Current Financial Position and Current Financial Needs - Case Study Example

Current Financial Position and Current Financial Needs

Cash Flows

Currently, Phoebe’s only constant cash inflow is her salary of ₤46,000 and the one-time ₤300,000 she has received as an inheritance from her deceased parents. The inheritance is not subject to inheritance tax since it is less than the estate tax threshold of ₤325,000. Her yearly cash outflows include contributions to her pensions’ schemes, contributions to savings accounts, credit card payments and mortgage payments.

She contributes 10.5% of her gross income to her employer’s pension plan and at her current salary, the amount is ₤4,830 per year. Contributions to the National Insurance (NI) that funds the state pension are 2% of her gross that is, ₤920. She also contributes approximately ₤200 per month to her savings accounts which amount to ₤2,400 per year, and she pays a mortgage amount of ₤600 per month or ₤7,200 per year. Assuming that she uses her credit card to pay for her day to day needs including food, fuel, and other household bills, using rates provided by Edinburgh’s Hillcrest housing association, she approximately pays ₤5,000 for her credit card every year. After deducting a personal allowance of ₤11,000 and pensions relief, she has a tax burden of ₤5,850 bringing her total cash outflow to ₤26,200 and her net cash flow to be ₤19,800.

Assets and Liabilities

Phoebe has a combination of liquid assets, large assets, and investments. She has her inheritance and salary worth ₤346,000 and savings totaling ₤9,500. With the new state pension implemented on 6th April 2016, she is eligible for a state pension since she has been contributing to the National Insurance (NI) for the ten years she has been in employment and that pension guarantees her a yearly income of ₤8,094 at retirement. Her employer’s plan is a one-eightieth that promises her a lump sum of at least ₤65,550 at this particular moment, assuming she stays with the same company until retirement and using her current salary to calculate the pension. Currently, the market value of Burberry Group shares is ₤11.76 per share, making her total investment to be ₤23,520. Finally, she has a house worth ₤140,000 taking into account the current market value of two bedroom flats in Edinburgh.

Phoebe’s current liabilities include her credit card payments, her outstanding mortgage of ₤95,000, pension payments totaling ₤5,750 and a tax burden of ₤5,850 making her total liabilities be ₤111,600.

Future Financial Position and Needs

Phoebe aims to attain financial stability by ensuring she has a steady income in future to make sure that she lives comfortably while still meeting all her obligations. Her inheritance allows her to start taking steps towards financial independence. ₤95,000 of her inheritance will go towards paying her outstanding mortgage, and she plans to get married at an undetermined time in the future. A wedding report based on statistics from Edinburgh states that the average cost of a wedding with an approximate 50-100 guests, is ₤6,200- ₤10,300, therefore, some of her money will go towards financing this. She also plans to invest in interest bearing and dividend yielding financial instruments that will provide additional income which she will add to her usual ₤200 and invest in more financial products.

Financial Products

Deposit Savings Accounts

Depending on the type of saving’s account opened, an account holder may be able to access a joining bonus, but most accounts of the fixed kind levy a penalty for early or frequent withdrawals of savings. However, some of the accounts have a stepped interest plan that allows for the application of marginal interest rates on the money saved in the accounts.

Shares

There are several types of shares that a public limited company in the United Kingdom can issue: bearer shares, cumulative preference shares, ordinary shares, preference shares and redeemable shares. These shares are distinguishable from each other by the degree of ownership they confer to the holder, the rights they have, and the terms of each share. Ordinary shares are the most common and they give the owner rights to vote at annual general meetings, cumulative preference and preference shares have the qualities of both stocks and bonds in that, they have a predetermined dividend yield. Dividends on preference shares are paid before dividends on any other shares, and the cumulative ones have cumulative dividends so that dividends not paid over the years are added together and paid before payment to ordinary shares. Bearer shares are like warrants; they are transferrable, and they show that the holder is entitled to own shares and therefore claim and collect on any unpaid dividends. Redeemable shares, on the other hand, have a proviso for repurchase by the issuing company at a specific date or after a period, and they vary depending on the party that has the option to exercise the company’s buyback provision.

Investment Trusts

Investment trusts are publicly traded companies on the London stock exchange, and these companies invest in shares of other businesses to generate a profit for their shareholders. A shareholder in an investment trust has partial ownership of the company, to the extent of their investment and with that ownership, comes the right to vote in members of the board and vote for or against changes in investment policy. The board safeguards a shareholder’s interests in the company, so these voting rights are of great importance to an investor.

Various features distinguish investment trusts from other vehicles that serve the same purpose and among them are: they are close-ended meaning that they have a fixed number of shares. Closed means that a new investor or someone wanting to increase their investment has to buy the company’s shares on the stock exchange since it is impossible for new shares to be created to accommodate the new investment. This feature is advantageous in that the capital base is stable, and fund managers only buy or sell assets at their discretion instead of doing it to cater to an investor’s needs. These trusts are also able to utilize the concept of gearing to maximize the chance of profit- this comes in handy when there is an investment opportunity but inadequate funds. Cash gotten from borrowing can provide additional returns for the investors when the conditions are favorable, but they can also cause significant losses when the conditions turn.

As mentioned above, sometimes an investment trust is not able to make a profit and to ensure that the fund can distribute some cash to the investors; it is common practice to reserve up to 15% of a year’s profit which is then used in times of negative income. Since shares in an investment trust can be traded at prices different from the Net Asset Value (NAV) of the underlying assets, shareholders can benefit from capital gain if they buy at a discount and sell at a premium.

These trusts also have subscription shares which give the shareholder and option to purchase a specific number of full shares of the fund, at a particular date in the future. These subscription shares are also traded on the exchange, but they may not be appropriate as a short term investment since investment trust shares and the subscription shares are very volatile, especially the latter. Price movement of either share is influenced by different factors which could result in different price action in the two which may lead to the subscription share becoming worthless before exercise.

Unit Trusts and OEIC’s

Unlike investment funds, Unit trusts distribute all income to the investors rather than reinvesting some, but the main difference between the two investments is that while the former is close ended, Unit trusts are open-ended. This means that the funds are virtually limitless since new units or shares are created when an investor decides to buy in, and units eliminated when an investor decides to liquidate. This particular feature could be dangerous since people tend to sell when the markets are doing badly because of fear, instead of buying or holding the position. Unit trust shares are priced once per day which means that the investor has no price visibility on the exact amount they will pay or receive per unit.

Open Ended Investment Companies (OEIC’s) are similar to the unit trusts but where some unit trusts and investment trusts have a bid-ask spread, OEIC’s only have a single price.

Tracker Funds

Where managers actively manage investment trusts and unit trusts, tracker funds are passive in nature. These funds contain stocks from all companies listed on an exchange, and they closely resemble the all-market index. They do not require constant management and their performance commonly mirrors the performance of the market. Tracker funds are heavily diversified; hence, they are less risky than most other investments.

Pound Cost Averaging (PCA)

This investment technique is based on discipline, and it aims at eliminating the risk associated with market movements that may make entry into the market at a particular time, a disastrous decision. PCA requires an investor to invest in a particular product after every predetermined period, say a month, regardless of the price of said product. This means that the investor acquires more units when the price is low but few units when the price is high. The rationale behind this is that the average cost per share becomes smaller as more units of the security are purchased hence reducing the risk that is apparent when one invests in a large quantity of a product at a go (Morningstar, 2016). This technique takes advantage of the fact that it is almost impossible to time the right moment to enter a market.

Tax-Free Products

There are several tax-free products in the UK, and Individual Savings Account (ISA) is one of them. However, there are more products including the current account and other interest-earning investments whose income is subject to exemptions under the new interest tax law which makes them virtually tax-free. Pensions' savings, also enjoy tax relief, and some types of capital gain and dividends are also exempt.

Pension Schemes and AVC’s

Simply, a pension scheme is a long-term saving plan with the added benefit of being tax-free as seen above. Governments and employers among other institutions, run pension schemes. One is not limited to join only one plan since it is permissible to belong in more than one scheme, thus creating more income avenues for the years after retirement. Additional Voluntary Contribution (AVC) plans, allow an individual to pay more than the required amounts into their schemes. These funds are then invested over the years and depending on the terms; one could start drawing benefits at the age of 55.

The amount of money an individual is able to access via AVC is dependent on several factors including the amount of contribution made, the length of time each contribution is invested, and the rate of growth of each investment. The AVC is however linked to the employer’s pension scheme. Therefore, benefits are reaped at the same time as when benefits from the employer’s plan are taken.

Discussion and Recommendations

Phoebe has plans for a wedding, and as shown above, the cost of a wedding varies with the number of people invited. Towards this end, I will recommend putting 2.33% (₤7,000) of the inheritance in a high-interest current account that allows one withdrawal. The ISA is completely interest-free, but current accounts offer higher interest rates and with her tax bracket, Phoebe is entitled to a personal savings allowance of ₤500 on any interest income which makes the product virtually tax-free.

The lady is not risk averse, and she is amicable to invest in risky endeavors for the chance of gaining higher returns. Towards this end, I would recommend she puts 30% (₤90,000) on ordinary shares of her choice, and buy cumulative preference shares worth ₤15,000 (5%). Common shares are cheaper and offer a wide profit margin, but the cumulative shares are less risky with the added advantage of guaranteed dividends. Only capital gains valued above ₤11,100 are taxable, and dividends below ₤5,000 are tax exempt. Some of the money allocated for shares will be in an ISA for drip feeding.

Investment trusts are more volatile than unit trusts. Despite the fact that the latter has been found to do better in the short term, investment trusts do better in the long run since fund managers can focus on a long-term strategy without worry that an investor could recall their investment necessitating the sale of some assets. Investment trust shares are cheaper than those of unit trusts since the former has fewer expenses. Unlike Unit trusts, they have no initial charges and they also charge a flat rate rather than the percentage charges levied by unit trusts. Therefore, it is cheaper and more advantageous to invest in an investment trust than a Unit trust. Thus, I recommend a 10% (₤30,000) investment in that. Up to ₤5,500 of capital gains from investment trusts is tax exempt.

Tracker indexes are relatively safe, so I recommend a 20% (₤60,000) investment in them. Part of that money and the remaining ₤3,000 of the inheritance will be in an ISA from where the drip feeding technique can be used to buy shares of the tracker index, company shares, and investment trust shares on a monthly basis. ₤2,400 from the ISA account can also be used to contribute to the employer’s AVC plan.

Portfolio Creation and Management

As explained, it is almost possible to time the market perfectly so for investments not using the PAC technique, research has to be done to recognize factors that may affect the stock price before deciding when to buy or sell. This can be done by using reputable websites like Yahoo! Finance or investment and unit trust sites. One does not need to personally contact the fund providers or banks to purchase these products and the best option I would recommend is contacting an online stock broker. A keywords query in a search engine will produce a list from which one can choose an online broker after investigating them and the products they offer. These discount brokers are cheap and even cheaper if one selects, “execution-only-service” option, which means that one does not need advice before a trade.

Discount online brokers offer several services some of which are: convenient and cheap way of buying, selling and holding securities, and providing varied choices of investment vehicles and tax shields like ISA. They also facilitate drip feeding into chosen investments, portfolio tools to track one's investments, fund and securities search facilities, and convenient access to funds and paperwork. Most importantly, they provide cost details of funds including the cost of investing and cost per trade, so that one gets into a transaction with all the information necessary (Wilson, A. 2014).

It is important to keep track of an investment portfolio so that one can react to market changes that may affect their portfolio either positively or negatively. Online brokers provide portfolio tracking services but there are also free portfolio management applications available which are compatible with most mobile platforms, this can be used to track minute-by-minute changes in portfolio.