaten price
stability.
Inflation will be considered further in section 9.2.
compared with 66 per cent of people only 50 years ago, and those who do collect
their pension receive it on average for eight years longer than did pensioners in
the early 1950s.
u is aged 22 or over;
u is under state pension age;
u earns more than an ‘earnings trigger’ (£11,000 for the tax year 2016/17);
u works in the UK.
The Act also introduced changes to the state pension age timetable. From
April 2016, women’s state pension age will rise faster than originally planned,
equalising with men’s at 65 by November 2018. Between December 2018 and
October 2020, the state pension age for men and women will rise from 65 to 66.
State pension age will increase from age 66 to 67 between 2026 and 2028. Going
forward, state pension age will be reviewed at least once every five years, with the
aim of enabling people to spend one third of their adult life in retirement.
The Act also changed the measure of inflation for revaluation and indexation of
benefits from occupational pension schemes from RPI to CPI.
The Taxation of Pensions Act 2014 introduced new flexibility in the way benefits
from money purchase pensions schemes can be accessed, from 6 April 2015.
It remains a fact, however, that individuals will increasingly have to take
responsibility for their own retirement provision, and they will need advice to help
them through this complex area of financial services. It should also be borne in
mind that many employers are closing their pension schemes to new employees
as the performance of their pension funds fails to meet the projected values.
There are basically two approaches that people can take to minimise the impact of
IHT: one is to try to avoid having to pay it and the other is to make provision for
paying it when it is due.
To avoid paying IHT, it is necessary to reduce the value of the estate to below the
nil-rate threshold. This can be done by making use of various exemptions to make
tax-free, or potentially exempt, gifts during one’s lifetime. Another method is to
place assets in trust, since trust property no longer forms part of the deceased’s
estate. Life policies can be bought specifically for the purpose of paying IHT and
placed in trust to meet the tax liability.
This is usually a specialist area and customers should consider this along with
making wills. Making a will is important as it directs how their assets will be
distributed. Dying ‘intestate’ (without having made provision) means that assets
are distributed in accordance with state guidelines, which may not be according to
the owner’s wishes. These issues are covered in section 20.6.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
1. When making recommendations to clients what are the benefits and drawbacks
of deposit accounts?
2. What is the concept of ‘risk and reward’?
10. What are the three main taxes that advisers and planners need to be aware of?
Learning objectives
After studying this topic you should be able to:
u summarise the main options for savings and deposits;
u explain the purpose of financial protection;
u explain the purpose of mortgages and other loans;
u summarise direct investment;
u explain collective investments;
u summarise retirement funding options.
8.1 Introduction
Having considered the main priorities of consumers in terms of their financial
goals, needs and objectives, we are now going to take an overview of how these
can be served by the retail financial services industry. The product areas that relate
to financial advice and planning will be covered in more detail in later topics, but
at this point it is useful to understand the full range of products at a high level.
This enables them to be seen in the context of other factors that affect consumers
such as economic conditions (Topic 9) and taxation and state benefits systems
(Topic 10).
u money market deposit accounts, for large amounts often in excess of £50,000,
and often with notice required;
u interest-bearing current accounts, although the interest rates offered tend to
be very low.
There are also other ways of saving cash.
u repaying debts;
u meeting additional living expenses (eg adapting a property, paying for
childcare);
u ensuring existing plans can be completed;
When people do make provision against the financial difficulties caused by death
or sickness, they often refer to three main factors that influence their decision to
do so.
u Peace of mind − security and peace of mind come from knowing that in the
event of premature death or long-term inability to work, their dependants will
not face financial hardship.
u Control − death or long-term incapacity can often mean having to rely on state
benefits, family generosity or charity. Adequate protection means control over
the availability of funds that enable the family to make their own choices.
u Value for money − protection policies can provide a way to ensure the
payment of very large amounts of money to safeguard the family’s future. The
amounts are generally much greater than could be amassed by saving and yet
the cost of the cover (ie the premium payments) is relatively small, especially if
the policy is started at a young age.
result of an accident or illness, the amount paid out will depend on the severity
of the effects of the illness / accident.
u Mortgage payment protection insurance is also designed to provide an
income in the event that a person cannot carry out their job due to illness. The
amount of benefit may be linked to the level of monthly mortgage repayments,
although it is sometimes possible to build in extra cover to meet some
household bills.
u Payment protection insurance is designed to provide income in the event
of accident, illness or redundancy. It covers loan repayments and is often sold
alongside personal borrowing.
8.4.1 Mortgages
Since a mortgage is usually a large, and long-term, transaction the consequences
of selecting an unsuitable product can be very serious. It is therefore particularly
important for an adviser to choose wisely and to suit the products chosen to the
client’s needs.
u Choosing the wrong lender or the wrong interest scheme can lead to the client
paying more than is necessary for the loan.
u the mortgagee: the lender (bank, building society or other institution) that has
an interest in the property for the duration of the loan.
Borrowers should be made aware of the risks involved in taking out an interest-only
mortgage, in particular that repayment of the mortgage is dependent on the
performance of an investment plan achieving a predetermined rate of return. If
this is not achieved, then the borrower will be left with a shortfall: the value of the
policy or plan will be lower than that of the total debt.
Following changes to the FCA’s MCOB rules from April 2014, interest-only
mortgages can now only be arranged in limited predetermined circumstances,
including where the borrower has investments that provide a pre-determined level
of benefit. In the run up to the changes, and in the period following the changes,
most mainstream lenders withdrew from the interest-only mortgage market and
offered mortgages only on a repayment basis. More recently, lenders have begun
to offer interest-only mortgages again.
Mortgage loans and associated products are considered further in Topic 16.
Secured lending on ‘bricks and mortar’ does not have to be directly, or even
indirectly, related to house purchase or improvement.
of loan applications through telephone call centres, using a form of credit scoring
to assess the suitability of the borrower.
The loan can be used for any purpose by the customer: typically it might be used
to purchase a car, fund a holiday, or consolidate an existing higher-cost borrowing
such as a credit card balance.
8.4.3.2 Overdrafts
An overdraft is a current account facility, offered by all retail banks and some
building societies, which enables a customer to continue to use the account in
the normal way even though their own funds have been exhausted. The bank sets
a limit to the amount by which the account can be overdrawn. An overdraft is
a convenient form of short-term temporary borrowing, with interest calculated
on a daily basis, and its purpose is to assist the customer over a period in
which expenditure exceeds income − for instance, to pay an unexpectedly large
household bill or to fund the purchase of Christmas gifts.
As it is essentially a short-term facility, the agreement is usually for a fixed period,
after which it must be renegotiated or the funds repaid. Overdrafts that have been
agreed in advance with the provider are normally a relatively inexpensive form of
borrowing, although there may be an arrangement fee. Unauthorised overdrafts,
on the other hand, attract a much higher rate of interest.
u Local authority stocks − local authorities can borrow money by issuing stocks
or bonds, which are fixed-term, fixed-interest securities. They are secured on
local authority assets and offer a guaranteed rate of interest, paid half-yearly.
u Corporate bonds are similar in nature to gilt-edged stocks, but they represent
loans to commercial organisations rather than to the government and therefore
are not considered as safe for investors.
u Loan stocks and debentures are also issued by companies to raise finance.
These types of borrowing are usually over the longer term, which helps the
company to make long-term business plans.
8.5.3 Property
Customers can invest in property (real estate) and, in broad terms, investment in
real estate falls into three categories:
u residential property;
u agricultural property;
u commercial and industrial property.
The vast majority of investors will only ever be involved in residential property. For
most people this does not extend beyond the purchase of their own home, although
an increasing number of people are buying residential properties specifically as an
investment. The significant fall in property values in 2008 was a timely reminder
that property can prove to be a risky investment in the short term.
Most companies also offer one or more managed funds. This is an unfortunate
choice of name, since it seems to imply that other funds are not managed.
Nevertheless, the name has become accepted as applying to the type of fund
where its managers sometimes invest appropriate proportions in a range of the
company’s other funds to meet the managed fund’s objectives. Most managed
funds are ‘middle-of-the-road’ in terms of risk profile, and are often chosen by
people seeking steady, market-related growth in situations where risk of loss needs
to be kept to a minimum, such as pension provision or mortgage repayment.
A further categorisation is possible: into funds that aim to produce a high level of
income (perhaps with modest capital growth); those that aim for capital growth at
the expense of income; and those that seek a balance between growth and income.
u investment trusts;
the age of 75. Some AVCs are final salary arrangements, although most are
money purchase. All FSAVCs, PPP / SHPs are money-purchase schemes. SIPPs allow
investment in a broader range of investments that are not permitted in normal
personal pensions; however, they are primarily for people with more complicated
arrangements and larger pension funds.
Pension funds do not pay capital gains tax, pay no income tax on savings income
and no income tax on dividend income.
Any individual who is a UK resident and under the age of 75 can receive income
tax relief at their highest marginal rate on annual contributions to occupational
and private pension schemes up to a maximum of the higher of:
u 100 per cent of UK earnings (to a maximum amount of £40,000 for 2016/17,
the annual allowance); or
u £3,600 (this includes where the individual does not have earned income).
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
1. What are the main reasons why investors deposit money with banks and
building societies rather than other forms of investment?
2. What are the three factors that influence people to make provision for financial
protection?
3. Explain the two types of family protection plan that provide benefits in the
event of the death of a policyholder.
4. What is the purpose of critical illness cover?
5. Who are the parties to a mortgage loan?
6. Explain the difference between a repayment mortgage and an interest-only
mortgage.
7. What is a second mortgage?
8. What types of unsecured borrowing are available to consumers from banks
and building societies?
9. How can consumers invest directly in companies?
Learning objectives
After studying the topic you should be able to:
u explain inflation, deflation and disinflation;
u explain the difference and impact on consumer arrangements of fixed and
variable interest rates;
u summarise the impact of socio-economic factors;
u identify key economic indicators.
9.1 Introduction
This topic is about understanding the impact of various economic factors on
consumers and their financial well-being.
The first of these is inflation: we will consider the effects of inflation on individuals
and their financial circumstances.
We will then go on to look at the impact of interest rate movements on borrowers
and savers. Any movement in interest rates will affect these two groups in different
ways, depending on whether they have fixed or variable interest-rate arrangements
and the direction in which rates are moving.
Socio-economic factors can affect financial markets in a variety of ways, and global
events can influence the domestic outlook. We will touch on the main factors at
play here, together with a brief look at international relations that have affected
world stock markets and economies in recent times.
The final part of this topic focuses on key economic indicators for the UK and why
some of these are important in assessing the health of the economy. You should
aim to keep up to date with these matters from your own reading so that you are
able to have an understanding of them when talking with clients.
9.2 Inflation
Inflation is the term used for general increases in the price of goods and services
over a period. If an article were to cost £100 today and £101.50 in a year’s time,
it would have been subject to inflation of 1.5 per cent over the year.
u Retail Prices Index (RPI) − an index based on a ‘basket of goods and services’
selected to reflect the expenditure of an average household. The rate of RPI will
increase or decrease in line with changes in the prices of the goods and services
included in the basket. The RPI is used to calculate increases in pensions,
benefits and index-linked gilts.
u RPIX (underlying rate of inflation) − the largest single factor in the basket
of goods used to calculate the RPI is mortgage payments. As a result, the RPI
will be affected by interest rate movements and may not reflect the real picture.
This is because interest rates are often used to counter future inflation, and so,
a rise in interest rates would result in higher borrowing costs, which would be
reflected in the RPI. However, the apparent rise in inflation through the RPI will
actually mark the fact that inflation is now under control. The RPIX reflects the
underlying rate of inflation and is calculated as the RPI less mortgage payments.
u Producer Price Index − this index is made up of the costs of raw materials
and the price of goods as they leave the factory. The Producer Price Index is
often regarded as an indicator of how the RPI may change in the near future
since higher production costs will feed through into higher retail prices.
weightings, are different. The name has been changed to the CPI to keep it in
line with other indices with which the UK public is already familiar.
Lowering interest rates, however, can increase inflation: this will increase the
amount of disposable income and boost spending.
Using interest rates can be a crude tool because the effect will not be felt for some
months.
It is also important to consider taxation. If the interest rate were 4.5 per cent, a
person who is liable to basic-rate tax on their interest would end up with a net
(after-tax) interest rate of 3.6 per cent on the portion of their interest subject to
tax. A person who is liable to higher-rate tax on their interest would end up with
an after-tax rate of 2.7 per cent on the portion of their interest subject to tax. If
the real rate of interest (after inflation) were 2.5 per cent, the real rates of return
would be 1.1 per cent and 0.2 per cent respectively.
Those with savings in UK-based building societies and banks are protected by the
Financial Services Compensation Scheme, meaning that the investor is taking a
low level of risk. Investors have to consider the risks of placing large amounts,
which are over the compensation scheme limits, with one institution. Other
interest-bearing investments may carry a higher level of risk and, as a result, offer
higher rates of interest.
For example, companies often borrow funds by issuing loan stock. Institutions and
individuals lend money to the company in return for an agreed rate of interest. The
investor is usually low on the list of creditors and may not receive their money
back if the company defaults or ceases trading. The risk is reflected in the rate of
interest paid.
possible, that savings and pensions for the elderly are protected from losing their
real value. The end of the 1939−45 war signalled a boom in the number of babies
born. These babies, born between the mid-1940s and the 1960s, are now well into
middle age and represent a significant part of the invested wealth in the UK. In
modern Britain, the over-50s have inherited more than ever before because the
house-buying ‘revolution’ enabled their parents to leave them a legacy.
Research has shown that increased saving by those aged over 55 was a significant
factor in the increase in equity values in the late 1990s. Conversely, when
this generation enters retirement, they will be drawing on their investments to
supplement retirement. The next generation represents a smaller proportion of
the population and may not be able to maintain the investment pace, although
they are likely to inherit more than previous generations due to their parents’
increasing wealth.
One interesting consideration is that, with an ageing population, companies that
provide goods and services for the elderly are likely to benefit from increased
profits. This may lead to a shift in the relative value of some sectors of the equity
market.
Other social factors that affect both the economy and the financial markets are as
follows.
u Living standards are generally increasing and the expectations of the population
are high.
u There has been a move from manufacturing to a more service-based economy.
This has led to a reduction in the industrial sector and more cheap imports from
abroad. This, in turn, affects the balance of payments (see section 9.5.3.4).
u The attitude of government towards wealth distribution: while some
governments take steps to redistribute wealth through social policies, taxation
and benefits, markets tend to be nervous of this ‘social engineering’.
u Employment and productivity: in times of high unemployment, the state is
required to pay more in benefits, which means more money is needed for public
spending. Those in employment are likely to cut spending because they feel
vulnerable. Where the level of employment is high and productivity is good,
companies make more profit, share values rise, and employees spend more,
which increases demand.
u A relaxation in attitudes to debt has led to over-borrowing by some and potential
financial hardship. As there is less stigma attached to bankruptcy, many see this
as a possible way out of their money problems. We will look at this in more detail
in section 20.7.
many ways, the world’s largest economy sets the trend for the rest, particularly its
major trading partners. Recession or recovery in the USA leads to similar problems
in the rest of the world, as can be seen in the recent economic downturn.
The expansion of the European Union has resulted in a major economic bloc
emerging. The plan is to harmonise taxes and interest rates throughout the
EU. However, there have been concerns about the role and strength of the
euro in the aftermath of the financial crisis that developed in 2008. Several
eurozone countries have experienced difficulties and have had to be helped out of
potential bankruptcy.
International relations can also influence world stock markets and economies.
u Problems in the Middle East in the early 1990s led to reduced consumer
confidence in the USA.
u German reunification in 1990 meant internal interest rates had to be raised
to counter inflationary pressures. In view of the interlinking of European
economies, it was no surprise that the rest of Europe suffered too.
u The terrorism problems of 2001, aimed at the USA, affected the entire global
economy. The world’s markets continue to become unsettled when there is bad
news from Iraq.
The US and the UK equity markets are larger, relative to the economy, than those
of other major countries and have significant influence over how companies are
run.
Attitudes towards companies are also different from country to country. In Europe
and Asia, more emphasis is placed on the employee and on other interested parties,
while in the UK and the USA, investor returns and value tend to dominate company
thinking.
u Recovery − the economy improves because people start to spend more, which
means providers start to increase production and the level of employment
improves.
u Boom − the economy is strong, people have jobs and will buy goods and
services. Suppliers try to increase prices to gain maximum profit, and inflation
is likely to rise.
Interest rates tend to follow this cyclical pattern, although they generally tend to lag
behind it. In times of boom for example, interest rates will be high, and in decline
they will tend to be low. However, the lag when the economy is booming means
that interest rates are high as the economy tips into recession, thus accentuating
the fall as it occurs.
Equity prices are very sensitive to the market view of the current state of the
business cycle, and sometimes a share will be driven down in value purely based
on perception rather than on fact. In times of recession, share prices will fall, due
to pessimism about economic prospects; if the market senses a recovery, prices
will rise.
u A bull market is the term used to describe a period when investors are
confident prices will rise and adopt a ‘bullish’ approach to the market, by buying
to hold long term.
u A bear market describes a pessimistic feeling in the market with investors
looking to sell in the short term.
There are two main elements of the cycle − peak and trough. The peak is when
the price of a share is at the top and is unlikely to increase in the short term. The
trough (or bottom) is when the share reaches its lowest price. We have all heard
of the maxim ‘buy low and sell high’ − the ideal time to sell a share is at the peak,
before it starts to fall, and the ideal time to buy is when the share has just started
to move back up from its trough.
Cycle theorists believe they are able to predict peaks and troughs over defined
time periods − typically 39 and 78 weeks. Armed with this information, investors
can buy or sell at the supposed optimum point in the cycle.
Movements in exchange rates will affect buyers and sellers: depending on which
way the rates move this can be to the benefit or detriment of both parties to the
transaction. Imagine that sterling is high against other currencies. This will make
it expensive for UK products and services to be bought by overseas buyers, which
will affect the balance of payments (section 9.5.3.4). If sterling falls against other
currencies, then UK products and services become cheaper compared with those
abroad and exports rise, so improving the balance of payments.
u M0 − known as ‘narrow money’, which measures the cash base in the UK. It
comprises notes and coins in circulation and the operational balances of banks
held at the Bank of England. Some 99 per cent of M0 is held in notes and coins.
In March 2009 the Monetary Policy Committee (MPC) announced it would start to
inject money directly into the economy in order to raise inflation to its target of
2 per cent. It was unable to reduce Bank Rate any further from 0.5 per cent. The
emphasis shifted towards the quantity of money provided rather than its price
(Bank Rate). Influencing the quantity of money directly is essentially a different
means of reaching the same end.
9.5.3.7 Taxation
Taxation is the government’s main source of income, but the amount by which
taxes can be increased is a political issue and may limit the options available.
Reducing taxes can stimulate the economy by increasing the amount of disposable
income.
Taxes can also be used to redistribute the money in the economy. Increasing the
higher income tax rate or reducing the point at which higher-rate tax is paid can
reduce the taxation burden for the majority of taxpayers. Whether this is a desirable
or acceptable approach is largely a matter of political ideology. We will consider
taxation in more detail in Topic 10.
9.5.3.8 Unemployment
Unemployment measures relate to all people aged 16 and over who can
be classified into one of three states: in employment; unemployed; or
economically inactive. The figures are collected by the Office for National Statistics
(www.statistics.gov.uk) and provide an insight into the state of the economy. The
statistics cover people’s participation in the labour force, working patterns and
the types of work they do. The statistics also show any earnings and benefits they
receive and are available on a quarterly basis.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
1. What is ‘disinflation’?
2. What is RPI?
3. Which types of investor are at risk from inflation?
4. Why are interest rates on mortgage loans less than on credit card borrowings?
5. What tends to influence interest rates?
6. Which main socio-economic factor affects pensions and the rising costs of
healthcare in the UK?
7. How is economic growth measured?
Learning objectives
After studying this topic you should be able to:
u explain income tax;
u explain capital gains tax;
u explain inheritance tax;
u summarise other personal and business taxes.
10.1 Introduction
This topic will enable you to understand taxation and the state benefits system
and how they affect personal financial arrangements. We will focus on three of the
main taxes in the UK: income tax, which is applied to most forms of income; capital
gains tax, charged on gains or profits from the disposal of assets; and inheritance
tax, which applies to the value of a person’s estate on death. From an adviser’s
and planner’s perspective it is important to understand taxation of income whether
this is from earned income, investment income or from state benefits.
Governments use taxation not only for the basic process of raising revenue but
also as a means of controlling the money supply (see section 9.5.3). This topic will
give an overview of the main UK taxes, together with some detail, but it is not
intended to equip its readers to give professional taxation advice.
Each year, following delivery of the Chancellor’s Budget Statement, a Finance Bill
is published containing the taxation proposals made. When the Bill is approved by
Parliament and receives royal assent it is passed into law as a Finance Act. The new
tax measures take effect at dates provided in the legislation, which can sometimes
be several years in the future.
The new Act becomes a part of the substantial body of legislation that forms the
basis of the rules relating to income tax and other taxes.
Changes in taxation affect the market for financial services and products in two
main ways.
u Increased general taxation reduces the amount of money available for
investment or to repay borrowing.
u The taxation regime can be used to encourage or discourage the demand for
financial products by making them more or less attractive. An example of the
The income of a child that arises from a settlement or arrangement made by the
parents will normally be treated as the parents’ income for tax purposes (subject to
a £100 threshold below which it is treated as the child’s). If treated as the parents’
income, a child’s unused tax allowances cannot be set against this income.
Not all of the income that an individual receives is taxable. Examples of types of
income that are taxable and of those that are not are given below.
Income assessable to tax includes:
u salary/wages from employment, including bonuses and commissions, and
taxable benefits in kind;
u pensions and retirement annuities, including state pension benefits;
u profits from a trade or profession;
u inventor’s income from a copyright or patent;
u tips;
u interest on bank and building society deposits (where in excess of the personal
savings allowance of £1,000 per year for basic-rate taxpayers and £500 per
year for higher-rate taxpayers);
u dividends from companies, where in excess of the £5,000 dividend allowance
(see section 10.2.8);
u income from government stocks and local authority stocks;
u income from trusts;
u rents and other income from land and property;
u the value of benefits in kind, such as company cars or medical insurance (see
Appendix A).
Income not assessable to tax includes:
u redundancy payments and other compensation for loss of office (see
Appendix A);
u interest on NS&I Savings Certificates (when available);
u the first £1,000 of interest received by a basic-rate taxpayer and the first
£500 received by a higher-rate taxpayer each tax year (the personal savings
allowance);
u the first £5,000 of dividend income received each tax year (the dividend
allowance − see section 10.2.8);
u income from ISAs;
u certain covenanted or Gift Aid payments;
u proceeds of a qualifying life assurance policy (in most circumstances);
u casual gambling profits (eg football pools, etc);
u lottery prizes;
u wedding presents and certain other presents from an employer that are not
given in return for one’s services as an employee;
10.2.1.1 Income
The amount taken into account is usually that which the claimant, and their
partner if appropriate, has left each week after paying things like taxes and rent
or mortgage. Typically this might include:
u earnings from full-time or part-time employment, or self-employment, or an
employment training scheme;
u income from pensions;
u income from other state benefits (income from a number of state benefits is
ignored, including that from Attendance Allowance, Disability Living Allowance,
Personal Independence Payment and Housing Benefit);
u maintenance payments to support an adult (child maintenance payments are
disregarded);
u payments from trust funds;
u student grants and loans;
u any other money coming in as regular amounts.
From this income can be subtracted certain specified outgoings, including:
u rent or mortgage interest;
u income tax and National Insurance contributions;
u half of occupational or personal pension contributions.
The resulting figure is the amount of income that will be taken into account in
setting the level of benefit payment.
To try to avoid the risk that people are better off on state benefits than they
would be in work, there is a limit on the total amount of state benefits that most
people aged 16 to 64 can get. This is called the benefit cap. The cap is applied to
the total amount that people in any one household get from certain benefits. See
section 11.8 for more details.
10.2.1.2 Savings
If both claimant and partner are below state pension age and have savings of
more than £16,000 between them, they will not be entitled to the income-related
benefits, notably income-based Jobseeker’s Allowance and Income Support.
Benefits will be reduced if savings between £6,000 and £16,000 are held, although
savings below £6,000 will not affect benefits at all.
The definition of savings includes the following:
u money in current accounts and bank and building society deposit accounts;
u National Savings including Premium Bonds;
u gilt-edged stocks;
u shares, unit trusts, investment trusts.
Although pension funds are not taken into account in the means testing, income
from pensions in payment will result in a pound-for-pound reduction in benefit.
Personal possessions such as house contents are excluded from the assessment.
Married couples, where at least one spouse was born before 6 April 1935, are
entitled to receive an additional allowance.
In addition to these allowances, taxpayers are permitted to make certain
deductions from their gross (pre-tax) income before their tax liability is calculated.
These include:
When all the relevant deductions have been made from a person’s gross income,
what remains is their taxable income. This is the amount to which the appropriate
tax rate or rates is applied in order to calculate the tax due.
Income tax rates and the bands of income to which they apply are reviewed by the
government each year. Any changes are announced in the Budget and included in
the subsequent Finance Act. Income tax rates are set out in Appendix A.
Where a person is employed and their financial affairs are straightforward, their
employer will calculate and collect any income tax due. Under self-assessment
rules, the self-employed, company directors and those with more than £2,500 per
year of untaxed income (and certain other individuals) are expected to complete a
tax return and submit it to HMRC for approval. The self-assessment tax return
is able to calculate the tax payable. Many self-employed persons engage an
accountant to prepare their accounts for them and to deal with HMRC on their
behalf.
The method of collecting income tax depends on the nature of a person’s work, as
follows.
10.2.3 Employees
Employees pay income tax under the pay-as-you-earn (PAYE) system, under which
the amount of tax due is calculated by their employers using tables supplied by HM
Revenue & Customs (HMRC), deducted from their wages or salary and passed on by
their employers to HMRC. In order to deduct the right amount of tax, the employer
is supplied with a tax code number for each employee: the tax code is related
to the amount of ‘free’ pay for the employee, including allowances, exemptions
and adjustments for fringe benefits and for amounts overpaid or underpaid from
previous years.
A P60 is issued to each employee by the employer in April each year. This shows,
for the previous tax year, total tax deducted, National Insurance contributions (see
section 10.3) and the final tax code.
On leaving an employer, an employee should be provided with a form P45 showing:
u name;
u district reference;
u code number;
u week or month of last entries on the employee’s deductions working sheet;
u total gross pay to date;
u total tax due to date.
A copy is sent to HMRC. The P45 provides the new employer with all the information
they require to complete a new tax deductions working sheet for the employee.
of the gross income of an employee − ie they are the amount on which income
tax is based. They are calculated by taking the total income of the business and
deducting allowable business expenses and capital allowances.
Self-employed persons pay their income tax (plus Class 2 and Class 4 National
Insurance contributions) in two equal parts. The first payment is due on 31 January
of the tax year in which their business year ends; the second is due on 31 July,
six months later.
on the capital gain, meaning there is no personal capital gains tax liability to pay
on the proceeds from a life policy.
The net result for the investor is that all benefits taken out of a life policy are
deemed to have already borne tax at the basic rate, so for the basic-rate taxpayer
there is no further liability. There may, however, be a tax liability for higher-rate
and additional-rate taxpayers.
This additional tax liability can only arise if the policy is ‘non-qualifying’. Qualifying
policies do not suffer any higher or additional-rate income tax when proceeds are
paid out. Where a payment is taken from a policy that is non-qualifying then a
higher- / additional-rate taxpayer, or a basic-rate taxpayer who is moved into the
higher-rate band by the payment from the life policy, will have further tax to pay in
respect of the liability over and above the basic-rate tax deducted within the fund.
Broadly speaking, in order to be a ‘qualifying’policy, a policy must meet the
following rules.
u Premiums must be payable annually, half-yearly, quarterly or monthly for at
least ten years. If premiums cease within ten years, or three-quarters of the
original term if less, the policy becomes non-qualifying.
u Premiums in any one year must not exceed twice the premiums in any other
year or one-eighth of the total premiums payable.
u The sum payable on death must be at least equal to 75 per cent of the total
premiums payable.
u Premiums paid by an individual to all qualifying policies held cannot exceed
£3,600 per year.
of 20 per cent and 25 per cent respectively. Unit trusts are exempt from capital
gains tax (CGT) but unit holders may have a liability if they sell units at a profit.
4. The resultant figure is known as the taxable income and current tax rates are
applied to the appropriate bands of income, as described earlier.
at their market value at the time of death. This is to establish the cost of acquisition,
should it be necessary at some time in the future to calculate capital gains.
Similarly, there are certain assets that are exempt from CGT, including:
u main private residence;
u ordinary private motor vehicles;
u personal belongings, antiques, jewellery and other tangible movable objects
(referred to as ‘chattels’), provided each object is valued at £6,000 or less;
u gifts to the nation of items of national, historic or scientific interest;
u foreign currency for personal expenditure;
u UK government stocks (gilts);
u NS&I Savings Certificates and Save As You Earn schemes;
u Premium Bond winnings and lottery winnings;
u gains on qualifying life assurance policies disposed of by the original owners;
u individual savings accounts (ISAs).
If an individual makes a loss on disposal of an asset, this can be offset against
gains made elsewhere. It must be offset first against gains in the year the loss
occurred. Residual losses may then be carried forward to future years. A capital
loss cannot, however, be carried back to a previous year.
Tax is payable on net gains made in the tax year, after deducting any allowable
capital losses that were made in the same year or carried forward from previous
years. Each individual also has an annual CGT allowance (see Appendix A),rather
like the personal income tax allowances; this is the level of gains that can be made
in the tax year before CGT starts to be payable. This figure also applies to trustees
of a person with learning difficulties, and to personal representatives; half the
amount applies to most other trustees (see Appendix A).
The annual allowance cannot be carried forward to subsequent years if it is unused
in the year to which it applies.
Given that capital losses can be carried forward but the annual exemption cannot,
capital losses brought forward are used only to the extent necessary to reduce
gains to the level of the annual exemption. Residual losses are then carried forward.
When the amount of the gain has been calculated, deduct the annual CGT allowance
(if this has not been used against other gains in the same tax year). Then deduct
any losses that can be offset against the gain. What remains is the taxable gain.
The rates used are set out in Appendix A, which also includes an example of a CGT
calculation.
One constant source of complaint about the capital gains tax regime is that CGT
is due on the whole gain in the year in which the gain is realised, even where
that gain has actually been made over a longer period. This means that only one
annual exemption can be set against what may be many years’ worth of gain. In
the past, some holders of shares and unit trusts sought to minimise the effect
of this by selling their holding each year and repurchasing it the following day,
thus realising a smaller gain that could be covered by that year’s exemption. This
was known as ‘bed and breakfasting’, but the government effectively outlawed the
process in the 1998 Budget. Since then, any shares and unit trusts that are sold
and repurchased within a 30-day period are treated, for CGT purposes, as if those
two related transactions had not taken place.
The gifts are offset against the nil-rate band first and, if there is any nil-rate band
left, this is offset against the remainder of the estate, the balance being subject to
tax (see Appendix A). If the value of the gifts alone exceeds the nil-rate band, the
portion of the gifts that exceeds the threshold is taxed along with the remainder
of the estate (although the amount of tax on the gifts is scaled down by ‘taper
relief’). For an example of taper relief see Appendix A.
Some lifetime gifts − notably those to companies, other organisations and certain
trusts − are not PETs but chargeable lifetime transfers, on which tax at a
reduced rate (see Appendix A) is immediately due. This ‘lifetime’ tax is only payable
if the value of the chargeable lifetime transfer, when added to the cumulative total
of chargeable lifetime transfers over the previous seven years, exceeds the nil-rate
band at the time the transfer is made. As with PETs, the full tax is due if the donor
dies within seven years (subject to the same taper relief) and any excess over the
tax already paid then becomes payable.
There are a number of important exemptions from inheritance tax, as set out in
Appendix A.
Some goods and services are exempt from VAT, including certain financial
transactions such as loans and insurance. The supply of financial advice is not
exempt and advisers who charge a fee for their service are subject to VAT in the
same way as solicitors or accountants.
The supply of health and education services is exempt and a number of related
goods and services are currently zero-rated. This is not technically the same
as being exempt: zero-rated goods and services are theoretically subject to VAT
but the rate of tax applied is currently 0 per cent (although this could change).
Zero-rated items include food, books, children’s clothes, domestic water supply
and medicines. Domestic heating is charged at a reduced rate (currently 5 per
cent).
Businesses, including the self-employed, are required to register for VAT if their
annual turnover (not profit) is above a certain figure (see Appendix A). Firms with
turnover below this figure can choose to register for VAT if they wish, but are not
obliged to. An advantage of registering is that VAT paid out on business expenses
can be reclaimed; two disadvantages are (i) the fact that the firm’s goods or services
are more expensive to customers (by the amount of the VAT that the firm must
charge) and (ii) the additional administration involved in collecting, accounting for
and paying VAT.
See Appendix A for limits and rates for stamp duty reserve tax and stamp duty
land tax.
u trading profits (less allowable expenses such as labour and raw materials);
u capital gains;
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
2. Which form does an employer use to advise their employees of the amount
of pay, income tax and national insurance contributions that have been made
during the last tax year?
3. Would a basic-rate taxpayer have a further tax liability on income gained from
dividends in UK companies?
4. John has total income of £44,075; £43,775 is earned income from his
employment and £300 is gross interest. Assuming he has a full personal
allowance of £11,000 (2016/17), calculate John’s income tax liability.
5. Julie is employed and her salary is £91,000 per annum. She receives £900
in interest from her building society savings account and £3,200 in dividend
income from shares. Assuming she has the full personal allowance available,
will she have any further tax to pay?
Learning objectives
After studying this topic you should be able to:
11.1 Introduction
In the UK, the government, through its system of state benefits, plays a vital role
in providing assistance to those people most in need. Although the ‘welfare state’
has had its critics in recent years, largely because it is increasingly expensive to
run, it still remains the envy of many other nations. Successive governments have
tried various ways to make savings through reducing benefits payments, tightening
eligibility criteria and trying to find ways of encouraging claimants back into work.
Students should keep abreast of changes in this area.
Whilst normally set at a modest level, state benefits impact financial planning in two
main ways: benefits can affect the need for protection; and financial circumstances
can affect entitlement to benefits as certain benefits are means tested. There is
a wide range of benefits covering many different circumstances. Many of them,
however, are small in amount and can do little more than prevent people from
suffering extreme poverty. The structure of the benefits system is complex and
it is not possible to cover every detail here. The main benefits are described in
the remainder of this topic, together with some information about them that is
relevant to the work of financial advisers and planners.
The main areas in which state benefits are provided are for those who are:
u on low incomes;
u ill or disabled;
u requiring care or nursing; and
The Department for Work and Pensions (DWP) publishes a range of booklets that
provide detailed descriptions of the various benefits. These are available from DWP
offices or by visiting its website (www.dwp.gov.uk).
People with children can claim WTC if they are aged 16 or over and work at least
16 hours a week. Those without children can claim WTC if:
u they are aged 25 or over and work at least 30 hours a week; or
u they are aged 16 or over and work at least 16 hours a week and have a disability
which puts them at a disadvantage in getting a job; or
u they or their partner are aged 50 or over, work at least 16 hours a week and are
returning to work after claiming qualifying ‘out-of-work’ benefits.
u work less than 16 hours per week (with a partner working less than 24 hours
per week);
u live in England, Scotland or Wales.
As can be seen, Income Support can be claimed by people with no income at all or
can be used to top up other benefits or part-time earnings.
Eligibility for Income Support is not dependent on the claimant having paid National
Insurance contributions (NICs). It is, however, means-tested in relation to both
income and savings. Where an individual has savings of between £6,000 and
£16,000 then they are assumed to have £1 per week of income for every £250
above £6,000, and this is deducted from their Income Support payments.
The rules relating to Income Support are complex, and only a brief outline of them
can be given here.
u Personal allowances (not to be confused with the tax allowances of the same
name) are meant to cover the day-to-day living expenses of the claimant, partner
and dependent children.
u Other additions − these may include payments for mortgage interest and
certain other housing costs.
u People who do not qualify for contributions-based JSA may be able to get
income-based JSA, which is, to all intents and purposes, Income Support under
another name.
Claimants for JSA must satisfy a number of strict requirements. Claimants are
usually credited with NICs for every week when they receive JSA.
u She must have worked for the same employer, without a break, for at least
26 weeks including (and ending with) the 15th week before the baby is due −
known as the ‘qualifying week’.
u Her average weekly earnings in the eight weeks up to the qualifying week must
not be less than the ‘lower earnings limit’ (LEL).
SMP is payable for a maximum of 39 weeks. The earliest it can begin is 11 weeks
before the baby is due and the latest is when the baby is born.
There are two rates of SMP: for the first six weeks the amount paid is equal to
90 per cent of the employee’s average weekly earnings; after that, the remaining
payments are at a flat rate of £139.58 (2016/17) or 90 per cent of the employee’s
average weekly earnings, whichever is the lower.
SMP is taxable and NICs are due on the amount paid.
Maternity Allowance is paid at a lower rate than SMP but, unlike SMP, it is not
subject to tax or NICs on the amount paid.
will equal the amount of Child Benefit received, ie the charge will cancel out the
benefit.
To qualify, claimants must earn more than the lower earnings limit (LEL).
SSP is paid for a maximum of 28 weeks in any spell of sickness. Spells of sickness
with less than eight weeks between them count as one spell. It is payable to
employed people whose average weekly earnings are above the level at which
NICs are payable.
Amounts paid as SSP are subject to tax and to NI deductions, just as normal
earnings would be.
People who are still sick after 28 weeks may be able to claim short-term
Employment and Support Allowance (see section 11.4.3).
Entitlement to the single-tier state pension is based on NICs with some entitlement
once NICs (Class 1, 2 or 3) have been paid for at least 10 years and maximum
benefit after 35 years. Upon reaching state pension age a comparison is done
to see whether a person would receive more pension based on the entitlement
to the basic / additional state pension they had built up (to 5 April 2016) or if
the single-tier state pension had existed throughout their whole working life; the
higher amount is awarded as their starting amount under the new state pension.
The benefit levels for 2016/17 are as follows (per person per week):
More details on the operation of state pensions can be found in section 15.2.
u Income support;
u Child Tax Credits;
u Housing Benefit.
Universal Credit consists of a basic allowance with different rates payable for single
people / couples and younger people.
There are also additional payments for claimants who have:
u responsibilities as a carer;
u children / disabled children;
u housing costs;
u childcare costs;
u limited capability for work.
The payment is a single payment made on a monthly basis, to mirror the frequency
of payment of a salary to those who work.
u Carer’s Allowance;
u Child Benefit;
u Child Tax Credit;
u Employment and Support Allowance (unless it is just the support element);
u Guardian’s Allowance;
u Housing Benefit;
u Incapacity Benefit;
u Maternity Allowance;
they can make the benefit levels. The situation is worse in times of economic
downturn, because there are fewer people working (and therefore contributing
taxes and NICs) and more people claiming benefits.
State benefits can affect financial planning in two main ways.
u State benefits can affect the need for protection − the amount of additional
cover needed by a client can be quantified as the difference between the level
of income or capital required and the level of cover already existing. Existing
provision includes any private insurance that the client already has, any benefits
that might be paid by their employer and also any state benefits to which they
or their dependants would be entitled.
Employer benefits will depend on the type of employment contract they have.
Often those with salaried employment have more benefits that those on
waged or hourly paid jobs. Benefits could include death-in-service benefit for
dependants, salary paid in the event of ill health (within certain time limits), a
private healthcare scheme, and maternity payments.
The financial adviser or planner would need to ascertain the details of these
types of benefit and take them into consideration, alongside their knowledge
of the main state benefits and the circumstances in which they are payable.
u Financial circumstances can affect entitlement to benefits − certain benefits are
means-tested, meaning that the amount of benefit is reduced if the individual’s
(or sometimes the family’s) income or savings exceed specified levels. This
might mean, for example, that a financial plan that increases a person’s income
might be less attractive than it seems at first sight, if it also has the effect of
reducing entitlement to Income Support, for example.
If it can be shown conclusively that the same cover can now be obtained at a
reduced cost, however, it may be appropriate to recommend the cancellation of an
existing policy and its replacement with a new one.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
6. Which individuals in residential care are not eligible for any state support?
7. What is the main drawback of relying only on state pension benefits in
retirement?
Learning objectives
After studying this topic you should be able to:
u explain the purpose and considerations of life protection products;
u explain the purpose and considerations of income and health protection;
u summarise the purpose and considerations of business protection.
12.1 Introduction
Very few aspects of life are entirely free from some element of risk and most
people have some form of insurance to protect them against the financial effects
of adversity. Most families need protection against unforeseen events that would
deprive them of their sources of income, such as the untimely death or serious
illness of a main breadwinner. In this topic we will consider the main areas of
protection that are available to retail financial services consumers.
whole-of-life policies that are cancelled by the client before death has occurred.
These surrender values are, however, generally small in relation to the sum
assured. In fact, in the early years of a policy, the surrender value will be less
than the premiums paid. This emphasises the fact that whole-of-life policies are
protection policies and not investment plans.
Whole-of-life policies can be taken out on a number of different bases:
u non-profit;
u with-profit;
u unit-linked;
u unitised with-profit;
u low-cost;
u flexible;
u universal.
12.2.1.1 Non-profit
This policy has a fixed sum assured, which is payable on maturity (ie at the end of
the policy term) or on earlier death. Because the return is fixed and guaranteed,
the investor is shielded from losses due to adverse stock market movements; on
the other hand, they are equally unable to share in any profits the company might
make over and above those allowed for in calculating the premium rate (hence the
name: ‘non-profit’). For that reason, non-profit policies are rarely used today.
12.2.1.2 With-profit
Like its non-profit equivalent, a with-profit policy has a fixed basic sum assured
and a fixed regular premium. The premium, however, is greater than that for a
non-profit policy of the same sum assured, and the additional premium (sometimes
called a ‘bonus loading’) entitles the policyholder to share in the profits of the life
assurance company.
The company distributes its profits among policyholders by annually declaring
bonuses that become part of the policy benefits and are payable at the same time
and in the same circumstances as the sum assured. There are two types of bonus.
u Reversionary bonuses: these are normally declared each year and, once
they have been allocated to a policy they cannot be removed by the company,
provided that the policy is held until the end of the term or earlier death. Some
companies declare a simple bonus, where each annual bonus is calculated as
a percentage of the sum assured; others declare a compound bonus, with the
new bonus being based on the total of the sum assured and previously declared
bonuses. Most companies set their reversionary bonuses at a level that they
hope to be able to maintain for some time, in order to smooth out the short-term
variations of the stock markets, but with the low level of interest rates and the
volatility of stock market returns in the years following the 2007/08 credit crisis,
bonus rates fell and are now at much lower levels than they were in the 1980s
and 1990s.
u Terminal bonuses: these are bonuses that may be added to a with-profit policy
at the end of its life, when it terminates, typically when a death or maturity
claim becomes payable. Unlike reversionary bonuses, a terminal bonus does
not become part of the policy benefits until the moment of a death or maturity
claim, thus allowing the company to change the terminal bonus rate − or even
remove the terminal bonus altogether. Terminal bonuses are intended to reflect
the level of investment gains that the company has made over the term of the
policy, so the rate of bonus often varies according to the length of time that the
policy has been in force. In the current climate of reduced stock market values,
many companies have reduced the level of their terminal bonuses.
12.2.1.3 Unit-linked
The first unit-linked policies were issued in the late 1950s and represented a
revolutionary change in the way in which policies were designed. The development
reflected the desire of many policyholders to link investment returns more directly
to the stock market, or even to specific sectors of the market.
Unit-linked policies work on the basis that, when a premium is paid, the amount
of the premium − less any deductions for expenses − is applied to the purchase
of units in a fund or funds selected by the policyholder. A pool of units gradually
builds up and, at the maturity date, the policyholder receives an amount equal to
the total value of all units then allocated to the policy. Most unit-linked policies also
provide a fixed benefit on death before the end of the term. The cost of providing
this life cover is taken from the policy each month by cashing in sufficient units
from the pool of units.
Unit-linked policies have the potential to produce better returns than with-profit
policies, albeit without the guarantees that with-profit policies provide.
This policy is suitable for anyone seeking maximum life cover on a permanent
basis at minimum cost.
u The policyholder pays premiums of an amount that they wish to pay − or feel
that they can afford to pay.
u The premiums are used to buy units in the chosen fund or funds, and these
units are allocated to the policy.
u The policyholder selects the level of benefits that they wish to have.
− If a high level of life cover is required, a larger number of units will be cashed
each month, and a correspondingly lower number will remain attaching to
the policy. This means that the investment element of the policy (which
depends on the number of units) is also lower.
− Conversely, a low level of life cover means fewer units cancelled and hence
a higher level of investment.
The flexibility of the system, under which benefits are paid for by cashing units,
means that other options are often available. These include an option to take
income, indexation of benefits (for automatic adjustment of death benefits) and
the ability to add another life assured.
Although it can have a high level of investment, a flexible whole-of-life assurance
should never be thought of primarily as a savings vehicle, but rather as a protection
plan that could be adapted to investment if circumstances changed.
The initial life cover is guaranteed for a certain period, often ten years. Beyond
that point, the company reserves the right to increase the premiums or to reduce
the cover − to take account of increases in costs or to allow for the fact that unit
prices have not grown as quickly as had been assumed. The death benefit is then
guaranteed until the next review.
Further reviews are usually undertaken at five-yearly intervals, or even annually
with older lives assured, and adjustments may again be made. The need for such
reviews is the price that clients have to pay for the flexibility of the system. In fact,
the reviews are beneficial to the client because they reveal possible shortfalls at
any early stage, when they can be rectified before the cost becomes prohibitive.
u indexation of benefits;
u flexibility of premium levels;
u waiver of premium during periods of inability to pay due to, for instance,
disability or unemployment.
Most of the additional benefits will be at extra cost, the additional cost being met
by cashing more units.
u to protect dependants against loss of financial support in the event of the death
of a breadwinner;
u to provide a tax-free legacy;
u to cover expenses on death;
u to provide funds for the payment of inheritance tax.
the policy are used to meet the IHT liability and do not pass into the value of the
estate.
Term assurance can be used for personal and family protection and also for a
wide range of business situations. Business use includes the provision of key
person insurance, to protect against the loss of profits resulting from the death
of an important employee, and partnership insurance schemes, to enable surviving
partners to buy out the share of a partner who has died.
Other characteristics shared by term assurances are as follows.
u The term can be anything from a few months to, say, 40 years or more (for terms
that end after age 65, it may be worth considering taking out a whole-of-life
policy instead).
u If the life assured survives the term, the cover ceases and there is no return of
premiums.
u If premiums are not paid within a certain period after the due date (normally
30 days), cover ceases and the policy lapses with no value. Most companies will
allow reinstatement within 12 months provided all outstanding premiums are
paid and evidence of continued good health is provided.
u Premiums are normally paid monthly or annually, although single premiums
(one payment to cover the whole term) are also allowed.
u Premiums are normally level (the same amount each month or year), even if the
sum assured varies from year to year.
There are a number of types of term assurance and a number of options that can
be included if the policyholder wishes. These are described below.
It can also be used to provide family protection, for instance, against the loss
suffered by the death of a wage earner until the children leave home. If it is used
for that purpose, the policyholder should bear in mind that the amount of cover in
real terms would be eroded by the effect of inflation.
The new term is the same as the previous term and the new policy itself includes
a further renewal option, except that there is a maximum age, usually around 65,
after which the option is no longer available.
The premium for the new policy is based on the life assured’s age at the date when
the renewal option is exercised, not their age when the policy was first taken out.
Renewable and increasable term assurance is similar to the renewable policy,
with the added option on renewal to increase the sum assured by a specified
amount − often either 50 per cent or 100 per cent of the previous sum assured,
again without evidence of health.
u stroke;
u coronary artery disease requiring surgery;
u multiple sclerosis;
u kidney failure.
u blindness;
u loss of limb(s).
Many policies also make provision for payment of the sum assured in the event
of total and permanent disability. Again, the definition of total and permanent
disability varies between companies. Some take it as being a total and permanent
disability that prevents the policyholder from doing any job to which they are
suited by virtue of status, education or experience. Other companies employ a
tighter definition that requires that the disability prevents the person from doing
any job at all.
Typical uses of critical illness cover are:
u provision of long-term care, either in hospital or in the home;
u mortgage repayment;
u improving the quality of life of a terminally ill person.
years or so. In some cases, the premium may be reviewable every year, or every
five years, to take into account changing circumstances.
u Renewable premiums: renewable premiums are similar to reviewable
premiums, but every time the policy comes up for renewal, the premium is
reviewed and the amount paid to the insurer may change.
A waiver of premium option may also be provided whereby premiums for the IPI
policy are not required while benefits are being paid from the policy, but the policy
cover continues as normal.
Benefits are paid pro-rata if illness means that a person can work but only part-time.
Cover is ‘permanent’ in the sense that the insurer cannot cancel the cover simply
because the policyholder makes numerous claims. The policy could be cancelled,
however, if the customer fails to keep up their premium payments or takes up a
hazardous job or pastime.
Some policies will allow benefits to be indexed either before or during a claim. The
rate of increase may be at a fixed rate, perhaps 3 per cent to 7 per cent, or based
on a published measure of inflation.
Benefit is normally paid until death, return to work or retirement, whichever event
occurs first.
IPI is available as a standalone policy, either as a pure protection plan or on a
unit-linked basis. Additionally, IPI can be available as an option on a universal
whole-of-life plan.
ASU insurance is typically used to cover mortgage repayments in the event that
illness, accident or loss of employment prevents the policyholder from earning
a living. If used in this way it can be known as mortgage payment protection
insurance. A level of income equal to monthly mortgage repayments is paid for a
limited period, usually a maximum of two years.
Additional cover can sometimes be included to cover other essential outgoings.
ASU cover taken out with personal loans is known as ‘payment protection
insurance’ (PPI). Benefits cover the loan payments for the remainder of the loan
term. These policies have been mis-sold to some consumers, mainly due to
eligibility under the terms of the policy not being checked.
As with income protection insurance, there will be a deferred period, normally one
month, which must elapse before benefit payments can commence. Lump sums
may be paid on certain events (death, disablement and loss of a limb).
In contrast to IPI, these plans should be viewed as short term to protect mortgage
payments rather than as providing total protection of earned income.
It would be more accurate to describe these policies as accident, sickness and
redundancy insurance, as they do not offer protection from unemployment when
the insured is sacked, or resigns voluntarily. The policy will often include the
following restrictions.
u The proposer must have been actively and continuously employed for a
specified minimum period prior to effecting the plan.
u Any redundancy that the proposer had reason to believe was pending when they
took out the policy will be excluded.
u No benefit will be payable if redundancy occurs within a specified period of the
cover starting.
A person may have to have been employed for a minimum period either before
they can take out this type of plan or before the unemployment element of the
plan becomes valid.
ASU policies are annually renewable at the discretion of the insurer. This means
that the insurer could increase premiums in light of poor claims’ experience or
may even withdraw the cover offered. This is a major difference from IPI.
A major factor will be the type of scheme that is taken out. For example, many
providers offer a budget scheme, which may limit the patient’s choice of hospital
or require treatment on the NHS if the waiting list does not exceed a maximum
period, eg six weeks. Any limit on the range of cover provided will reduce the
premium payable. The limit may take the form of a financial limit on the amount
of benefit that is provided or limits on the range of treatment covered.
One other significant factor is the age of the person applying for cover. The
morbidity risk increases with age and consequently so does the probability of
a claim being made under the terms of the plan.
12.3.4.1 Underwriting
Certain events will be excluded from cover under the scheme. Cover will not be
provided for any pre-existing medical conditions, and other general exclusions are
the costs of:
u routine optical care (such as provision of spectacles or lenses);
u routine dental treatment;
u routine maternity care;
u chiropody;
u the treatment of ailments that are self-inflicted, eg the consequences of drug
and alcohol abuse;
u cosmetic surgery;
u alternative medicine.
12.3.4.2 Taxation
Premiums are subject to insurance premium tax but the benefits are paid out
tax-free.
Employers who contribute to PMI on behalf of their employees are able to claim
the cost as an allowable deduction against corporation tax.
Contributions paid by an employer are regarded as a benefit in kind as far as the
employee is concerned and will be taxable as if they had been paid as income.
12.3.5.1 Benefits
The amount of benefit paid from an LTC plan will depend on the degree of care
required by the insured. This will be established by ascertaining the person’s ability
to carry out a number of activities of daily living (ADLs). Typical ADLs would
be:
u washing;
u dressing;
u feeding;
u using the toilet;
u moving from room to room;
u preparing food.
Each LTC insurer will have its own definitions of what constitutes an inability to
carry out an ADL. Many follow the definitions laid down by the Association of British
Insurers.
The greater the number of ADLs that cannot be performed without assistance,
the greater the amount of care required and, therefore, the higher the level of
benefit that will be paid. It is normal for insurers to require that the person must
be incapable of performing at least two or three of the ADLs before a claim can
be accepted. A person need not be confined to a nursing home to receive LTC
benefits: for example, a person may be unable to dress themselves in the morning
and prepare and eat food without assistance. Therefore, the range of support they
would need may be limited to a person coming in at certain points during the day
to help with those specific activities.
long-term care policies, it doesn’t matter whether the benefits are paid direct to
the care provider or to the protected person.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
Learning objectives
After studying this topic you should be able to:
u explain equities;
13.1 Introduction
This topic will focus on the various asset classes and their key features to enable
an understanding of the types of investment product available for investors to
acquire, either directly or through collective investments. Collective investments
will be considered in Topic 14.
u Fixed-interest securities (eg gilts and bonds); these are low- to medium-risk
investments aimed at medium- to long-term growth.
u Equities (eg shares in companies); these present higher risk to the investor
and may be UK and international equities. They may be held in some form of
collective investment (see Topic 14) to help spread the risk.
u Property − some investors choose to hold property and we will consider this
in section 13.11.
Investment professionals usually drill down into the broad asset classes shown
above, often working with between 9 and 15 asset classes. For example
equities can be divided into additional ‘sub classes’ including shares in different
indices (FTSE 100/250/All-Share), shares by market capitalisation (large and small
companies), shares in different countries and so on.
The client’s objectives and attitudes to risk will dictate which of the classes are
appropriate for them. For example, if the client needs income, they may meet
this objective by holding cash and fixed-interest securities; however, there are
other alternatives that can be considered. Some of the portfolio should be held in
income-producing shares or collectives in order to provide the potential for capital
growth. If an income portfolio does not benefit from capital growth, the income
will remain static and inflation will reduce its value. Allocating assets in the right
proportion will help the client to meet their objectives.
At the opposite end of the spectrum, a client with a capital growth objective will
hold very little in cash and fixed-interest securities − they do not provide significant
capital growth.
When allocating assets within a portfolio, it is also important to look at the types of
vehicle within each class. A client wanting capital growth should consider investing
in overseas, as well as UK, equities, because at certain times overseas markets may
outperform those in the UK, and vice versa. The exact allocation of each will depend
on their precise objective, their timescale and their attitude to risk.
The remainder of this topic looks at these classes in more detail.
There is also the risk of loss of capital if the institution becomes insolvent. This
is rare with banks and building societies, but is not unknown. In the event of
insolvency, investors may be able to reclaim some of their funds through the
Financial Services Compensation Scheme.
The convenience of the ready accessibility of banks and building societies is a
strong reason for investors to deposit money with them; it is believed that, to
some extent, inertia inhibits an investor’s search for a more rewarding home for
their deposits.
If the reason for saving or investing money is for a short-term purpose (next
year’s holiday or a new car, perhaps) then few would argue that a deposit-based
savings account is a sensible place in which to invest the money. It is prudent to
have a part of an investment portfolio that is easily accessible in, for example, a
no-notice deposit account; this is often referred to as money put by for a ‘rainy
day’. Institutional investors (eg pension funds) maintain a part of each of their
funds in readily accessible form.
Some deposit accounts offer higher interest rates provided that a certain minimum
investment is made. Deposits can be subject to notice of withdrawal, with the
typical notice period being seven days. Often the requirement for notice will be
waived subject to a penalty, which is normally equal to the amount of interest that
could be earned over the notice period.
Deposit accounts may be considered as an investment of funds kept for an
emergency or otherwise in case of need. Over the longer term, however, they
have proved to be unattractive when compared with asset-backed investments.
u Notice accounts have no fixed term but, as the name implies, there is a
requirement on the investor to give an agreed period of notice of withdrawal.
Similarly, the bank must normally give the investor the same period of notice
of a change in interest rate. A typical period of notice could be anything from
seven days to six months, although 12-month notice periods are available.
Money market deposit accounts may be suitable for individuals with very large
amounts of cash to place on short-term deposit until they commit the cash to
other purposes.
13.3.4 Taxation
The system of taxing interest changed from 6 April 2016. Interest is paid gross,
without deduction of tax. Where the interest payment falls into the first £5,000
of an individual’s taxable income or where it falls within an individual’s personal
savings allowance (£1,000 for basic-rate taxpayers, £500 for higher-rate taxpayers)
then no tax is paid on the interest. Otherwise income tax is payable at:
u 20 per cent for basic-rate taxpayers;
The interest on an offshore deposit will be paid gross. A UK resident must declare
the income to HM Revenue & Customs (HMRC). Overseas interest is taxable in the
hands of UK residents (unless they are not ordinarily resident or domiciled in the
UK). They may, however, be able to obtain relief from some or all of this tax under
a double taxation agreement if the interest has been taxed overseas.
The Foreign Account Tax Compliance Act (FATCA) is a US federal law and forms
part of the US Hiring Incentives to Restore Employment Act of 2010. The Act aims to
combat tax evasion by US tax residents using foreign accounts. It includes certain
provisions on withholding taxes and requires financial institutions outside the US
to pass information about their US customers to the US tax authorities, the Internal
Revenue Services (IRS). Failure to meet these reporting obligations would result in
a 30 per cent withholding tax on the financial institutions.
The FATCA provisions imposed new and substantial burdens on UK businesses
in identifying US taxpayers, and reporting information to the IRS. Significantly for
UK institutions the Data Protection Act precludes UK businesses from passing the
required information to the US.
The UK government (along with France, Germany, Italy, and Spain) with the
support of the European Commission, took part in joint discussions with the US
government to explore an intergovernmental approach (IGA) to FATCA, supporting
the overall aim to combat tax evasion, while reducing risks and burdens on financial
institutions.
The UK and the US subsequently signed an IGA in September 2012 agreeing to
implement the provisions of the FATCA, subject to a reduction in some of the
administrative burden of complying with the US regulations. The IGA provides a
mechanism for UK financial institutions to comply with their obligations without
breaching the data protection laws. Under the IGA, financial institutions pass
information to HMRC who will then exchange this information with the IRS.
The IGA has changed since it was signed, in that Annex II was updated and the
changes resulted in a wider scope of institutions and products exempt from the
FATCA requirements.
be held in a single name, ie joint accounts are not permitted, although husbands
and wives can have one each.
Investors are exempt from income and capital gains tax on their ISA investments.
Fund managers are exempt from tax on other income and gains received for the
benefit of ISA investors.
Many ISAs allow no-notice withdrawals to be made, although there are some
fixed-rate cash ISAs available that do not permit withdrawals during the fixed-rate
period. Withdrawals from the innovative finance ISA are subject to notice. It is
now possible to replenish withdrawals made during a particular tax year. For
example, if an investor aged 40 paid in £15,240 cash to open an ISA on
20 November 2016 and then withdrew £2,000 on 25 January 2017, they could
reinvest the £2,000 withdrawn during the remainder of the 2016/17 tax year to
top the investment back up to the maximum level of £15,240.
Since December 2014 it has been possible for ISAs to be transferred to a spouse
/ civil partner where the account holder dies. Under the previous system, the ISA
had to be encashed and its tax privileges were lost. Now, the spouse / civil partner
of the deceased gains an additional ISA allowance equivalent to the ISA holdings
of the deceased, referred to as an additional permitted subscription. This enables
the ISA savings to be transferred into another ISA.
Maximum contributions are £4,000 per year, and the government will provide a £1
bonus for each £4 saved (25 per cent). As long as the savings are used to purchase
a first home with a value of up to £450,000 or to provide an income in retirement
from age 60, the bonus is retained. The monies are otherwise accessible but the
bonus would be lost and any withdrawal subject to a 5 per cent charge.
interest payment. If, however, the stock is bought ex dividend, then while the
buyer acquires the stock itself, the forthcoming interest payment will be payable
to the previous owner of the stock (ie the seller).
Any capital gains made on the sale of gilts are free of capital gains tax (CGT).
Example
Andrew, a higher-rate taxpayer, buys £100,000 par value of Treasury 5 per
cent 2019 at a price of 80.0, ie he pays £80,000 for the stock.
He receives annual interest of £5,000 (actually £2,500 per half year), which
represents a yield of 6.25 per cent on his investment of £80,000.
The interest is paid gross and, assuming that he has no other savings income,
the first £500 is tax-free with the balance of £4,500 taxed at 40 per cent
(£1,800).
Later he sells the stock for £90,000. There is no capital gains tax to pay on his
gain of £10,000.
bonds are related to risk and to help investors they are given gradings by ratings
agencies (such as Standard and Poor’s). As an example, a ‘AAA’ rating would be
considered very low risk.
13.9 Eurobonds
A Eurobond is a bond issued or traded in a country using a currency other than the
one in which the bond is denominated. This means that the bond uses a currency,
but operates outside the jurisdiction of the central bank that issues that currency.
Eurobonds are issued by multinational organisations and governments.
For example, a UK company may issue a Eurobond in Germany, denominating it in
US dollars. It is important to note that the term has nothing to do with the euro
currency, and the prefix ‘euro’ is used more generally to refer to deposits outside
the jurisdiction of the domestic central bank.
The prices at which shares are traded depend on a range of factors, including:
u the profitability of the individual company;
u the strength of the market sector in which it operates;
u the strength of the UK and worldwide economies;
u supply and demand for shares and other investments.
In the short term, share prices can fluctuate both up and down − sometimes quite
spectacularly − but in the long term, investment in equities and equity-linked
markets has outpaced inflation and has provided higher growth than deposit-type
investments.
business to finance expansion, for instance. This in turn leads to the concept
of dividend cover.
u Dividend cover: this factor indicates how much of a company’s profits are
paid out as dividends in a particular distribution. If, for example, 50 per cent of
the profits are paid in dividends, the dividend is said to be covered twice. Cover
of 2.0 or more is generally considered to be acceptable by investors, whereas a
figure below 1.0 indicates that a company is paying part of its dividend out of
retained surpluses from previous years.
u Price/earnings ratio: as its name suggests, the P/E ratio, as it is commonly
known, is calculated as the share price divided by the earnings per share. It is
generally considered to be a useful guide to a share’s growth prospects: a ratio
of 20 or more, for example, indicates that a share is doing well and can be
expected to increase in value in the future. Such a share is likely, as a result, to
be relatively more expensive than others within the same market sector. A low
ratio − less than about 4 − indicates that the market feels that the share has
poor prospects of growth.
Example
An investor who is a higher-rate taxpayer receives a dividend of £1,000 from
shares in a UK company.
If the investor has not used their dividend allowance, the payment is tax-free. If
the dividend allowance has already been used, tax at 32.5 per cent is charged
(£325).
Gains realised on the sale of shares are subject to capital gains tax (CGT), although
investors may be able to offset the gain against their annual CGT exemption
allowance.
13.10.5 Ex dividend
Dividends are usually paid half-yearly. Because of the administration involved in
ensuring that all shareholders receive their dividends on time, the payment process
has to begin some weeks before the dividend dates. A ‘snapshot’ of the list of
shareholders is made at that point, and anyone who purchases shares between
then and the dividend date will not receive the next dividend (which will be paid
to the previous owner of the shares). During that period, the shares are said to
be ex dividend (or xd). The share price would normally be expected to fall by
approximately the dividend amount on the day it becomes xd.
issuing company. Traditionally they were issued in a form that effectively made
them a loan (with a lower rate of interest than conventional debt because of
the right to convert to equity) but, in recent years, they have been increasingly
issued as convertible preference shares.
13.11 Property
In broad terms, investment in property (or real estate) falls into three categories:
u residential property;
u agricultural property;
The vast majority of investors will only ever be involved in residential property. For
most people this does not extend beyond the purchase of their own home, although
an increasing number of people are buying residential properties specifically as an
investment. The significant fall in property values in 2008 was a timely reminder
that property can prove to be a risky investment in the short term.
On the other hand, there are a number of pitfalls and disadvantages of which
inexperienced investors in particular should be made aware.
u There is the risk of being unable to find suitable tenants or that tenants will
prove to be unsuitable.
u Location is of paramount importance and a badly sited development may prove
a problem.
u The property market is affected by overall economic conditions − in times of
recession, lettings may be difficult and property prices may fall.
u Property is less readily marketable than most other forms of investment.
u Investment costs tend to be high and can include management fees, legal
charges and stamp duty. As with direct investment in shares, direct investment
in property can be a risky business for the small investor, although the
advent of buy-to-let mortgages has made it easier. For smaller amounts of
capital and for those who wish to spread the risk, there are property bonds
where the underlying fund is invested in a range of properties and shares in
property companies. Another alternative is real estate investment trusts (see
section 14.4.3).
13.11.1 Taxation
Income from property, after deduction of allowable expenses, is subject to income
tax. It is treated as earned income for tax purposes. On the disposal of investment
property, any gain will be liable to capital gains tax (CGT), but any capital
expenditure on enhancement of the property’s value can be offset against taxable
gains.
13.11.2 Buy-to-let
Despite some dramatic falls from time to time, the overall trend in UK house prices
over the last 30 years has been strongly upwards. The early 2000s saw dramatic
rises in the price of property in the UK. One unfortunate consequence of this is that
young people and other first-time buyers now find it difficult to afford to purchase
a property, especially in the south-east of England, which has seen significant
increases. In times of economic downturn, this effect is worsened by an uncertain
job market that makes it difficult for people to commit to large mortgages.
The situation can be eased if there is a reasonable supply of good-quality properties
to rent but traditionally the UK has had a shortage of private rental property,
particularly compared with most other European countries, for instance. There are
a number of reasons for this, including the following.
u Historically, lenders viewed loans to buy property to let as being commercial
rather than residential loans − even if the property was to be let for residential
purposes. This meant higher rates of interest than for standard mortgage loans
on owner-occupied property.
u Rental income was traditionally excluded from a borrower’s income when
assessing their ability to make the mortgage repayments.
Buy-to-let is an initiative designed to stimulate growth in the private sector of the
rental market. The aim is to encourage private investors to borrow at competitive
interest rates with a view to investing in rental property that should give them a
reasonable expectation of sustained income and capital growth. Lenders involved
in this scheme will now take potential rental income into account and will charge
interest rates broadly in line with those for owner-occupation mortgages.
The scheme is the result of a joint initiative by the Association of Residential
Letting Agents (ARLA) and mortgage lenders. Alliance and Leicester (now part of
Santander), Halifax and NatWest were instrumental in the early stages, although
many more banks and building societies now offer buy-to-let mortgages.
This change in policy results from the knowledge that a buy-to-let scheme will be
professionally managed. For many schemes, it is a requirement that an agent who
is a member of ARLA should be involved in:
u selecting suitable properties;
u selecting suitable tenants;
u arranging appropriate tenancy agreements (normally assured shorthold
tenancies);
u managing the properties.
Gross rents for buy-to-let properties are typically 125−150 per cent of the
monthly mortgage payments. There are of course other costs, such as agents’
commission/fees, insurance and maintenance costs.
The government has become increasingly concerned about the buy-to-let market
and its effect on the ability of first-time buyers to enter the property market. As a
result it introduced a number of measures to reduce the attractiveness of buy-to-let
ownership, as follows:
u Stamp duty on the purchase of additional properties is subject to a 3 per cent
surcharge.
u The ability of landlords to deduct mortgage finance costs from income before
tax, and therefore gain tax relief at the highest rate paid, is in the process of
being replaced by a basic-rate tax credit. This change will be phased in between
April 2017 and April 2021.
u The previous ‘wear and tear’ allowance for furnishings has been replaced with
a one-off capital allowance in respect of expenditure on furnishings.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
4. What are the risks associated with investing in offshore deposit accounts?
7. Explain the terms ‘cum dividend’ and ‘ex dividend’ in relation to gilts.
8. What are the two main rights that shareholders of a company have?
9. How can the financial returns on shares be measured?
Learning objectives
After studying this topic you should be able to:
14.1 Introduction
In this topic we will be focusing on indirect investments as a way of spreading
risk. Such investments are referred to as ‘indirect’ as the investor doesn’t own the
underlying investments directly but rather the underlying investments are selected
by and owned by the fund provider, the investor owning a share in the fund. These
types of investment are also known as ‘collective funds’, examples of which are
unit trusts, open-ended investment companies and investment trusts; the term
‘collective’ derives from the fact that smaller investments from a large number
of individual investors are gathered together. We looked at these in overview
in section 8.6. Collective investments have proved very popular in the UK, with
total funds under management of the order of £950bn as at November 2015 (The
Investment Association, 2016). Collective funds can be managed in two ways.
In general, management charges on passive funds are lower, reflecting the reduced
involvement of the manager.
Finally in this topic we will consider a selection of other types of investment option
that are available to investors. These are:
u commodities;
u foreign exchange; and
u money market instruments.
determined at the end of the dealing period. The prices published in the financial
press are therefore only a guide to investors, who do not know the actual price at
which their deal will be made.
Fund managers are still permitted to use historic pricing if they wish, subject to the
proviso that they must switch to forward pricing if an underlying market in which
the trust is invested has moved by more than 2 per cent in either direction since
the last valuation.
− the contract note: this specifies the fund, the number of units, the unit
price and the amount paid. It is important because it gives the purchase
price, which will be needed for capital gains tax (CGT) purposes when the
units are sold;
− the unit certificate: this specifies the fund and the number of units held,
and is the proof of ownership of the units.
u In order to sell some or all of the units, the unit holder signs the form of
renunciation on the reverse of the unit certificate and returns it to the managers.
If only part of the holding is to be sold, a new certificate for the remaining units
is issued.
14.2.5 Charges
There are two main types of charge applied to unit trusts.
u The initial charge covers the costs of purchasing fund assets and the costs
involved in setting up the plan. The initial charge is typically covered by the
bid−offer spread, the difference, on any given day, between the (higher) offer
price at which the manager offers units for sale and the (lower) bid price at
which they will buy units back.
u The annual management charge, as its name suggests, is the fee paid for the
use of the professional investment manager. The charge varies but is typically
0.5−2 per cent of fund value depending on the degree of active management
required. Although an annual fee, it is commonly deducted on a monthly or
daily basis.
Dividends are paid out without deduction of tax. Each individual has a dividend
allowance of £5,000 and where total dividend income received by an individual
each tax year falls within the dividend allowance, it is free of tax. Where dividend
income exceeds the £5,000 dividend allowance, the excess will be taxed according
to the tax status of the individual.
u Basic-rate taxpayers pay tax at 7.5 per cent.
Income from a fixed-interest trust is paid as interest, and tax at 20 per cent is
deducted at source. As the income is paid as interest and is classed as savings
income it counts towards an individual’s personal savings allowance, £1,000 for
basic-rate taxpayers and £500 for higher-rate taxpayers.
u Non-taxpayers can reclaim the tax that has been deducted.
u Where the income falls within the personal savings allowance of a basic-rate
taxpayer they can reclaim the tax deducted, otherwise they have no further tax
liability.
u Where the income falls within the personal savings allowance of a higher-rate
taxpayer they can reclaim the tax deducted, otherwise they have a further
tax liability of 20 per cent on the income in excess of their personal savings
allowance.
higher-rate taxpayer with savings income of less than £500, can reclaim the £10
deducted.
Given the nature of a unit trust as a pooled investment, the risk will be lower than
that of an individual investing directly into equities on their own behalf. Unit trust
funds will typically invest in a spread of between 30 and 150 different shares.
The actual risk will depend on the type of unit trust selected. The wide range of
choice means that there are unit trusts to match most investors’ risk profiles. A
cash fund will carry similar risks to a deposit account, while specialist funds such
as emerging markets are high risk by their very nature and overseas funds carry
the added risk of currency fluctuations.
Unit trusts provide no guarantee that the initial capital investment will be returned
in full or that a particular level of income will be paid.
14.3.4 Charges
u Initial charge: as already mentioned, OEIC shares are single-priced so there is
no bid−offer spread. An OEIC will levy an initial charge, however, normally in
the region of 3−6 per cent of the value of the individual’s investment.
u Annual management charge: annual management charges based on the
value of the fund are deducted, normally from the income that the OEIC
14.3.6 Risks
The risks associated with investing in an OEIC are similar to those of investing
in a unit trust. As a pooled investment employing the services of professional
investment managers, the degree of risk is lower than direct equity investment.
Risk is also mitigated by the spread that can be achieved for a relatively small
investment. There is, however, no guarantee of the maintenance of the original
capital invested or the level of income that will be generated.
in a falling market. This factor led to some high-profile difficulties for certain
investment trusts in the volatile stock market of the early 2000s.
There is no capital gains tax whilst monies are held within an investment trust.
Upon encashment there may be personal capital gains tax if the gain, when added
to other gains realised by the investor during the current tax year, exceeds the
annual CGT exemption.
u income shares, which receive the whole of the income generated by the
portfolio but no capital growth;
u capital shares, which receive no income but which − when the trust is wound
up at the end of the fixed term − share all the capital growth remaining after
fixed capital requirements have been met.
14.5.1 Endowments
The most common form of savings contract offered by life assurance companies
is endowment assurance, which is, broadly speaking, a policy on which the sum
assured is paid out at the end of a specified term or on the earlier death of the life
assured (although some policies are open-ended and allow policyholders to choose
when to receive the proceeds of their investment). The client’s investment is made
in the form of regular premiums to the life assurance company throughout the
term of the policy. There are a number of variations, the most common of which
are as follows.
bonuses are intended to reflect the level of investment gains that the company
has made over the term of the policy, so the rate of bonus often varies according
to the length of time that the policy has been in force. In the current climate of
reduced stock market values, many companies have reduced the level of their
terminal bonuses.
The difference from a standard unit-linked policy lies in the fact that unit prices
increase by the addition of bonuses which, like the reversionary bonuses on a
with-profit policy, cannot be taken away once they have been added. This means
that unit prices cannot fall and the value of the policy, if it is held until death or
maturity, is guaranteed. If the policy is surrendered (ie cashed in before its maturity
date), however, a deduction is made from the value of the units. This deduction,
the size of which depends on market conditions at the time of the surrender, is
known as a market value adjustment (MVA).
14.6.1 Taxation
The funds in which the premiums are invested are internal life company funds and
their tax treatment is different from that of unit trusts. In particular, they attract
tax at 20 per cent on capital gains (whereas unit trust funds are exempt) and
this tax is not recoverable by investors even if they themselves have a personal
exemption from capital gains tax. The taxation system for policy proceeds in the
hands of the policyholder is complex but, broadly speaking, because gains have
been taxed at 20 per cent within the fund, tax on the gain is payable only by
higher-rate taxpayers, and then only at 20 per cent − the excess of the higher rate
over the 20 per cent already deemed to have been paid within the fund. This is
because investment bonds are non-qualifying policies.
Unlike investment trusts and unit trusts, investment bonds do not normally provide
income in the form of dividends or distributions, but it is possible to derive a form
of ‘income’ from them by making small regular withdrawals of capital (by cashing
in some of the units allocated to the policy). These do not attract additional tax for
basic-rate taxpayers, and even higher-rate taxpayers can withdraw up to 5 per cent
of the original investment each year without incurring an immediate tax liability.
This 5 per cent allowance can, if not used, be carried forward and accumulated up
to an amount of 100 per cent of the original investment.
These withdrawals are tax-deferred and on maturity, death or encashment of the
bond, a tax liability may arise and this is determined by top slicing. Top slicing is
a term that refers to the way of determining what tax is due for UK residents by
calculating the average return over the term of the bond so that the whole gain is
not taken into consideration in one year.
If the planholder is a higher rate or additional rate taxpayer in the tax year a plan is
surrendered, the gain (ie the surrender value + withdrawals, less original purchase
money) will be subject to tax.
1. The gain on the policy (surrender value + withdrawals less original investment)
is calculated.
2. This gain is divided by the number of complete years the investment has been
in force.
3. This gives what is termed the ‘average gain’.
4. The average gain is added to the planholder’s taxable income in the year of
surrender
5. There is a tax liability if the combined taxable income and average gain (after
personal allowance) takes the planholder from a 20 per cent taxpayer into the
40 per cent rate. In this instance 20 per cent tax would be payable on the income
in excess of the higher rate tax band.
If the taxable income plus average gain straddles the additional rate tax band
then 20 per cent tax will be payable on the income that falls within the 40 per
cent band and a further 25 per cent on the income in excess of the additional
rate band.
6. The proportion of any gain above the preceding tax band is the investment
bond’s taxable slice − referred to as the ‘Top Slice’.
7. The ‘top slice’ is multiplied by the complete years the investment has been in
force to give the taxable gain.
Most offshore life offices offer funds from a variety of investment managers, rather
than offer their own in-house funds. This open approach helps investors choose
from the best-performing funds in a particular sector. During the lifetime of the
bond, investors can switch between funds and investment sectors.
14.7.1 Taxation
Investments within an offshore bond can grow gross of any tax. Any income drawn
from the bond is liable to tax in the country where the investor lives. In the UK,
any income and proceeds are liable to income tax, but this can be deferred if the
withdrawal is less than five per cent of the original investment.
This means that offshore bonds can be a good investment for someone who is
planning to move overseas at a later date and will be able to benefit from the
gross roll-up of income within the wrapper. They may also be suitable for overseas
workers who may be able to take an income when not subject to UK tax, although
local taxes may apply.
Offshore bonds can also help mitigate inheritance tax liabilities. Many UK
expatriates may live outside the UK income tax net but, unless they change their
domicile, their estate is still liable to IHT.
14.7.2 Risks
When the investment is outside the jurisdiction of the FCA, it would be a wise
move for investors to consult only those advisers who are regulated in reputable
jurisdictions, where there is a formal regulatory system to protect investors. This
system should ideally include redress for poor advice including a mechanism for
complaints and compensation in the event of default. Investors should also bear
in mind that there could be currency and exchange rate risks and that the returns
may be affected by different economic factors to those driving the UK economy.
14.8.1 Commodities
Commodities have been traded for thousands of years, particularly metals (such as
silver and gold) and foodstuffs (including wheat and other grain crops). In modern
times the concept of a commodity has been broadened considerably and now
includes, for instance, electricity, timber and even future royalties on music and
other artistic work.
For the modern investor, commodities offer a number of opportunities, both
directly and indirectly.
u Investment in precious metals, particularly gold, is available even to small
investors through the sale, by various governments, of gold coins such as South
African krugerrands.
u A lot of trade in commodities is carried out through the medium of ‘forward
contracts’, ie binding agreements made now under which one party must sell
and the other party must buy a specified amount of a commodity at a specified
price on a particular date in the future. Other, more sophisticated, commodity
derivatives have also been developed, primarily to enable farmers and other
producers to hedge their risks (for instance the risk of a crop failure). The
majority of trading in the commodity derivatives markets is now done by people
who have no need of the commodity itself: they make a profit by speculating
on the price movements of the commodities through the purchase and sale of
derivatives.
Currency speculators trade in the currency markets on their own account. They
aim to make profits by anticipating changes in exchange rates and buying/selling
at the appropriate time. A speculator might spend £1m on buying US dollars at
an exchange rate of 55p and then exchange the resulting $1,818,182 back into
sterling when the rate changed to 57p, making a profit of £36,364.
George Soros, perhaps the world’s most renowned currency speculator, caused
a sensation in September 1992 when he sold around $10bn worth of sterling in
anticipation of the UK’s devaluation of sterling. The devaluation happened as the
UK withdrew from the European Exchange Rate Mechanism (ERM), and it is believed
that Soros made over a billion dollars in one day’s trading.
Because they are such short-term securities, changes in market rates of interest
have little impact on the day-to-day prices of Treasury bills unless the changes are
significantly large.
Throughout their term, Treasury bills can be bought and sold, and there is a
strong secondary market, provided mainly by banking organisations as there is
no centralised marketplace. The price tends to rise steadily from the issue price
to the redemption value over the 91-day period, but prices can also be affected by
significant interest rate changes, or by supply and demand.
Treasury bills are purchased in large amounts, and they are not, therefore,
generally of interest to small private investors. They are held in the main by
large organisations (particularly financial institutions) seeking secure short-term
investment for cash that is temporarily surplus to requirements.
References
The Investment Association (2016) Funds under management [online]. Available at:
http://www.theinvestmentassociation.org/investment-industry-information/fund-statistics/funds-
under-management.html [Accessed: 24 May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
Learning objectives
After studying this topic you should be able to:
15.1 Introduction
We overviewed pension products in section 8.7 and support from the state for
people in retirement in section 11.6. In this topic we consider in some detail the
various options available to people to provide for their retirement.
The major consideration in retirement is usually the reduction in income.
Irrespective of other changes that occur in retirement, the loss of such income
can have enormous effect on the lifestyle of the retired person. It is earned
income that usually allows people to maintain a reasonable standard of living.
On retirement, there are many expenses and costs that do not decrease and some
that may even increase. Lighting and heating of the house, for example, may
increase because more time is spent at home. Most other costs of accommodation
or property maintenance will probably remain constant, apart from inflationary
effects. Individuals will also have increased leisure time and may require more
income to enable them to enjoy it. One can now begin to understand the difficulty
in maintaining a standard of living after retirement.
Income lost can only be replaced as a result of carefully considered financial
planning. If no provision is made, the consequences are severe.
There are a number of other factors affecting retirement that are beyond our
control:
u retirement ages;
u legislation.
You need to be aware of these factors in considering retirement planning, in order
to present an accurate picture and to give yourself a better appreciation of some
of the potential financial problems at retirement.
A pension − whether this is provided via the state, employer or the individual − is
a fund built up by contributions that are invested until the beneficiary retires. At
this point decisions need to be made about whether to receive all the benefits as
an income or to take part of the benefit as cash with a reduced income.
Anyone who is uncertain about their entitlement to state pension benefits can
request a state pension benefits statement from the Department of Work and
Pensions (DWP).
u The maximum level of new state pension is £155.60 per week (2016/17).
u Each claimant is awarded a starting amount based on what their NIC record
would give them under the previous system of basic / additional state pensions
as compared with what it would have entitled them to had the new state pension
been in place throughout their working life − the higher amount is awarded as
a starting amount.
A person’s entitlement to the new state pension may be reduced where they had
periods of being ‘contracted out’ of the additional state pension during their
working life.
have retired is taken from general tax revenue as required, rather than invested
into assets to provide funds at a later time.
u Funded schemes rely on the payment of regular contributions, by the
employer and usually also by the member, and the investment of those
contributions to provide a fund which will be the source of future benefits for
scheme members. The majority of occupational schemes are funded schemes.
In turn, these funded schemes are either contributory or non-contributory.
− A pension scheme is non-contributory if only the employer pays
contributions.
− Contributory schemes are those into which both employers and employees
make contributions.
The employer decides on the level of benefit that will be payable, guarantees this
in the scheme rules and is required to ensure that sufficient contributions are paid
into the fund to meet the commitment.
Naturally, the employer is unable to forecast accurately the cost of the scheme
because a member’s ‘final earnings’, investment returns and the level of death
benefits that must be paid will be very difficult to predict. Nonetheless, since
benefits are defined, the employer must ensure that the pension fund is sufficient
at all times to meet the benefit promises made. It might be said that the employer
is bearing the risk in this sort of scheme − if there is a shortfall, it must make it up.
There have been problems in recent years with employers facing difficulties with
the investment performance of the pension fund. In light of such problems, many
employers have closed final salary schemes, either to new members or in respect
of all future benefit accrual, or changed the benefit structure.
A public sector scheme, such as the civil service pension, is normally structured
with a 1/80th accrual rate. The main difference to other occupational pension
schemes is that public sector schemes combine accrual of pension income benefits,
at a rate of 1/80th, and lump sum tax-free cash benefits, at a rate of 3/80ths, for
each year of scheme membership. For example, an individual with 30 years’ service
in the scheme, retiring on a salary of £40,000 per annum, will receive a pension of
£15,000 per annum (30/80 × £40,000) plus tax-free cash of £45,000 (30 × 3/80
× £40,000).
Where the scheme accrues pension benefits in this way, the member has no choice
− both parts must be taken, even if there is no particular need for a lump sum
or if the member would like to draw a lump sum only and defer their income.
The individual cannot forgo the tax-free cash in order to receive a larger pension.
Public sector pensions are fully inflation protected and will therefore increase in
payment. Another benefit is that if the individual moves to a different public sector
occupation, they will be given full credit for existing years’ service (under what is
known as the ‘transfer club’).
A money-purchase, also referred to as a defined-contribution, scheme is
more straightforward in that individual contributions are identifiable. An agreed (or
defined) contribution is paid by the member and employer and invested for each
individual member or for entire funds. On retirement, the accumulated fund is then
used to purchase whatever benefits it can. With a money-purchase arrangement,
benefits depend on the amounts paid in, which the member has control over, and
investment returns / investment conditions when benefits are taken, which the
member has little control over.
Money-purchase schemes can be contrasted to defined-benefit schemes. They are
not open-ended commitments for the employer, who can decide how much to put
in without being bound by a predetermined commitment to provide a certain level
of benefits.
This gives the employer the advantage of knowing how much the pension scheme
will cost, which helps, especially for smaller firms, to predict outgoings. It might
be said that the member bears the risk associated with a money-purchase scheme.
An occupational money-purchase scheme is obliged to provide an annual pension
statement that includes a statutory money purchase illustration. This includes
an estimate of future fund growth and income. The income is then discounted at
a specified inflation rate percentage per annum to show how much it would be
in today’s terms (ie if the member were to retire today). This will hopefully give
the member an idea of their current level of provision and whether they need to
increase their contributions.
Schemes such as this make it easier for employers to fulfil their duties under the
legislation and help people to save for their retirement. The legal minimum for
contributions is, until April 2018, a total of 2 per cent of an employee’s qualifying
earnings, of which the employer must contribute 1 per cent. Qualifying earnings
are defined as earnings between £5,824 and £43,000 a year for the 2016/17 tax
year. Qualifying earnings include an employee’s salary, wages, overtime, bonuses
and commission, as well as statutory sick, maternity, paternity or adoption pay.
By 2019 the minimum contribution level will have risen gradually to 8 per cent, of
which employees will need to pay at least 3 per cent.
u AVCs can be cost-effective, despite the restrictions, because the main scheme
usually covers some, or all, of the costs.
Some schemes offer AVCs in the form of added years. This means that the AVC
provides additional years of service as if the member had actually worked them.
The benefits will include all of the standard scheme benefits, such as pension,
cash and dependant’s benefits. The scheme actuaries will work out how much the
member needs to pay to gain one year’s additional service and it is up to the
member how many years they fund, within the overall limits allowed. Added years
provide certainty regarding benefits but can be much more expensive than other
forms of top-up. The benefits earned in this way must be taken with the main
scheme.
The advantages of AVCs include that they are low cost, that all of the pension is
held with one source, that there is immediate tax relief at the highest marginal
rate and that added years can provide guarantees. The disadvantages of AVCs are,
however, that there is often limited investment choice, that an employer will know
the individual’s funding level and that the AVCs are tied to the main scheme.
For individuals in these categories and for those who wish to make contributions
in addition to their occupational schemes, there is a facility to contribute through
personal pension plans (PPPs). These contracts were introduced by the Finance Act
1986 and have been available since 1 July 1988 as a means by which individuals
can accumulate their own pension funds independently.
Stakeholder pensions (SHPs) were first introduced on 6 April 2001. They are a
flexible, low-cost form of personal pension provision, which we will look at later
in this section, although most of the rules and regulations governing personal
pension plans also apply to SHPs. In general terms, a stakeholder pension is a type
of personal pension plan that meets certain minimum standards.
What distinguishes the stakeholder pension from others are its additional rules
and standards, exclusive to the stakeholder pension and introduced to ensure that
it offers value for money, flexibility and security.
Providers are not precluded from making extra services available at a cost to those
who have taken out stakeholder pensions; neither are they prevented from levying
additional charges. In both cases, however, they may only do so with the express
agreement of the pension holder. Any additional charges must be clear and be
distinguished from the charges allowed by law.
For safety, stakeholder pension schemes must be run either by authorised
managers or trustees. Their legal duty and responsibility is to ensure that the
particular scheme for which they are responsible meets the legal requirements
u Each scheme must nominate a default investment option for customers who do
not want to choose how their payments are invested.
u Charges must not exceed 1 per cent per annum for members who joined before
April 2005. For those who joined after 5 April 2005, the maximum charge is
1.5 per cent for the first 10 years, reducing after that time to 1 per cent per
annum.
u Transfers to and from SHPs are unrestricted provided they are between
registered pension arrangements.
u There must be no restrictions on scheme membership.
u All payment methods must be accepted, except payment via cash, debit and
credit card.
u The minimum contribution must be no more than £20, excluding tax relief.
Schemes must also provide access to low-risk investment media that investors can
use to reduce the risk of loss as they approach retirement age.
u commercial property;
u derivatives.
Residential property is not an appropriate direct investment since it will class as
a prohibited asset and will be subject to punitive tax charges. For prohibited
assets, there is an unauthorised payment charge of 40 per cent on the member
and a surcharge of 15 per cent on the scheme. If such assets represent 25 per cent
or more of fund value, there are further tax charges and the risk that the scheme
will be deregistered.
Indirect investment (such as real estate investment trusts), however, will be
acceptable.
A SIPP can borrow up to a maximum of 50 per cent of the net fund value (to
purchase commercial property, for example).
The contribution and benefit rules are the same as for personal pensions. A SIPP
can accept transfers from other contracts if the product provider offers this facility.
15.5.1 Contributions
There is a limit of £40,000 per year on the maximum tax-relieved pension
contribution that an individual can pay into a pension during a tax year. Where
a person earns less than £40,000 per year this limit is set at the level of their
earnings. This is referred to as the annual allowance.
For those who are ‘high earners’, those earning £150,000 or more per year,
the annual allowance is reduced by £1 for every £2 of earnings over £150,000,
reducing to a minimum level of £10,000.
Those who flexibly access their pension using flexi-access drawdown or by taking
an uncrystallised funds lump sum (see section 15.6.1) are also subject to a special
‘money purchase annual allowance’ of £10,000.
UK residents without earnings can contribute up to £3,600 gross per annum to
registered pension schemes. This means that minors (those under the age of 18) or
those who look after the home and family can have stakeholder or personal pension
plans. The legal guardian must enter into the contract on behalf of the minor; to
ensure that the ownership of the pension reverts to the minor, the guardian will
sign a declaration. The declaration will indicate that the pension is for the benefit
of a specific minor and that the guardian acknowledges that ownership of the
pension will revert to the minor when they reach the age of 18.
Personal and stakeholder pensions have the flexibility to receive transfer payments
from previous pension schemes of which an individual was a member. These
transfer payments will generally not affect the full value of pension rights built
up or the amount of contributions that the individual has made in respect of the
particular scheme. Anyone considering transferring their pension rights from one
scheme to another should take professional financial advice on the matter.
Once any pension commencement lump sum has been taken, the remaining
pension benefits may be taken in a number of ways.
u Scheme pension − the pension income is provided from the registered scheme
or from an insurance company selected by the scheme administrator. This is
the only option available to members of defined-benefit schemes.
Where a member of a pension scheme dies before the age of 75, their pension
benefits are separated into two parts: crystallised funds that are already being
used to provide pension benefits and uncrystallised funds that remain invested
within the fund.
Any death benefits paid from uncrystallised funds are tested against the member’s
lifetime allowance, with any excess taxed at 55 per cent where taken as a lump
sum or 25 per cent if taken as an income.
Crystallised funds will already have been tested against the lifetime allowance, so
no lifetime allowance check is triggered by the member’s death.
Death benefits paid from crystallised funds, from uncrystallised funds within the
annual allowance and for those benefits remaining after any lifetime allowance
charge has been paid are free of income tax.
A member’s pension benefits are tested against the lifetime allowance at age 75,
so where a member dies at age 75 or older there is no lifetime allowance check.
Where the member dies at age 75 or older, death benefits, whether lump sum and
or income, are added to the income of the recipient, in the year of receipt, and
subject to income tax.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
1. Where an individual was ‘contracted out’ for periods during their working life,
what will the effect on their entitlement to the new state pension be?
9. How much is the maximum allowed for a pension commencement lump sum?
10. What are the main ways of taking pension benefits after the pension
commencement lump sum has been taken?
Learning objectives
After studying this topic you should be able to:
u summarise the range of mortgage solutions;
u explain the purpose of equity release.
16.1 Introduction
We looked at mortgage loans in overview in section 8.4.1 and we are now going
to consider mortgage products in more detail. There is a vast array of different
schemes available to customers, and advisers need to be sure that they are
recommending the most suitable for customers’ needs, circumstances and income.
We will also consider equity release schemes. In section 8.4 we covered further
advances and second mortgages, but there are other ways in which a customer
can free up value from their property.
One feature of life policies is that they can be legally assigned to a third party, who
effectively becomes the owner of the policy and is entitled to receive the benefits in
the event of a claim. Some lenders require the endowment to be assigned to them
as part of the mortgage deal; others may simply require that the policy document
be passed into their possession, without a formal assignment.
This means that pensions have the potential to be used as mortgage repayment
vehicles, with the loan being repaid out of the cash lump sum(s).
The plans have other financial benefits.
u Pension contributions qualify for tax relief at a person’s highest rate of tax.
The practical effect of this for a higher-rate taxpayer, for instance, is that each
£100 of contribution costs them only £60. (There is no tax relief on endowment
policy premiums.)
u The fund in which the contributions are invested is not subject to tax on capital
gains, meaning that it should grow faster than a comparable endowment policy
fund, which is taxed on both income and capital gains.
On the other hand, there are a number of factors a borrower might feel are possible
drawbacks to the use of a pension plan for mortgage repayment purposes.
u As benefits cannot be taken until normal minimum pension age, the term of the
mortgage must run until at least age 55. The pension cannot be used to repay
the mortgage any earlier, even if the fund has grown to a sufficient value.
u If the tax-free PCLS is to be used to repay the mortgage then the pension fund
must be worth four times the value of the mortgage (as the PCLS is limited to
25 per cent of fund value). As there is a lifetime allowance that limits the total
value of lifetime tax-relieved pension holdings, the maximum mortgage that
can be repaid from the PCLS is £250,000 (the lifetime allowance for 2016/17
is £1m). It may be possible to draw additional taxed lump sums to pay off a
mortgage but this option is limited to money-purchase pensions and, even then,
not all providers offer this facility.
u If a lump sum is drawn from the pension to repay a mortgage then the value
available to provide benefits in retirement will be reduced.
u A personal pension or stakeholder pension, unlike an endowment assurance,
does not automatically carry any built in life assurance. A separate policy will
be required to cover the repayment of the loan in the event of premature death.
There is a further characteristic of the use of a pension plan that might be
considered a disadvantage by the lender: pension contracts cannot be assigned
to a third party as security for a loan or for any other purpose. The lender cannot,
therefore, take possession of the plan or become entitled to receive benefits
directly from it. This fact has not, in practice, prevented many lenders from being
willing to accept pensions as a means of funding a mortgage.
u if the fund’s rate of growth exceeds that assumed in the initial calculations, the
mortgage can be repaid early.
Drawbacks associated with the use of ISAs (and other similar investment schemes)
are as follows:
u If growth rates do not match the initial assumptions, the final lump sum will
fall short of the mortgage amount − unless additional investments have been
made.
u In the event of premature death, the value of the ISA investment is unlikely to
be sufficient to repay the loan. Additional life assurance cover is required to
meet this eventuality, meaning there is an additional cost to the customer.
u The limits on annual contributions can make it difficult to pay back a loan
quickly or to fund a large loan. This is less of an issue for couples, as they are
each allowed to invest their individual maximum but it is not normally possible
for these funds to be held together in order to accumulate at a faster rate.
Remember also that how interest is charged will vary from one lender to another:
some charge interest on an annual basis, some on a monthly basis, and some on
a daily basis.
u the facility to take a payment holiday, again within certain parameters laid down
at the outset.
difficulties. Such a situation can be further relieved by the borrower being able to
‘borrow back’ previous overpayments.
Most flexible mortgages allow the borrower to draw down further funds as and
when required, although the lender will have set a limit on total borrowing at the
outset. Some lenders provide borrowers with a cheque book to enable additional
funds to be drawn. Flexible mortgages involve a much easier administrative
process than is usual when dealing with further advances. The wording of the
mortgage deed generally used for flexible mortgages is such that all additional
funds withdrawn, within the limit on total borrowing, will automatically take priority
over any other subsequent charges registered against the property.
The combination of salary credits and the calculation of interest on a daily basis
considerably reduces the amount of interest payable and consequently also the
mortgage term.
Even more complex offset mortgages are becoming available that enable the
borrower to offset interest payable on various savings accounts against interest
charged on their mortgage and on any other secured or unsecured loans held with
the lender.
Many lenders now offer flexible mortgages with a fixed, discounted or capped
rate for an initial period. Early repayment charges do not normally apply to these
products but an arrangement fee may be payable and, in some cases, it may be
a condition of the loan that a particular insurance product is purchased from the
lender.
16.3.9 Cashbacks
A cashback is a relatively common incentive offered by many lenders. A lump sum
is paid to the borrower immediately after completion of their mortgage, either as
a fixed amount or as a percentage of the advance. Generally, lower loan-to-value
ratios will result in higher cashbacks. For example, the cashback may be 3 per cent
of the advance for a loan-to-value ratio of up to 80 per cent, and 2 per cent for a
higher loan-to-value ratio.
It is usually a condition of the mortgage that some or all of the cashback must be
repaid if the loan is redeemed within a specified period.
Discounted rates and cashbacks are sometimes used by lenders either to tempt
borrowers away from competitors or as a loyalty bonus to persuade them to
stay. Payment of legal fees is another offer that is commonly made to encourage
switching of the loan between lenders while incurring minimum costs.
u The variable interest rate must be no more than 2 per cent above Bank of
England base rate and must be adjusted within one calendar month when the
base rate is reduced.
When the borrower dies or moves (perhaps into residential care), the property
is sold and the mortgage loan, plus rolled-up interest is repaid to the lender. If
any of the sale proceeds remain once the loan has been repaid, the borrower, or
their estate, receives the balance. If the property is owned jointly, the mortgage
continues until the second death or vacation of the property.
The main providers of equity release plans have formed a trade association called
the Equity Release Council, formerly known as Safe Home Income Plans (SHIP). This
has established a code of practice designed to safeguard the interests of borrowers.
Since 2004, additional protection for customers taking out equity release plans has
been provided through the regulation of such plans by the FCA (and formerly the
FSA) through MCOB.
They also have to covenant to insure the property adequately. A lender is permitted
by law to:
u insist that a property, but not the owner’s contents, is continuously insured by
means of a policy that is acceptable to the lender;
u have its interest as mortgagee noted on the policy;
u secure a right over the proceeds of any claim and to insist that the proceeds be
applied to remedy the subject of the claim or to reduce the mortgage debt.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
10. What rights does a lender have in relation to the insurance of a property that
it has as security for a mortgage loan?
Learning objectives
After studying this topic you should be able to:
17.1 Introduction
Topic 2 covered regulations as they apply to organisations and the senior
management. This topic looks more closely at what is required of people who
are in contact with the customer and who provide information on which product
recommendations are based.
Advising on investments is defined by the FCA in its Handbook as ‘the regulated
activity specified in article 53 of the Regulated Activities Order’ (see section 2.2),
which is, in summary: advising a person if the advice is: (a) given to the person in
his capacity as an investor or potential investor, or in his capacity as agent for an
investor or a potential investor; and (b) advice on the merits of his doing any of
the following (whether as principal or agent):
1. buying, selling, subscribing for or underwriting a particular investment which
is a security or relevant investment (that is, any designated investment, funeral
plan contract, pure protection contract, general insurance contract or rights to
or interests in a funeral plan contract); or
2. exercising any right conferred by such an investment to buy, sell, subscribe for
or underwrite such an investment.
Advising on a home finance transaction is defined by the FCA as: ‘any of the
regulated activities of advising on regulated mortgage contracts, advising on a
home purchase plan, advising on a home reversion plan or advising on a regulated
sale and rent back agreement’.
We looked at who can give advice in section 2.2. These employees have to pass the
PRA’s/FCA’s ‘fit and proper test’ and also maintain necessary ongoing competence
to undertake their roles. This will mean passing the required examinations,
receive advice then potentially they may suffer financial hardship because a need
has gone unprotected at a time when they would value it most. Advice should be
given based on the expertise of the financial adviser and based on full disclosure
of customer information, matched to the products available. In cases where there
is no suitable product the adviser is obliged to say so.
To the adviser, regulation may seem onerous at first but it is there to protect them
and their organisation. Advisers should seek to have long-term relationships with
their clients and this should be based on mutual trust. Advisers and planners need
to be professional in dealing with their clients and the regulation gives them a
framework within which to work.
As we have seen, any person working in an authorised firm who carries out a
controlled function must be approved by the FCA. The FCA is responsible for
approving individuals who have conduct-focused roles. Approved persons are
approved to carry out a specific controlled function or functions. Advisers and
planners are classed as having customer functions and these cover client-facing
roles such as:
u an investment adviser;
u customer trading;
u investment management.
17.3.1.1 Comparisons
Comparisons with other products must be meaningful, and presented in a fair and
balanced way. Markets in Financial Instruments Directive (MiFID) firms are subject
to additional requirements to detail the source of information and the assumptions
made in the comparison. MiFID aims to be part of a plan to make a single market
in financial services across the EU and, among other things, increases the range of
core investment services and activities that firms can provide in other EU countries.
− only make contact at an appropriate time of day, for example between 9am
and 9pm Monday to Saturday and not on Sundays;
− identify themselves and the firm they represent at the start and make clear
why they are calling;
− ask whether the client would like to continue or terminate the call, ending
the call if asked to do so; and
− give a contact point to any customer who they arrange an appointment with.
recommendations they should clearly disclose the nature of their service and set
the level of their charges related to the amount of work done. This should prevent
motivation based upon the level of fee associated with a particular product type or
product provider.
The consultation fee for any financial advice given will be subject to VAT if it does
not result in a sale, ie if it is advice only. If the advice does result in the adviser
arranging with a provider to make a sale then VAT is not chargeable (even though
the sale may not be concluded). Ongoing reviews to ensure that the product is still
suitable are also free of VAT (Professional Adviser, 2012).
17.3.5 Record-keeping
The maintenance of clear and readily accessible records is vital at all stages of the
relationship between financial services professionals, their clients and the FCA,
from details of advertisements to information collected in factfinds, to the reasons
for advice given and beyond. Record-keeping requirements for the different stages
can be found in appropriate sections of the Conduct of Business Sourcebook,
including details of what must be kept and the minimum period for which it must
be retained.
There are many business reasons for maintaining good records. From a regulatory
point of view, the most important reason is to be able to demonstrate compliance
with the regulations. Records can be kept in any appropriate format, which includes
storage on computer, although the rules say that records stored on computer must
be ‘capable of being reproduced on paper in English’.
Firms are expected to take reasonable steps to protect their records from
destruction, unauthorised access and alteration.
17.4.1 Training
Firms must, at appropriate intervals, determine each employee’s training needs
and must organise training that is both appropriate and timely. The success of the
training in achieving its objectives must be evaluated.
Advisers have thirty months, from being appointed to role, in which to attain the
relevant qualification (FCA, 2011).
knowledge and behaviour of their employee, and their ability to apply these in
practice.
There are specific continuing professional developments (CPD) requirements
for firms undertaking retail investment activities. Of the 35 hours minimum
requirement, at least 21 hours must be structured activity (eg some sort of
formal training). Retail investment advisers are also required to make an annual
declaration that they are meeting standards and, as evidence, hold a Statement
of Professional Standing (SPS) from an accredited body such as the Institute of
Financial Services ( FCA, 2016).
17.4.1.4 Record-keeping
Firms should keep records on anything that relates to the firm complying with
the TC Sourcebook. They will need to keep appropriate records relating to staff
recruitment, training, assessment of competence, supervision of staff and details
of appropriate qualifications for any activity within the scope of TC.
Typical records might include some, or all, of the following:
u initial assessments;
u training courses, etc, attended;
How long records should be kept depends on which type of business the records
relate to. For MiFID business, records must be kept for at least 5 years after an
individual has stopped carrying on an activity within the scope of TC, for non-MiFID
business it is 3 years after stopping the activity and for a pension transfer specialist
the records must be kept indefinitely.
It is, however, vital that the relationship should also be one of mutual trust. This
will be much more easily achieved if the adviser can show an understanding not
only of the products that they sell, but of human nature and of the situations in
which people find themselves − and both the perceived and real needs that they
consequently have.
Part of this relationship of trust will be the confidentiality with which the adviser
treats the customer’s personal and financial information. Some confidentiality
requirements are specified by legislation − for example the Data Protection
Act 1998; however, an adviser should make it clear that all of the customer’s
information will be kept confidential at all times unless there is a legal requirement
for it to be revealed.
An adviser must also be aware of the consumer protection legislation that regulates
the relationship with the client. As we have seen, there are also specific rules set
down by the FCA that should be followed.
u Professional client: this category includes all the bodies that would otherwise
be eligible counterparties, except for the fact that they require a higher
level of service than would apply to ‘eligible counterparty business’, eg they
require advice, in addition to execution of transactions. This category also
includes other types of large clients, particularly ‘other institutional investors
whose main activity is to invest in financial instruments’. When dealing with
professional clients, advisers can assume an adequate level of experience and
knowledge and an ability to accept financial risks.
u Retail client: this category provides the highest level of investor protection and
comprises customers who do not fall into either of the previous two categories
− especially, customers who might be described as ‘the person in the street’
and who cannot be expected to have anything more than a simple general
understanding of financial services. It is expected that most customers will fall
into this category.
References
FCA (2011) Calculation of time limits for attaining an appropriate qualification [online]. Available
at: https://www.handbook.fca.org.uk/handbook/TC/2/2A.html [Accessed: 13 June 2016].
FCA (2015) Training and competence [online]. Available at:
https://www.the-fca.org.uk/training-and-competence [Accessed: 13 May 2016].
FCA (2016) Professional standards: advisers [online]. Available at:
https://www.the-fca.org.uk/professional-standards-advisers [Accessed: 13 May 2016].
Professional Adviser (2012) HMRC’s final VAT guidance in full [online]. Available at:
http://www.ifaonline.co.uk/ifaonline/feature/2156211/hmrcs-final-vat-guidance [Accessed: 13
May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
1. What is the biggest issue that consumers, advisers and planners face when
giving financial advice?
2. What are the four Statements of Principle that apply directly to advisers and
planners?
Case study 1
1 Geri has a meeting with Lucy and her civil partner Lindsey. Lindsey has received
an inheritance of £180,000 which she would like to invest in their joint names.
They have no existing investments and plan to buy a new car costing £15,000
and a new kitchen for their house. Geri thinks that there is probably a need for
retirement planning and this would be good as it would help with her quarterly
target. What would be a reasonable course of action for Geri to take?
a. Refer Lucy and Lindsey to an IFA as the amount available is above her
threshold.
b. Suggest to the couple that after the car and the kitchen refit it is likely
that she will be able to give them advice as the amount will be below her
threshold.
c. Find out how much they intend to spend on the kitchen and car and then
decide whether she needs to refer them to an IFA.
d. Suggest that they make lump sum contributions to stakeholder pensions
bringing the amount that each invest below her threshold.
2 Geri has an annual review with her client David. During the interview David
mentions that he feels he has been far more successful at investing since he
started using the bank’s products. He says that he used to invest directly in
shares but suffered a number of losses. Geri knows that past losses can be
offset against gains to reduce capital gains tax. What should Geri advise David
to do?
a. As these were not bank products she should not give any advice and she is
not qualified to give detailed tax advice.
b. She should ask David to bring the details into the branch so she can work
out how much he could claim back.
c. She could tell David that he will be able to make significant savings if he
signs up for the bank’s tax service.
d. She can mention in general terms that losses may be used to reduce capital
gains tax and recommend that David takes advice from an accountant or
takes up the bank’s tax service.
3 Tom has £75,000 to invest, and in conversation with Geri it seems that indirect
investment would be the best option for him. Geri feels that an OEIC might be
the best option for Tom but isn’t too confident in explaining how they work.
She is much more confident explaining investment bonds as they are the main
form of investment that she deals with and she will receive more sales points
for this product. Geri thinks that she has more chance of gaining the business
for the bank if she talks about investment bonds. What should Geri do?
a. Recommend investment bonds; she is more likely to gain the business for
the bank.
b. Make a second appointment with Tom to give her a chance to research the
products and how they work and decide on suitability.
c. Refer Tom to the IFA as she knows that he will be able to explain both
products more clearly.
d. Consider another product, as this may be a better way to deal with her
problem.
4 Geri is completing a factfind with Joanne who is reviewing her finances as she
is expecting her first child in four months. Joanne seems very interested in
protecting herself from financial hardship due to illness, but Geri feels there
is more need for protection in the event of her death. When Geri broaches the
subject with Joanne, she brushes it off , saying, ‘My husband has a good job,
so why would he worry?’ What would be the best course of action?
a. Go along with what the customer wants; it is up to her in the end anyway.
b. Suggest that a joint meeting with Joanne’s husband to discuss their joint
finances would be advisable.
c. Ask the customer if everything is all right with her marriage and the fact she
is pregnant.
d. Steer Joanne away from the subject and talk about saving for the child (Geri
knows that a stakeholder pension would be useful here).
Case study 2
a. File the form; the client gave Greg a cheque anyway, so it must be okay.
b. Accept Greg’s signature on the form in place of the client’s.
8 Greg is also authorised to undertake mortgage advice. Ben takes the opportunity
to sit in on a factfind interview with a new client to see how the process differs
from investment and protection factfind interviews. In the interview Greg finds
out that the client is self-employed and hasn’t brought all of the information
relevant to income and expenditure with her. What should Greg not do in this
instance?
a. Ask the client for a copy of her last tax return to HMRC.
b. Ask the client to give him copies of her last six months’ bank statements
and credit card bills.
c. Indicate to the client that she will be offered a loan by the mortgage company.
d. Indicate to the client what type of mortgage will be the most suitable for her.
Learning objectives
After studying this topic you should be able to:
18.1 Introduction
In this topic we will consider the first part of the sales process from the adviser and
planner perspective. Depending on the organisation, planners may or may not have
face-to-face contact with clients. Planners are however responsible for supporting
the adviser and ensuring that the client’s relationship with the organisation runs
smoothly.
Retirement planning and investment advice are, in the main, delivered though
face-to-face meetings, with a combination of such meetings and telesales for the
sale of protection, mortgages and general insurance. We will focus mainly on
face-to-face meetings as these tend to be for full reviews rather than the sale
of single products. We will, however, touch on some of the issues around telesales
calls (which are also discussed in section 19.7).
The Financial Ombudsman Service (FOS) has highlighted that complaints relating
to execution-only business often result from the customer not realising they have
taken out an investment on an execution-only basis. The FOS has indicated that it
expects firms to be able to provide ‘clear and credible’ evidence that a transaction
was conducted on an execution-only basis. Such evidence would be a signed
statement from the customer confirming that:
In this first meeting with a client, advisers are required to give information about
the products and services they provide and about possible costs to the client. This
information will be in a combined initial disclosure document and includes:
u the nature of the services they provide and the types of products offered;
u from where products are sourced − independent advice or restricted advice;
u the fact that different firms offer clients different options for meeting the cost
of advice;
u charging arrangements for advice and options for payment.
The FCA requires that the information is provided in a ‘durable medium’ and
provides a format for supplying the required information via a services and costs
disclosure document (SCDD).
Firms are not obliged to use the templates provided by the FCA; they can if they
wish develop their own disclosure material, provided that it satisfies the FCA’s
disclosure requirements.
Note: at the time of updating for 2016, the FCA is consulting on changing the
format of the initial disclosure documentation, as it believes the current approach
leads to the duplication of information and causes confusion. The FCA is proposing
that the SCDD template it currently provides will be removed.
The agreement recognises the fact that the services provided put an additional
reliance on the adviser’s advice and general service. The agreement should contain
the terms, information about the firm and its services relating to the agreement,
and include information on communications, conflicts of interest and authorised
status.
u expenditure;
u assets;
u liabilities;
u attitude to risk − where relevant to the service the adviser will provide.
We can look at each of these areas in more detail.
u Marital status: the use of the word ‘marital’ in this context now carries
a wider meaning than in earlier generations, and may include those who
are single, married, civil partners, cohabiting, divorced, widowed, etc. It is
usually preferable to have both partners of a relationship involved in the
financial planning process, since the decisions made will often affect both
partners. Some clients, however, prefer to keep their financial affairs separate.
If the client is divorced or separated it is important to understand the
terms of any maintenance arrangement, property arrangements and pension
splitting/sharing arrangements.
u Family details: the client’s family details are important for a number of
reasons.
− There may be family members who are, or who will be, financially dependent
on the client. This may be children or older family.
− The client may become the beneficiary of gifts or trusts.
− The most important group of family members is usually the children, and
this may include children from previous relationships. In order to give
appropriate advice about protection against death and disability, as well
as about planning for school or university fees, for example, it is necessary
to know how old the children are and the parents’ ambitions/objectives for
them.
− Minor children may have income of their own, from investments, trust
settlements and so on; it is important to establish the level of the income
and the source. Where the income exceeds £100 a year and is generated
from investments funded by the parents, it will be subject to income tax as
if it were the parents’ income. Where the parents are not the source of the
funds, the income is treated as the child’s.
u Wills: have the client and partner made wills? If so, the adviser should establish
the broad outline of the terms of the wills and when they were last reviewed.
If no wills are in place, at the very least the adviser should recommend that
the clients address the situation as a matter of urgency, explaining why it is
important.
u Trusts: has the client established any trusts? If so, details should be recorded.
An analysis of the client’s expenditure can be more difficult: certain items are easily
determined, for example those paid by standing order such as rent or mortgage
and some household bills. Other items will cause a degree of difficulty − or even
embarrassment: trying to pin down how much is spent on, for example, food and
drink, holidays or motoring.
Many firms split expenditure into two categories:
18.4.4 Assets
When discussing assets and investments with clients the following key information
should be obtained:
18.4.5 Liabilities
The relevant information with regard to certain borrowing liabilities includes the
following:
u lender;
u amount of loan;
u balance outstanding;
u original term and term remaining;
u type of loan, eg secured, unsecured (and if secured, on what);
u amount of monthly or other periodic payment;
u rate of interest; repayment method;
u protection of capital or payments.
Clients are often unaware of the details of any arrangements that they have. It is
an adviser’s responsibility to try to obtain this information and clients should be
asked, wherever possible, to bring all relevant details with them.
18.4.6.3 Investment
The adviser should seek the following information:
u type of investment − shares, deposits, unit trusts, investment bonds, etc;
u the purpose of the investment − income; capital growth; future target, etc;
u the tax status of the investment;
u the date and value of the initial investment;
u current value;
u fund selection; surrender penalties, tie-ins, etc;
u views on how the investment has performed to date;
u details of any investments that have been cancelled and why;
u ethical and socially responsible perspectives.
It may be necessary to ask the client to sign letters of authority to existing product
providers to obtain up-to-date information on policy benefits and investment
details. This will then enable analysis of the client’s existing policies to meet their
goals, needs and objectives. At this point it will be possible to decide whether
any further information is necessary to completely understand the client’s existing
financial circumstances.
u how the client feels about their current arrangements (or lack of them) in each
area − for example, how they would feel if their family had insufficient income
if the breadwinner died (this can be difficult for a client to think through and
requires careful questioning and listening on behalf of the adviser);
u their attitudes and objectives within each area, now and in the future;
u What is their attitude towards tying up money for the medium to long term
versus having access to it in the short term?
u In the case of income, does the client want the income now or at a point in the
future? Can the client accept a fluctuating income?
u Is there a specific time and purpose for the investment? How important is it to
achieve the objective?
u Sensible investors will want to make the most gain from their investments while
taking the lowest risk. The adviser’s role is to find out what they want the
investments to achieve and then the level of risk the client is prepared to take
to achieve those objectives. In most cases, the client will only achieve objectives
by taking a degree of risk.
There are two main factors in the equation.
u The client’s objectives and how much money they have available to
meet them: if the client has sufficient resources it may be possible to achieve
their objectives without taking any risks, although that is unlikely. For example,
if the client wished to provide a lump sum of £39,000 in 10 years’ time, they
would need to invest £33,780 in a deposit account earning interest of 1.5 per
cent a year (ignoring tax). This would provide a virtually no-risk investment,
as long as the interest rate averaged 1.5 per cent over the term, which is not
unrealistic given that interest rates do not vary widely in a stable economy. In
contrast, a share-based investment growing at 5 per cent a year would be more
volatile, less reliable and possibly outside the client’s ‘comfort zone’.
with their money. They will have to weigh up the probability of missing the
target by taking a safe approach against the possibility of reaching the target
but risking their capital by taking the more adventurous option. The key is to
balance the objectives against the risk the client is prepared to take. It is also
important to realise that a couple may each have a different attitude to risk; this
needs to be taken into account when formulating any advice.
u Medium risk/balanced − accepts that some risk may be necessary with some
of their available money but would prefer any risk to be controlled.
u Medium to high risk − relatively happy to gamble with a larger part of their
capital if the potential reward is attractive, and accept losses as part of the
bigger picture.
u High risk/adventurous/speculative − prepared to take a high level of risk
in order to achieve growth.
Risk categories with relatively broad definitions should be supported by brief
sub-sections within each definition to aid customer understanding. This can
include:
u a short summary description that is fair and balanced;
u bullet points to provide more detail of the risk of capital loss and the nature of
typical investments in each category; and
u a simple chart showing the ‘shape’ and variability of annual returns over a
period that helps the customer to understand that they need to be comfortable
to accept the gains and losses associated with a particular level of risk.
This approach explains the risk in a number of different ways. Descriptions that
include text and a visual representation give different elements to engage different
customers.
Some firms use fewer categories, while others extend the categories further. It
is very likely that the client’s investment experience will be reflected in their risk
acceptance; the more experience, the more adventurous the investor.
u risk to capital;
u way in which different investments work and the risk involved − deposits
versus shares, for example;
u effect of time on an investment − secure investment is sensible for
short-term investment, while asset-backed investment (ie based on stocks and
shares) is prudent for medium- to long-term investment;
u risk of not achieving the objective by being too cautious or too adventurous;
u What investments does the client already have (or what investments have they
had in the past)?
u How would they feel if the value of their investment went down?
u How do they feel about the risk−reward relationship?
u their own feelings on their attitude to, and tolerance of, risk;
u past financial decisions they have made;
u how they would feel and react in a number of ‘what if’ financial scenarios
containing positive and negative outcomes;
u how they would feel about a number of hypothetical events and outcomes in
relation to their finances.
The results should not be relied upon in isolation and need validating against other
information from the customer.
References
FCA (no date) Execution-only transaction [online]. Available at:
https://www.handbook.fca.org.uk/handbook/glossary/G395.html
[Accessed: 16 May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
10. What are the five risk categories generally used by financial service providers?
Learning objectives
After studying this topic you should be able to:
19.1 Introduction
In this topic we will continue our discussion of the sales process begun in Topic 18,
here focusing on steps 3 to 7 in Figure 18.1. We will also consider some of the skills
that advisers and planners need in order to undertake their roles effectively.
u a draft net worth statement using information about the client’s assets and
liabilities (net worth is arrived at by subtracting outstanding liabilities from the
value of assets held; it will also be necessary to undertake a valuation of any
existing investments);
u a detailed income and expenditure statement;
Once the above has been completed a draft financial strategy can be prepared. A
financial strategy is a plan that will enable the client to achieve their goals and
objectives and it entails a number of steps. These are to:
At this point the adviser and planner can move on to the next step.
u life policies;
u pension policies;
u unit trusts and OEICs, and investment trusts (where acquired through an
investment trust savings scheme);
u pension transfers and opt-outs.
They are not required for mortgage advice, although many mortgage providers will
prepare one to help the customer understand the mortgage being recommended.
For a life policy the report must be sent before the contract is concluded unless
the necessary information is provided orally or immediate cover is necessary. For
a pension plan, where a cooling off notice is required, the report must be sent
no later than the fourteenth day after the contract is concluded. For investment
business the report must be issued or as soon as possible after the transaction is
effected or executed.
There is a range of other information that will need to be presented and this should
be prepared in advance of the next meeting.
Products defined as PRIIPs, and thus subject to the requirement to provide a KID,
include:
u investment funds;
The FCA frequently highlights the risks that customers face when taking out
financial products.
For example its business plan for 2016/17 (incorporating a Risk Outlook)
highlighted the following:
u inflation and interest rates are expected to remain low − this can encourage
and sustain high levels of indebtedness and fuel the search for higher returns
from investments, encouraging riskier investments;
u changing market conditions create and increase volatility and uncertainty, which
can lead to capital losses for investors who may not fully understand the risks
associated with their investments;
u the referendum on EU membership;
off-notice, which explains the process. This time period is either 14 or 30 days
depending on the product type.
u Life and pensions and contracts of insurance which are, or have elements of, a
pure protection contract or payment protection contract the period is 30 days.
u For investments, deposits and other insurance contracts the period is 14 days.
The notice must be sent by post direct from the product provider to the client.
The notice runs either from the date when the contract begins or from the date on
which the client receives the contractual terms and conditions if this is later.
The client can withdraw from the contract at any time during the cooling-off
period, without any commitment or loss, by returning the signed cancellation
notice to the product provider. Generally the client will receive a full refund of
any premiums paid if they cancel the contract during this period. The exception
to this is where the client cancels a lump-sum unit-linked investment (a unit trust,
open-ended investment company (OEIC) or investment bond, for example). Where
the money has been invested and the value of the investment has fallen. Under
these circumstances, the client is entitled to a refund of the reduced investment:
no charges can be taken but an adjustment can be made to reflect the fact that
the value of the lump sum has fallen. This is to prevent people cancelling due to
falls in the market. This risk should be explained to the client before the contract
is effected.
For mortgages the situation is slightly different. Once the mortgage offer has been
issued, the borrower(s) has a seven-day period of reflection and can accept the
terms of the offer at any stage.
In practice, advisers will wish to retain the information in all cases for as long
as they believe they may be required to justify the advice and recommendations
given.
It may be useful to agree a time for review of the customer’s financial situation
in, say, 12 months’ time, perhaps linked to an annual pay review or if there
is a significant life event pending, such as marriage or having children, which
would warrant a meeting to discuss arrangements. Being able to approach existing
customers as part of ongoing relationship management is much easier and less
time-consuming than trying to prospect for new customers. Part of the initial
interview process could be to flag with the client times when financial advice would
be appropriate as it may be something that the client was unaware of. For example,
a change in employment may require advice, as benefits with a new employer may
be curtailed and cash given instead. For each client it may therefore be necessary to
record and review certain future events that the adviser has been made aware of to
enable them to make contact with the client and resume their dialogue. However,
in doing so they must be aware of their obligations under the Data Protection Act
not to retain information longer than necessary (see section 5.8.2).
It is also useful for advisers and planners to review client files and client holdings
to determine how well the products or investments sold are performing. It may be
necessary to revisit the client’s attitude to risk and rebalance investment portfolios
or products. This may give opportunities for future meetings to discuss client
requirements.
It is important to ensure that any queries from the client are dealt with effectively
and efficiently and that service standards are maintained. Once a client has been
gained, ongoing good service is one of the main ways of ensuring their loyalty.
19.7 Telesales
While protection, mortgages and general insurance can be sold on a face-to-face
basis, these products can also be sold over the telephone. With the increased use
of technology to provide information to the adviser it is possible to provide clients
with quotes immediately and also to record conversations in case a query arises
later. This method is more suitable for the sales of single products rather than a
more in-depth review of the client’s financial situation.
The process is essentially the same, although steps four (evaluating affordability
and suitability) and five (matching appropriate solutions to client needs) will be
completed by a computer program based on the information given by the client.
After the call has been concluded the documentation will be printed off and sent
directly to them for review and, if they wish to go ahead, for signature.
Many organisations require advisers to work to a script, which follows the input
of information into the electronic factfind. This ensures that what is said to the
client is compliant with regulations and that all the necessary data is collected.
For example, ICOBS rules state that firms must take ‘reasonable steps to ensure
a customer is given appropriate information about a policy in good time and
in a comprehensible form so that the customer can make an informed decision
about the arrangements proposed’. Complaints that telesales advisers have not
followed compliance procedures (especially in the case of pure protection and PPI
policies) led to scripts being developed. Following poor results from a ‘mystery
shopper’ exercise undertaken by the FSA in 2009 in relation to critical illness
sales, a checklist of points and sample sales script was approved for use by the
Association of British Insurers.
References
FCA (2016) Business plan 2016/17 [pdf]. Available at:
http://www.fca.org.uk/static/documents/corporate/business-plan-2016-17.pdf
[Accessed: 16 May 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
3. What are the rules relating to disclosure of charges when business is being
arranged by telephone?
4. When should written details of packaged products be given to clients?
Learning objectives
After studying this topic you should be able to:
20.1 Introduction
In this final topic we will consider some of the underlying legal considerations in
the relationship between the customer and their provider of financial services. It is
important for financial advisers and planners to have this underpinning knowledge,
as although it will not be at the forefront of their dealings with clients, it is very
relevant to their dealings with them.
relatively young. There also used to be some tax advantages of setting up a trust,
but the rules on this have been tightened in recent times.
Legal persons also includes organisations such as limited companies.
u Offer and acceptance: there must be an offer made by one party (the offeror)
and there must be an unqualified acceptance by the other. This acceptance
abroad. The person who makes a power of attorney is called the donor and the
person who acts for them is called the donee, or simply the attorney.
A person who does not have the legal capacity to enter into a contract (eg a minor
or a mentally incapacitated person) cannot appoint someone else as their attorney.
In fact, an ordinary power of attorney would automatically cease if a person were to
become mentally incapacitated. The Enduring Powers of Attorney Act 1985 created
a new type of power, called an enduring power of attorney, which does continue
if the donor becomes mentally incapacitated. Enduring powers of attorney have to
be registered with the Public Guardianship Office if the attorney believes that the
donor is becoming mentally incapacitated. Once the enduring power has been
registered, the attorney can continue to act despite the donor’s mental capacity.
An enduring power of attorney can be revoked only with the consent of the Court
of Protection.
As of October 2007, when the Mental Capacity Act 2005 came into force, enduring
powers of attorney have been replaced by lasting powers of attorney (LPAs)
under which attorneys are able to make decisions not only about financial matters,
but also about personal and health matters. An LPA is established while a person
still has a mental capacity, but only comes into force when they have become
incapacitated. Following the implementing of the Mental Capacity Act, the Public
Guardianship Office has been renamed the Office of the Public Guardian. Existing
enduring powers of attorney can remain in force, but all new arrangements must
be LPAs.
The minimum age for making a valid will under English law is 18.
The will should be a clear and unambiguous statement of the deceased’s wishes
in respect of their estate, and must be signed by the testator in the presence of
two witnesses, who must not be beneficiaries under the will (or the spouses of
beneficiaries).
In the event of marriage or remarriage or entering into a civil partnership, a will is
automatically revoked, unless specifically written in contemplation of the change
of status.
In the UK, approximately seven out of ten people die intestate, without leaving a
valid will. Writing a will is the first step in gaining control over an estate and is,
therefore, a vital part of financial planning.
The cost of writing a will is quite reasonable and should not be viewed as a barrier
to making a will. A financial adviser’s role should not involve the writing of a will
but it is important that clients understand the benefits of a valid will and the risks
of not having one. If the client has no will, the financial adviser should recommend
that they seek professional advice from a solicitor.
In certain circumstances it may be advantageous, following the death of the
testator, for the beneficiaries under a will to vary the way the estate has been
allocated. This can be achieved by executing a deed of variation. All those who
would have benefited from the provisions of the will must be over 18 years of
age and be in agreement on the terms of such a variation. A deed of variation is
often executed for tax purposes: a change in beneficiaries or in the relative shares
received could reduce the inheritance tax liability, for example. In order to be
effective for tax purposes, the deed of variation must be executed within two years
of the death and HM Revenue & Customs must be informed within six months of its
execution. The variation must not be entered into for any consideration of money
or money’s worth.
20.6.1 Intestacy
A person who has died without having made a valid will is said to have died
intestate. This includes the situation where the deceased has left a will but where
the will turns out to be invalid.
If a will makes valid provision for the distribution of some of the assets of the
estate, but not of others, this is referred to as partial intestacy.
The distribution of the estate of a person who has died intestate is determined
by a complex set of rules known as the rules of intestacy. They are very specific
and there is no flexibility or discretion for their variation by the person dealing
with the estate. The destination of property under the intestacy rules depends on
the size of the estate and the deceased’s family circumstances. In many cases −
especially if the estate is a large one − the distribution of the assets may not be
as the deceased would have wished. In particular, it is not necessarily true − as
many people believe − that a surviving spouse or civil partner will receive the whole
estate.
The main rules are as follows. Please note that for the purpose of these rules, the
word ‘spouse’ includes civil partner.
u If the deceased leaves a spouse but no children: the spouse inherits the
estate of the deceased, in full.
u If there is both spouse and children: the spouse gets all of the deceased’s
personal chattels plus the first £250,000 plus half the balance of the residue
in excess of £250,000, absolutely; the other half of the balance in excess of
£250,000 goes to the children.
u If there are children but no spouse: the estate is shared equally among the
children.
u If there is neither spouse nor children: the estate goes to the deceased’s
parents or (if they are dead) to the deceased’s brothers and sisters (or their
children), if there are no brothers or sisters then the estate goes to half-brothers
/ half-sisters.
This is just a summary of the main rules and ultimately, if no blood relative can be
found, the estate will pass the Crown.
There are now a large number of firms that assist individuals with significant
personal debts to enter into IVAs. In most cases they are able to arrange for interest
to be frozen, for a reduction in the amount of the debt, and for legal protection
from creditors if the terms of the IVA are met. The firms are generally able to
persuade the bank or other lender to write off part of the debt in exchange for
a reasonable guarantee of receiving repayment of the remainder. In many cases
this is better for the bank than simply writing off the debt or selling it to a debt
recovery firm.
An individual with an IVA will find it difficult to obtain credit while the IVA is in place,
and creditworthiness is likely to be impaired even after the end of the arrangement.
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
7. What happens to the estate of someone who has died without making a will?
8. How can a will be altered after the death of the testator?
9. Define insolvency.
Please read this Appendix in conjunction with Topic 10, to which the section
numbering here relates.
u the value of benefits in kind, such as company cars or medical insurance; and
u redundancy payments and other compensation for loss of office (where in
excess of £30,000).
For savings income such as interest from bank, building society and National
Savings and Investments accounts, there is a starting-rate band at 0 per cent
for savings income up to £5,000. This starting-rate band is available where
an individual’s taxable non-savings income is below £5,000, ie total income
including savings income is below £16,000 (£11,000 personal allowance plus
£5,000 starting-rate band).
For those whose taxable non-savings income exceeds £5,000, there is a personal
savings allowance (PSA) of £1,000 for basic-rate taxpayers, and £500 for
higher-rate taxpayers; there is no PSA for additional-rate taxpayers. Where an
individual is entitled to the PSA they pay no tax on the first £1,000 / £500 of
savings income. In calculating entitlement to the PSA, income, including that from
savings interest, is taken into account.
For dividend income, each individual has a tax-free dividend allowance of £5,000
per tax year, which means that no tax is paid on the first £5,000 of dividend
income, regardless of an individual’s personal tax status, and the amount of
non-dividend income a person receives. Dividend income in excess of the £5,000
dividend allowance is taxed as follows:
u 7.5 per cent on dividend income within the basic-rate tax band;
u 32.5 per cent on dividend income within the higher-rate tax band;
u 38.1 per cent on dividend income within the additional-rate tax band.
Example 1
A married man aged 30 receives £10,000 as employment income and interest
of £2,500 from a building society account in the 2016/17 tax year. He has a
personal allowance of £11,000.
No income tax is payable, as the £1,500 of taxable income is interest and falls
within the starting-rate band of £5,000, subject to 0% tax.
Example 2
A single woman aged 30 receives £11,400 as employment income and interest
of £5,000 from a building society account in the 2016/17 tax year. She has a
personal allowance of £11,000.
The remaining £400 of savings income falls within the personal savings
allowance of £1,000 (for a basic-rate taxpayer).
Total income tax is £80.
Example 3
Example 4
A married man aged 30 receives £25,000 as employment income and dividend
income of £7,500 from shares in the 2016/17 tax year. He has a personal
allowance of £11,000.
All of the taxable employment income falls in the basic-rate tax band.
Tax of £2,800 (£14,000 x 20%).
In respect of the dividend income:
Example 5
A single woman aged 40 earns £50,000 (gross) in the 2016/17 tax year.
She has no other income. She is employed and has a personal allowance of
£11,000.
u Class 3: these are voluntary contributions that can be paid by people who would
not otherwise be entitled to the full state pension or state sickness benefits.
This can occur because a person has, for instance, taken a career break or
spent some time working overseas. They are flat-rate contributions (£14.10 per
week in 2016/17).
u Class 3A: these are another class of voluntary National Insurance contributions.
They can be paid by those who reached state pension age before 6 April
2016, and are used to boost entitlement to additional state pension. Class
3A contributions can be made until 5 April 2017.
u 10 per cent for basic-rate taxpayers and 20 per cent for higher-rate and
additional-rate taxpayers (the rate used will depend on the amount of their
total taxable income and gains).
u An 8 per cent surcharge applies on the above rates where the disposal is of
residential property that is not eligible for private residence relief, giving rates
of 18 per cent and 28 per cent.
u 20 per cent for trustees or personal representatives; 28 per cent where the
disposal is of residential property that is not eligible for private residence relief.
Example
Vanessa, a basic-rate taxpayer, bought units in a unit trust for £50,000 in May
2005 and sold them for £80,000 in June 2016. At the same time she sold some
shares for £10,000 that she had bought for £12,000. What capital gains tax
will she pay?
Example 1
If on the first death an estate of £200,000 was left entirely to the deceased’s
son when the nil-rate band was £300,000, the unused proportion is 33.33
per cent. If the wife then died when the nil-rate band was £325,000, this
could be increased by 33.33 per cent to £433,333. If, on the first death, the
estate of £200,000 was left entirely to the deceased’s wife (with or without a
will), the unused proportion of the husband’s nil-rate band is 100 per cent,
since transfers between spouses and civil partners on death are exempt from
inheritance tax. If the wife then died when the nil-rate band was £325,000,
this would have increased by 100 per cent to £650,000.
If the estate − including any assets held in trust and gifts made within seven years
of death − is more than the threshold, inheritance tax will be due at 40 per cent
on the amount over the nil-rate band.
For deaths after April 2012, a lower rate of IHT of 36 per cent is applicable where
10 per cent or more of the deceased person’s net estate is left to charity.
Example 2
Joe made a gift of £350,000 on 15 January 2013. He died on 15 April 2016.
The IHT threshold for the year he died is £325,000. Follow the steps below to
work out the inheritance tax due.
u Step one: take away the threshold from the value of the gift: £350,000 −
£325,000 = £25,000. So IHT is due on £25,000.
u Step two: work out the IHT at the full rate of 40 per cent: £25,000 × 40
per cent = £10,000.
u Step three: the gift was made within three to four years of death. So taper
relief at 20 per cent is allowed: £10,000 × 20 per cent = £2,000.
u Step four: take away the taper relief from the full tax charge:
£10,000 − £2,000 = £8,000.
In this example, taper relief reduces the amount of tax payable from £10,000 to
£8,000. 2
Chargeable lifetime transfer tax rate = 20 per cent.
Exemptions from inheritance tax:
u Transfers between spouses and between same-sex couples registered under the
Civil Partnership Act both during their lifetime and on death.
u Small gifts of up to £250 (cash or value) per recipient in each tax year.
u Up to £3,000 per tax year for gifts not covered by other exemptions. Any part
of this £3,000 that is not used in a given tax year can be carried forward for
one year, but no further.
A reduced rate of 36 per cent applies where at least 10 per cent of an estate is
left to charity.
u The system of stamp duty land tax (SDLT) has changed. Under the previous
system SDLT was taxed at a single rate according to the price paid for the
property. Under the new system, in place since 4 December 2014, different
rates of SDLT are allocated to different portions of the purchase price.
− There is no SDLT on the portion of the purchase price up to £125,000.
− On the portion of the purchase price between £125,001 and £250,000, SDLT
is charged at 2 per cent.
− On the portion of the purchase price between £250,001 and £925,000, SDLT
is charged at 5 per cent.
− On the portion of the purchase price between £925,001 and £1.5m, SDLT is
charged at 10 per cent.
Where the purchase price exceeds £500,000, the rate of SDLT is 15 per cent of
the whole purchase price for certain types of purchasers, including corporate
bodies.
Where property is purchased but will not be the main residence of the buyer,
a buy-to-let property or second home for example, a 3 per cent stamp duty is
payable in addition to the rates above.
In Scotland, stamp duty land tax was replaced by land and buildings transaction
tax (LBTT) from 1 April 2015. It operates in a similar way to SDLT but the
thresholds and rates are different.
For companies with profits up to £1.5m, corporation tax is normally due nine
months after the end of the relevant accounting period. For those with profits over
£1.5m, corporation tax is due in quarterly instalments beginning approximately
halfway through the accounting period.
Endnotes
1 Source: www.direct.gov.uk
2 Source: www.direct.gov.uk
u customers’ interests: a firm must pay due regard to the interests of its
customers, and treat them fairly;
u communications with clients: a firm must pay due regard to the information
needs of its clients and communicate information to them in a way that is
clear, fair and not misleading;
u clients’ assets: the adequate protection that a firm must arrange for clients’
assets when it is responsible for them.
5. To pass the ‘fit and proper test’ an individual must show their:
u financial soundness.
6. The FCA expect that all firms must be able to show consistently that the fair
treatment of consumers is at the heart of their business. Firms are required to
provide management information as evidence.
7. Capital adequacy is a bank’s own funds (from shareholders), not money
deposited by investors, and should be sufficient so as to make it very unlikely
that customers’ deposits would be placed at risk.
8. Financial crime includes market abuse (insider dealing and market
manipulation) and money laundering.
− answer questions;
− provide information;
u any person (whether or not they are being investigated or are connected
with the person under investigation) provide documents. In the case of a
specific investigation, any person can also be required to answer questions
or provide information.
10. The main enforcement powers of the FCA are:
2. The APR represents a measure of the total cost of borrowing and its aim is
to allow a fair comparison, between different lenders, of the overall cost of
borrowing. The calculation of APR is specified under the terms of the Consumer
Credit Act 1974 and it takes account of two main factors:
u the interest rate − whether it is charged on a daily, monthly or annual basis;
u the additional costs and fees charged when arranging the loan, eg an
application fee.
The result is that the APR is higher than the actual rate being charged on
the loan; however it gives consumers the opportunity to make comparison
between different providers with the ability to compare ‘like with like’ on the
basis of total cost rather than simply headline rates, which are often used to
attract customers.
3. The aim was to make improvements in three broad areas.
u To enhance consumer rights and redress. Consumers are able to challenge
unfair lending and will have access to more effective options for resolving
disputes.
u To improve the regulation of consumer credit businesses by ensuring fair
practices and through ‘targeted action to drive out rogues’.
u To make regulation more appropriate for all kinds of consumer credit
transaction. Protection is being extended to all consumer credit and to
create a fairer regime for business.
4. The role of TPR is to regulate occupational pensions schemes − ie schemes that
employees join that are run by their employers. It has a number of statutory
objectives that include:
u to protect the benefits and rights of members of occupational pension
schemes;
u to protect members of personal and stakeholder pension schemes where
employees have direct payment arrangements;
u to promote, and improve understanding of, the good administration of
work-based pension schemes;
u to reduce the risk of situations arising that may lead to claims for
compensation from the Pension Protection Fund;
u to maximise employer compliance with employer duties and safeguards
under the Pensions Act 2008 (including the requirements in respect of
auto-enrolment);
u (in carrying out its duties) to minimise any adverse impact on the
sustainable growth of an employer.
u legal, ie containing nothing that breaks the law, or incites anyone to do so,
and omitting nothing that the law requires;
u decent, ie containing nothing that is likely to cause serious or widespread
offence, judged by current prevailing standards of decency (account is
taken of the context of the advertisement, the medium used and the likely
audience; particular care should be taken with sensitive issues such as race,
religion, sex or disability);
u honest, ie not exploiting the credulity, lack of knowledge or inexperience
of consumers;
u truthful, ie not misleading by inaccuracy, ambiguity, exaggeration,
omission or any other means.
7. The areas covered by the Standards of Lending Practice are:
u consumer vulnerability.
3. A budget is required as affordability is one of the key factors a lender will take
into account when assessing a mortgage loan application.
4. The financial impact due to death, illness or unemployment.
5. In the event of their death, the normal earner may have to give up work to look
after the children or may have to meet the cost of full-time childcare.
6. On the death of one of the partners, the beneficiaries of that partner’s estate
(often their spouse and/or family) may wish to withdraw their share of the
partnership’s value. This can cause problems for the remaining partners
because it might mean that they will have to sell partnership assets to
pay the deceased partner’s family. Since much of the value may be in the
form of ‘goodwill’, it may not be possible to realise it except by selling the
whole business. ‘Goodwill’ is that intangible and yet real portion of the value
of a business that relates to the firm’s good name or reputation. In such
circumstances, the need for partnerships to insure against the death of each
partner − in order to buy out their share − is clear.
7. ‘Over-indebtedness’ broadly means that a borrower has taken on too much
debt, often from a variety of different sources, and for some reason starts
to have difficulty in repaying. As soon as the borrower is late paying loan
repayments (arrears) or goes over overdraft limits (excesses) their credit-rating
is downgraded and they will have problems borrowing further to ‘catch up’.
8. Before the recent credit crunch, homeowners with equity in their property
were able to extend their mortgage loans, using the increasing value of
their properties to fund their spending habit and clearing their outstanding
overdrafts and credit cards, only to start again. However, this ‘easy way out’ of
debt was closed following the credit crunch, as property prices fell and it was
more difficult to obtain mortgage loan borrowing.
and £33bn. Statistics show that 90 per cent of people now live to the age at
which they receive their state pension, compared with 66 per cent of people
only 50 years ago, and those who do collect their pension receive it on average
for eight years longer than did pensioners in the early 1950s.
10. Income tax, capital gains tax and inheritance tax.
and any subsequent charges. This means that, in the event of a sale due to
default, the original lender’s claim will be met first in full (if possible) and, if
sufficient surplus then remains, the second mortgagee’s charge will be met.
8. Personal loans, overdrafts and revolving credit (via credit cards).
9. Ordinary shares, also known as equities, are the most important type of
security that UK companies issue. They can be, and are, bought by private
investors, but most transactions in equities are made by institutions and by life
and pension funds. Loan stocks and debentures are also issued by companies
to raise finance. These types of borrowing are usually over the longer term,
which helps the company to make long-term business plans.
10. Collective investments help to spread risk and costs, and use the expertise
of professional fund managers. There is a wide choice of investment funds
catering for all investment strategies, preferences and risk profiles.
11.
u Defined-benefit (final salary) − the employee will receive a pension that is
calculated using a set formula. The scheme will provide benefits on the
basis of an accrual rate, such as 1/60th, and benefits are accrued or earned
in line with the accrual rate for each year the individual is a member of the
scheme. The longer the employee has been a member of the scheme, the
higher the percentage of their final salary they will receive as pension. For
example, an individual who has been a member of a scheme with an accrual
rate of 1/54th for 36 years would be entitled to a pension of two thirds of
final salary upon retirement.
2. The Retail Price Index (RPI) is an index based on a ‘basket of goods and services’
selected to reflect the expenditure of an average household. The rate of RPI will
increase or decrease in line with changes in the prices of the goods and services
included in the basket. The RPI is used to calculate increases in pensions,
benefits and index-linked gilts.
3. Those who save in any interest-bearing savings scheme such as deposit
accounts and gilts.
5. A number of economic factors will influence interest rates. These are the level
of government borrowing, higher levels of individual borrowing, monetary and
fiscal policy and foreign interest rates.
6. The ageing population.
7. Most UK income is generated by economic activity in the UK, and this is known
as the domestic product. The gross domestic product (GDP) is the term used for
the total of income from UK economic activity and is the measure of economic
growth.
8. The interest rate cycle.
u tips;
3. No − dividends are not subject to the deduction of income tax and are dealt
with by the use of tax credits, but the result to the taxpayer is the same.
4.
3. Statutory Sick Pay (SSP) is paid by employers to employees who are off work
due to sickness or disability for four days or longer. To qualify, claimants must
earn more than the lower earnings limit (LEL). SSP is paid for a maximum of
28 weeks in any spell of sickness. Spells of sickness with less than eight weeks
between them count as one spell.
SSP is payable to employed people whose average weekly earnings are above
the level at which NICs are payable. Amounts paid as SSP are subject to tax
and to NI deductions, just as normal earnings would be. People who are still
sick after 28 weeks may be able to claim short-term Employment and Support
Allowance.
4. Employment and Support Allowance.
5. People who need help with personal care and/or need help getting around.
6. Those people in residential or nursing care whose savings exceed £16,000.
7. State pensions are designed to provide little more than a subsistence-level
living standard.
8. Entitlement to new state pension is based on NICs with some entitlement once
NICs (Class 1, 2 or 3) have been paid for at least 10 years and maximum benefit
after 35 years. Upon reaching state pension age a comparison is done to see
whether a person would receive more pension based on entitlement to basic
/ additional state pension or if the new state pension had existed throughout
their whole working life; the higher amount is awarded as their starting amount
under the new state pension.
9. To keep down the costs of providing benefits and to encourage people to get
back to work as soon as possible.
10. State benefits affect the need for protection and financial circumstances can
affect entitlement to benefits through means-testing.
11. There are a number of factors when deciding how much protection cover
is required. There is no single rule for calculating the amount of cover
required but it is usually based on quantifying the shortfall in income that
the dependants would suffer. The shortfall can be expressed as the difference
between:
u how much protection would actually be needed if the risk event happened;
and
u how much protection the client currently has.
12. The cancellation of existing policies and their replacement with similar ones.
The regulator takes a dim view of this practice.
u stroke;
u coronary artery disease requiring surgery;
u multiple sclerosis;
u kidney failure.
u blindness;
u loss of limb(s).
6. The type of occupation of the life insured, plus:
9. The financial returns that shareholders hope to receive from their shares take
two forms: the growth in the share price (capital growth) and the dividends
they receive as their share of the company’s distributable profits (income).
There are a number of measures that can be used to assess the success of
investment in a company’s shares and to predict future performance; these
include earnings per share, dividend cover and the price/earnings ratio.
10. The Stock Exchange Daily Official List gives the closing prices of all listed
securities on the previous day. The Financial Times and other newspapers
produce daily lists of the share prices of most companies, making it easy to
check up-to-date share prices.
11. London Stock Exchange rules require that, when an existing company that
already has shareholders wishes to raise further capital by issuing more shares,
those shares must first be offered to the existing shareholders. This is done by
means of a rights issue offering, for example, one new share per three shares
already held, generally at a discount to the price at which the new shares are
expected to commence trading. Shareholders who do not wish to take up this
right can sell the right to someone else, in which case the sale proceeds from
selling the rights compensate for any fall in value of their existing shares (due
to the dilution of their holding as a proportion of the total shareholding).
12. Property investment has a number of benefits and advantages:
u Property is a very acceptable form of security for borrowing purposes.
u The UK property market is highly developed and operates efficiently and
professionally.
u Rents (and therefore capital values) tend to move with money values and
consequently provide a good hedge against inflation.
u Professional property management services are readily available.
The significant fall in property values in 2008 was a timely reminder that
property can prove to be a risky investment in the short term.
8. With the investment being outside the jurisdiction of the FCA it would be a
wise move for investors to consult only those advisers who are regulated in
reputable jurisdictions, where there is proper regulation, and some kind of
redress for poor advice.
Topic 15 Pensions
1. Contracting out, now abolished, enabled scheme members to forgo their rights
to the additional state pension. In return they would pay a lower level of
National Insurance contributions (NICs) with the reduced NICs rebated into
an alternative pension arrangement. As those who contracted out had their
NICs redirected, their entitlement to the new ‘single-tier’ state pension will be
reduced when they reach state pension age.
2. Unfunded schemes are known as pay-as-you-go schemes. An example of an
unfunded scheme in the public sector is the civil service pension fund. The
government (the employer) and the civil servants (employees) do not make
contributions. The money required to provide benefits on retirement is simply
taken from the public purse as required rather than invested into assets to
provide funds at a later time.
3. The employer is unable to forecast accurately the cost of the scheme because
a member’s ‘final earnings’ will be very difficult to predict. Nonetheless, since
benefits are defined, the employer must ensure that the pension fund is
sufficient at all times to meet the benefit promises made. It might be said
that the employer is bearing the risk in this sort of scheme − if there is a
shortfall, it must make it up. There have been problems in recent years with
employers facing difficulties with the investment performance of the pension
fund and the closure of final salary schemes (to new members) or changing
the benefit structure as a result.
4. There are three ways in which a member can make pension contributions to
enhance the benefits from a company scheme:
u additional voluntary contributions (AVCs);
u free-standing additional voluntary contributions (FSAVCs);
u stakeholder/personal pensions.
u deposit accounts;
u equities (quoted on a recognised stock exchange);
u bonds;
u commercial property;
u derivatives.
9. The maximum tax-free pension commencement lump sum that may be taken
is 25 per cent of the value of pension benefits. This must be payable when the
scheme member first crystallises all / some of the benefits payable under the
pension arrangement (or within three months of crystallisation).
10. Scheme pension (the only option in a defined-benefit scheme), lifetime annuity,
drawdown pension (through flexi-access drawdown or by using a pre-6 April
flexible drawdown arrangement) or uncrystallised funds pension lump sum
(UFPLS) drawdown.
u A tax-free lump sum is allowable from a pension on retirement and this can
be used to repay the mortgage loan. If the scheme is a money-purchase
arrangement it is possible that further, taxable, lump sums may be drawn.
u Pension contributions qualify for tax relief at a person’s highest rates of
tax, making it a tax-efficient way of saving.
u The fund in which the contributions are invested is not subject to tax on
capitals gains (in the same way as an endowment policy for example), which
means it should grow at a faster rate.
3. The potential drawbacks are as follows.
u The limits on annual contributions can make it difficult to pay back a loan
quickly or to fund a large loan. This is less of an issue for couples, as they
are each allowed to invest their individual maximum, but it is not normally
possible for these funds to be held together in order to accumulate at a
faster rate.
u If growth rates do not match the initial assumptions, the final lump sum
will fall short of the mortgage amount − unless additional investments have
been made.
u In the event of premature death, the value of the ISA investment is unlikely
to be sufficient to repay the loan. Additional life assurance cover is required
to meet this eventuality, meaning there is an additional cost.
4. A fixed-rate mortgage option allows the borrower to ‘lock in’ to a fixed interest
payment for a specified period, usually between one and five years. At the end
of the period, the rate reverts to the lender’s prevailing variable rate. There is
often a substantial arrangement fee, however, and there may be restrictions
or penalties on changing to another lender.
5. This would suit a borrower who had large cash balances on their accounts. They
might be unwilling to tie these into other forms of investment or, for example,
might receive payment for large expenses claims from their employers that
create large balances for a couple of weeks each month.
6. This type of mortgage will suit borrowers who want to keep the costs down in
the early years. Examples might be young professionals or others who are just
starting out in the world of work.
7. CAT-standard mortgages are those that meet specific standards in relation to
charges, access and terms; the intention behind their introduction was to avoid
confusing marketing and hidden charges.
8.
u Lifetime mortgages are designed mainly to enable elderly homeowners who
do not have a mortgage on their property to release some of the equity
in order to supplement their retirement income. The customer takes an
interest-only loan, secured on their property, which is mortgaged in the
normal way. Interest is allowed to roll up and is repaid, along with the
original loan, when the property is sold on the death of the borrower (or
second borrower, if a couple).
u Home reversion schemes involve the homeowner selling all or part of their
property to the company in return for an income for life. The customer(s)
retains the right to live in the house until their death(s), after which the
company sells the property and retains all the proceeds. The FCA regulates
these schemes even though they do not involve a mortgage loan.
u act with due skill, care and diligence in carrying out their controlled
function;
u observe proper standards of market conduct in carrying out their controlled
function;
u deal with the FCA and with other regulators in an open and cooperative
way and disclose appropriately any information of which the FCA would
reasonably expect notice.
3. Real-time financial promotions cover, for example, personal visits and
telephone conversations. Non-real-time financial promotions cover, for
example, newspaper advertisements and those on internet sites.
4. Cold calls are not permitted in relation to mortgage contracts.
5. ‘Know your customer’ relates to the need to take reasonable steps to find
out and record all details of the customer that relate to products and services
offered. Unless an adviser or planner has all the relevant information about
a customer it is impossible for them to understand their goals, needs and
objectives and so recommend the most suitable products.
6. Competence can be assessed by the adviser achieving an adequate level
of knowledge and skill to operate when being supervised and passing the
relevant regulatory module of an appropriate examination. Individuals must
work under close supervision until they have been assessed as competent.
Individuals must not be assessed as competent until they have passed all
Case study 1
1 Answer c) is the best course of action. Answer a) is incorrect because the amount
available is not actually known; b) is incorrect because Geri cannot make this
decision for the client in order to help her meet targets; d) is incorrect because
the investment required is to be in joint names and pensions have to be in sole
names.
2 Answer d) is the best course of action. Answer a) is incorrect because she can
discuss the issue in general terms; b) is incorrect because she is not qualified
to talk in this level of detail; and c) is incorrect because at this point she cannot
know what savings can be made.
3 Answer b) is the best course of action, although this highlights the need to
ensure that advisers are fully competent. Answer a) is incorrect as this is not
the most suitable advice for the client and Geri must put his needs before
the needs of the bank; c) is incorrect because the amount is below the IFA’s
threshold and Geri does not need to pass up this opportunity; d) is incorrect as
this is not acting in the best interests of the client.
4 Answer b) is the best course of action as Geri really needs to see the complete
picture. Answer a) is incorrect, although the customer will make the final
choice; c) may not be appropriate at this point and may be considered by some
customers to be a little forward; and d) is incorrect as it is avoiding the issue
entirely.
Case study 2
5 Answer c) is correct. Answers a) and b) are unacceptable courses of action.
Answer d) may be a little hasty as this could have been a genuine oversight and
not worth souring a working relationship for.
6 Answer d) is correct. This person may be in need of savings for an emergency
and putting funds into a stakeholder pension ties them up until retirement.
Answer a) is true up to a point; however, advisers need to find out about
customers’ circumstances and aspirations and help them to make decisions
based on these facts. Answer c) is untrue as stakeholder pensions are
tax-efficient for those with even no income.
7 Answer d) is the correct answer. While the other answers may be true, d) is the
one that will affect the customer most.
8 Answer c) is the correct answer − without having income and expenditure details
confirmed it is unwise to indicate that a mortgage offer can be made because
proving affordability is very important in mortgage advice. It is acceptable to
ask for the information in mentioned in answers a) and b) and it is also possible
to discuss what type of mortgage product is likely to be most suitable.
4. Written details of the products’ key features must be provided to clients before
the sale is concluded.
5. Clients have the right to withdraw from contracts. The time period is most
commonly 14 days (30 days for protection policies) and runs either from the
date when the contract begins or from the date on which the client receives
the contractual terms and conditions if this is later. The notice must be sent
by post direct from the product provider to the client.
6. The customer can withdraw from the contract at any time during the cooling-off
period, without any commitment or loss, by returning the signed cancellation
notice to the product provider. Generally the customer will receive a full
refund of any premiums paid if they cancel the contract during this period.
The exception to this is where the customer cancels a lump-sum unit-linked
investment where the money has been invested and the value of the investment
has fallen. Under these circumstances, the customer is entitled to a refund of
the reduced investment: no charges can be taken but an adjustment can be
made to reflect the fact that the value of the lump sum has fallen. This risk
should be explained to the customer before the contract is effected.
7. The information obtained through the factfind must be retained for a specified
period of time, depending on the nature of the product recommended. These
periods are: