Strengths of the Investment Portfolio - Assignment Example

PERSONAL FINANCIAL PLANNING David and Ruth prefer low risk and an assured and stable income from their personal investment portfolio. Hence, this important investment preference must be considered in the process of determining the best possible investment and retirement portfolio for the couple. a) The total wealth portfolio of the couple is as follows: David has 80,000 held in a building society 30 day notice account. Given an 8% annual return, he gets to earn 6,400 annually from this investment. He has 760,000 invested in equity unit trusts which earns annually. Ruth receives index-linked occupational pension of 16,000 per year. She has 50,000 in ISAs which earns 7,000 yearly. They own a house with a net value of 350,000. They also want to leave something to Edward and William, hence, they will need to invest in a National Savings Certificate which can be encashed by the mother if both boys are still below seven years old. Since they will need a pre-income tax level of 3,000 pounds monthly, the couple needs to invest their money in a better set of investment instruments that will let them achieve this income level. At the moment, they only earn a total of 2,450 monthly from the current wealth portfolio they hold. Except for the National Savings Certificate income, the other investment returns are subject to a 20% tax rate. b.) The investment portfolio of the stockbroker Ned Larken, has its strengths and weaknesses. Ned Larken's 300,000 in a FTSE Short Index 100 share Exchange Transfer Fund (ETF) and 200,000 in a S&P 500 Exchange Transfer Fund (ETF) nets a yearly return of 11%. An ETF is a basket of securities that trades throughout the day on a particular exchange in the same way that a company share does. The ETFs are priced continually, and the price fluctuates throughout the day. The ETF pays a dividend if the dividends of the portfolio shares exceed the fund's expense. The advantages of an ETF investment consist of passive management, low expenses, trading flexibility and transparency. The aim of the ETFs is to replicate the return of their benchmark indexes. The ETFs usually hold the same securities as their indexes in an effort to match their returns. The ETFs charges a low annual expense for management and other fund expenses. It also possesses a certain trading flexibility. The ETF is transparent as the securities held in an ETF are always well-known. As shares trade throughout the day, the fund's holdings must be disclosed in order for the shares to be correctly priced. Institutional investors can take advantage of the arbitrage opportunity as well, which exists when there is the potential to profit from the differences between the ETF price and the price of the given basket of securities. This tends to help keep the fund's price close to its Net Asset Value. The first disadvantage of the FTSE 100 and S&P 500 is that it is less diversified, owning a large number of shares in one or two industries. Thus, the ETFs are likely to be more heavily affected by movements in the prices of these securities than funds that are diversified across a greater number of shares. Their performance will depend more on how this kind of security performs. They are less diversified than the broad stock market ETFs. For example, the five biggest companies in the FTSE 100 constitute approximately one-third of the market value of the overall index, and two of them are global oil companies. This lack of broad diversification makes the performance of the FTSE 100 and related ETFs very sensitive to the changes in the oil industry. The second disadvantage of the FTSE 100 and the S & P 500 is that the performance of sector ETFs is dependent on the timing of their purchase and sale. For instance, the price of these funds can rise rapidly when demand increases for the product or service provided by the companies. Similarly, the price can also drop sharply when there is an economic meltdown in the sector. The third disadvantage is that it is hard to predict when a particular sector is going to earn or lose. For example, the country ETFs track indexes of individual countries around the world. The returns from these funds are high when the country is thriving, but they can be low given political and economic problems that beset a country. The fourth disadvantage is that the ETFs track commodities. These funds tend to be launched when a particular investment is popular, which is usually a poor time to invest. The fifth disadvantage is that the ETF returns may differ from the index as this is caused by the impact of the fund's expenses. The sixth disadvantage is that the ETFs entail costly trading as investors are subject to the same commission charged for trading shares. The constant buying and selling can eliminate any cost advantages the ETFs may have over mutual funds. The S& P 500 consists of the stocks of large publicly held US companies. The fund represents 500 American stocks with the largest market capitalization. An example of this type of investment is the product of Barclays. Barclays introduces a new FTSE 100 Investment Note available within an ISA. Investments can start from as little as 500 with the FTSE 100 Accelerated Return Investment Note Issue 2. The Note offers a return of five times the first 20 per cent rise in the Index (FTSE 100); meaning the final index level only needs to have risen by 20 per cent for an investor to receive a 100 per cent return. The final level of the FTSE 100 Index used for this purpose is averaged over the last six months of the term. The product is available to invest through a MarketMaster, Investment ISA and SIPP account. Barclays Stockbrokers offers comprehensive ISA proposition. Linked to the performance of the FTSE 100 index, it is a six year growth investment designed to produce capital repayment and a return of 140% of any rise in the FTSE 100 index at the end of the term. The Note is eligible to be held in a Barclays Stockbrokers Self-Select ISA account. It is listed on the London Stock Exchange and is fully capital protected until maturity. (Barclay Stockbrokers Website) Individuals are able to contribute to pensions managed by large financial institutions but are also able to invest via Self Invested Personal Pensions, or SIPPs. SIPPs allow individuals to appoint their own investment manager who can be entirely independent of the company administrating the SIPP. An Individual Savings Account (ISA) has proceeds which are currently tax free. They can be cashed in at any time. Personal pensions allow a higher maximum contribution and the added flexibility to allow the stopping and restarting of contributions. An employer gives an employer contribution to a pension plan. c.) 100,000 in a life assurance with-profits bond - This investment represents a fixed monthly amount for at least 10 years. In return one gets life insurance for a fixed sum and reversionary bonuses, are added every year. The bonus rate can rise and fall but once a bonus has been added to it, that bonus is guaranteed. The fixed sum insured plus bonuses are paid if the investor dies or whenever the investor choose to do so after 10 years. Some policies have to end after 20 to 25 years or when the investor reachs age 65. Anyone in good health usually up to age 50, 55, 60, 65 or 70 can invest in a life assurance. d.) 240,000 in banks, building societies, and money market funds. Banks and building societies are required by UK law to deduct income tax at 20% from interest before they pay it out to the retiree. They pay this to HM Revenue & Customs. Bank investment The UK branch of the Hongkong and Shanghai Banking Corporation offer the HSBC Global SRI Life Fund. This fund is benchmarked against the MSCI World Index. This fund earns a return of 11% per annum. Assuming that the couple puts 100,000, the annual interest earnings is 11,000 less the 20% tax rate, at 8,800.The main advantage of this Fund is convenience and the strong professional management of HSBC banking employees. Investment in a Building Society When an investor puts money in a Building society, he puts in a "term deposit". A term deposit is a Deposit invested with the Society for a fixed term of investment and at a fixed interest rate. The principal sum invested is then repayable by the Society to the investor upon maturity of the investment. The interest, which is pegged at a fixed rate, is paid to the investor or added to the principal sum of the Deposit on maturity. The interest is calculated daily. Assuming that the couple puts 80,000, the annual interest earnings of 5% is 4,000 less the 20% tax rate, at 3,200. The main advantage of this investment is that the Building Society has provided financial services and continues to offer a broad range of facilities for savings, loans and investment. The Society is incorporated as a building society under the Building Societies Act 1965. The disadvantages of a building society are multiple. First, borrowers from the Society may default on regular payments. In these cases, if the value of the mortgage security held by the Society is insufficient to meet the debt and the cost of enforcing such security, then the Society suffers an overall loss. Second, the Society lends to borrowers based on mortgage security over residential, commercial and rural properties which presents some degree of risks. Each of those property sectors has their own particular risks associated with them. Third, the Society relies on the Deposits as its primary source of funding. Any strong changes in the level of the Society's Deposits could affect the ability of the Society to meets its obligations to its depositors. The Trust Deed provides that at least 15% of the Society's total tangible assets are held in the form of liquid assets. Fourth, the Society is subject to macroeconomic factors outside its control. If the country experiences a war, the Society's investment can be heavily affected. Fifth, should the Society go bankrupt during the term of one's investment, secured creditors and those creditors preferred by statute will be processed ahead of a small investor's claim. b.) Investment in trust regular savings schemes, utilising funds selling at a discount to net asset value. Investment trusts are collective funds which enable individual investors to pool their money for a single fund and spreading their risk and tapping professional fund managers. Advantages: convenience, option to reinvest, small capital, diversification across countries, access to international financial markets and easy monitoring. The average return of investment is at 8 % annually. If the couple invested 40,000, the annual interest earnings is 3,200 less the 20% tax rate, at 2,560. d.) Investment in money market The funds can also be invested in the money market. The current return on investment in the UK money market is pegged at 9% per annum. If the couple invested 40,000, the annual interest earnings is 3,600 less the 20% tax rate 720, at 2,880. 2.) There are various advantages and disadvantages in the investment in the National Savings Certificates ISA which earns 4.15% per annum. If the couple puts in 760,000 in National Savings Certificate ISA, the annual interest earnings is tax free at 3,154,000 or 262,833 monthly. The primordial advantage is that the 15,000 for each issue can be re-invested any other fixed or index linked issues of savings certificates one holds when they reach their original maturity date after 2, 3 or 5 years. The second advantage is that the certificates can also be held in trust, thus doubling the maximum investment. One files a special trustee application the first time one invests as a trustee. At the end of the 3 or 5 year term one will be asked whether you want to cash or re-invest The best advantage of this form of investment is that it is tax free. All increases in the value of the certificates are tax-free. The same tax exemptions apply to the National Savings Fixed Interest Certificates. Another strong advantage of this type of investment is its usefulness as a means of holding money for adult children in an absolute trust. Third, it is a convenient investment instrument that can be given as a gift. Certificates in the name of a child under 7 can normally be cashed by a parent or guardian. Fourth, there is absolutely no risk. The full value of original investment is returned on withdrawal. 3.) There are many advantages and disadvantages of immediately en-cashing the personal pensions to purchase an annuity. An annuity is purchased with funds from a personal pension scheme or an occupational pension scheme to provide retirement income. If one is a member of a company pension scheme, it is a money purchase or defined contribution plan. This means that the investor savings are invested heavily in the stock market. The investor's income at retirement depends on the performance of the fund. The stock market slump means very bad news for millions of pension savers. The drop in the performance of the stockmarket affects the investor's income at retirement. When one retires, one is entitled to take 25% of your fund as a tax-free cash lump sum. Some retirees buy an annuity with the remainder of the fund, which pays a guaranteed income for the rest of your life. Annuity rates have been rising over the past year. A 65 year old man with a 100,000 pension could have bought a level annuity income of 7,378. For 20008, he could buy an annuity of 7,759 with a 100,000 fund, or about 5,173 with his smaller fund of 70,000. If one has a particularly big pension fund, an investor may decide that he can manage on a smaller income at retirement. The big risk of any investment retirement fund is inflation. The official rate of inflation is 7.4%, but older people suffer a higher rate because more of their money is spent on energy and food, two sectors where prices are rising sharply. There is also a danger that annuity rates will fall in the meantime, although one benefits from a higher annuity rate as one gets older. Company pensions should check whether their scheme offers a lifestyle facility so that their money is transferred into safer assets as they approach retirement. One can also determine if one can have a control over one's pension savings. One does not need to buy an annuity as soon as you retire. One can delay the purchase until you are 75, sometimes 80. A drawdown plan allows one to take your 25% lump sum and leave the rest of the fund invested in the stock market and other assets for the next 10 years or so. In the meantime you can draw an income from the fund to cover day-to-day expenses. Another dampening factor for retirement funds is the tax levied on these funds. For instance, the UK savings interest has tax taken off at 20% before a pensioner receives it. If one receives a savings income that falls within the 2,320 (2,440 for the tax year 2009-10) the starting rate Income Tax band is taxed at 10 per cent. A savings income that rises above the 2,320 (2,440 for the tax year 2009-10)the starting rate Income Tax band, but falls within the 34,800 (37,400 tax year 2009-10) basic rate Income Tax band, is taxable at 20 per cent. A savings income that rises above the 34,800 (37,400 tax year 2009-10)Income Tax band is taxable at 40 per cent. (g) Summarise other issues in financial planning Moreover, there are eight important issues that a prospective retiree needs to take into account with respect to personal financial planning. First, one needs to specify the income one needs at retirement. One needs to choose a level of income that would provide adequate buying power in the region where one plans to live during retirement. Second, one needs to seriously consider the inflation rate. One needs to take an investment fund that earns higher returns than the UK inflation rate. Third, one has to decide when is the best time to retire and to plan one's investment correpondingly. Fourth, one must adopt a personalized benchmark plan of making quarterly or monthly deposits or savings so one can plan for retirement in a systematic way. Fifth, one has to add a disability coverage in one's pension plan. If any of the couple acquires any form of disability in the future will lead to a higher level of monthly expenses. Sixth, self-discipline is very important. The propensity to consume is as strong in old age as it is when one was young. The wide assortment of discretionary expenditures can affect the retirement plan. Seventh, one can hire a certified public accountant or investment managers in order to get professional help in identifying and choosing the savings vehicles or retirement funds. One can choose from several options for accumulating retirement capital. The eighth and most important consideration is that one should categorize the specific investment instruments by their tax treatment. One can choose to have a diversified portfolio where one can choose a tax-free investment and combine it with some taxable investments. If one is not careful in studying one's investment instruments, the government taxes can just get the biggest chunk of one's retirement investments. References Chesser, Delton, Walter T. Harrison Jr., William R. Reichenstein, 2003, "Investment Tax Planning for Retirement: How to Make Taxes Work for the Client," Journal of Accountancy, vol 196, issue: 2, page 63. Goff, Robert H. Jr., and Robert B. Scott Jr., 1995, "Retirement Planning: Ten Key Steps," Journal of Accountancy, vol 180, issue 2, page 69. Pettibone, Craig, 2005, "Current and Retired Federal Managers and Executives Look to the Future, Focusing on Making Information Technology Interactive Leadership Challenges and Competencies, Renewed Commitment to Health and Fitness and the Pecuniary Side of Retirement Planning," The Public Manager vol 34, issue 1, page 1. "Retirement Planning (Don't Put It off for Later)," The Journal, March 16, 2007, page 44. "THE BIZ! Retirement Planning Choices Pensions in Doubt," Birmingham Evening Mail, January 31, 2005, page 37. Online sources Investing in UK Money Market. Available at URL: http://www.guardian.co.uk/business/2008/may/02/investing.creditcrunch . Barclays FTSE 100 Accelerated Return Investment Note Issue 2 18 December 2008. Available at URL: httpp://www.barclays.org Investment in UK Banks http://www.assetmanagement.hsbc.com/displayArticlecd_doc_path=/uk/press/2007/jan-jun/new_quant_funds.html&siab_microsite=uk Caine, Naomi, "Your pension in the crunch" October 15 2008. Available at URL: http://money.uk.msn.com/pensions/articles/article.aspxcp-documentid=10166641 Read More