AFA 1 2024 Part 2 FULL PDF

Part II Advanced Financial Advice Investment Topic 1 The economic environment Learning objectives After studying this topic, you will be able to demonstrate an understanding of the macro‑economic environment and its impact on investment, including: long‑term socio‑economic trends; economic cycles; macroeconomic factors: government policy; inflation; interest rates; exchange rates; the money supply; and balance of payments. 1.1 Long‑term socio‑economic trends Demographic and social issues can affect investment markets. The British population is ageing – we are all aware that pensions and healthcare for the elderly have caused a lot of controversy in recent times. As a result, there is a need for strong government action to control inflation: it is important to ensure, as far as possible, that savings and pensions for the elderly are protected from losing their real value. The end of the Second World War signalled a boom in the number of babies born; those people are now either at or approaching retirement. A second, bigger boom followed in the 1960s; these ‘babies’ are currently at their prime in the labour market but will reach state pension age in the late 2020s and early 2030s. The ‘boomers’ born between the mid‑1940s and the 1960s 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. The Office for National Statistics (ONS) produces population bulletins that contain research on the following: population projections into the future; factors affecting population changes, including migration; population demographics, including median population age; ©LIBF Limited 2024. All rights reserved. 125 1: The economic environment the ‘dependency ratio’, which is the ratio of people of pension age to those of working age, which may have implications for pensions, state benefits and care provision. FACTFIND Find the latest ONS population bulletins here: www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/ populationprojections/bulletins/nationalpopulationprojections/previousReleases Most population surveys show that many countries, including the UK and other developed nations, have an ageing population. Studies suggest that Spain, France, Japan and Italy are expected to show the highest population ageing. The USA is generally seen to be in a better position due to its younger population and levels of migration. 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. Living standards are generally increasing and the expectations of the population are high. 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. While some governments take steps to redistribute wealth through social policies, taxation and benefits, markets tend to be nervous of this ‘social engineering’. Employment and productivity – in times of high unemployment, the state is required to pay more in benefits, which means that more money is needed for public spending. Those in employment are likely to cut spending because they, too, feel vulnerable. Where the level of employment is high and productivity is good, companies make more profit, which is good for share values, and employees spend more, which increases demand. 1.1.1 The global perspective In what is now a truly global economy, trends in other countries impact on the UK: ‘When Wall Street sneezes, London catches a cold’ is a familiar saying. The major economies are closely linked, and problems in one tend to have an impact on others: look at the problems in the UK, US and European economies when oil prices rise; look at what happens when the US stock market falls – the rest tend to follow. The world is a more open and global trading platform than ever before. This has led to similar trends emerging across a number of national economies, although, on occasion, one might deviate from the rest, and there is no denying the influential position of the USA. In many ways, the world’s largest economy sets the trend for the rest, particularly 126 ©LIBF Limited 2024. All rights reserved. 1.1 Long‑term socio‑economic trends 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. International trade and free movement of capital have created a worldwide economy that allows consumers to buy from any country and mature economies to help those that are developing. This has led to challenges to the West from emerging economies, particularly as investors now have many opportunities to invest directly in these developing economies or gain exposure by investing in multinational companies. The expansion of the European Union has resulted in a major economic bloc emerging. The UK’s exit from the EU (Brexit) may have long-term implications for its economy. International relations can also influence world stock markets and economies. Problems in the Middle East in the early 1990s led to reduced consumer confidence in the USA. 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. The 9/11 terrorist attacks of 2001, although aimed at the USA, affected the entire global economy. The threat of a ‘trade war’ between the USA and China, which escalated in 2019, affected global markets. The Covid-19 pandemic, including the impact of lockdowns and other changes (eg to the working world) has had, and will continue to have, fundamental implications for almost all aspects of the global economy. Example – the Russian invasion of Ukraine Before Russia invaded Ukraine in February 2022, projections estimated global economic growth in 2022 would be around 5 per cent. The war in Ukraine was a ‘massive and historic energy shock’ to the markets, according to a November 2022 report by the OECD. The ‘shock’ of the war was one of the main factors that had slowed economic growth in 2022 to just 3.1 per cent, and why the OECD projected it to slow to 2.2 per cent in 2023. The war, the report found, has had the greatest impact on Europe’s economy, where growth in 2023 is projected to be just 0.3 per cent. Source: Jenkins The invasion had a significant impact on global economies. As we know, when demand exceeds supply, the prices of goods increase. Combined with increased costs of production, this has led to soaring inflation across the world. The reasons for the increase are complex and interlinked, but we can look at some of the main issues. Ukraine and Russia were major suppliers of fertiliser to the rest of the world. Ukraine was a major supplier of grain, producing 12 per cent of the world’s wheat before the invasion. Interruptions to supplies as a result of the invasion led to increased raw costs and shortages, in turn resulting in soaring prices for consumers. There were serious concerns over dangerous shortages in the supply of grain to many African nations dependent on Ukrainian grain supplies. ©LIBF Limited 2024. All rights reserved. 127 1: The economic environment Food inflation soared globally. In the 12-month period to March 2023, UK food and non-alcoholic beverage prices increased by 19.1 per cent. Much of the rise can be attributed to shortages resulting from the Ukraine situation and higher energy costs. Energy prices rose significantly, in part due to post-Covid-19 increases in demand from recovering Asian economies but mainly due to the Ukraine conflict. Before the invasion, Europe accounted for 74 per cent of Russia’s natural gas exports and 60 per cent of its oil exports; much of Europe was dependent on Russia for its energy. Sanctions against Russia and retaliatory threats by Russia led to uncertainty over gas supplies in particular. This shortage, combined with increased demand from other parts of the world, led to a classic supply–demand situation and a surge in energy costs. By mid- 2023, prices had reduced generally, but energy markets and pricing differed in each country, with some nations seeing prices reduce relatively quickly while others, such as the UK, experienced slower reductions. The instability caused by the invasion led to stock market volatility. At the end of June 2023, the FTSE 100 index was at roughly the same level as it had been just before the invasion: around the 7,500 mark. During that time, it had risen as high as 8,000 in February 2023 and dropped as low as 6,800 in October 2022. 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 other interested parties, while in the UK and USA investor returns and value tend to dominate company thinking. From an investment perspective the demographic trends discussed earlier mean that the ratio of households in their peak earning and saving years to those in retirement (and so saving less, if at all) will reduce in most of the developed world. Studies have also suggested that the demographic changes will drive a decline in the global growth of net financial wealth in the next few decades. Other studies have shown that the projected population gain in the next few decades will mainly take place in Africa and Asia, with the majority of the world’s population living in cities. We can already see the effect of this in China, where many cities have seen an influx of workers from rural areas, causing major socio‑economic problems. The world’s economic balance of power is changing, with emerging economies rapidly increasing their share of global wealth, despite recent tough economic conditions. The PwC research study ‘The World in 2050’ (2017) identifies the leading world economies in 2016 and then predicts the leaders in 2050, based on purchasing power parity. Although the report is now a few years old and does not take into account the effects of Covid-19 and the invasion of Ukraine, it does provide food for thought. The top ten is predicted to be: 128 ©LIBF Limited 2024. All rights reserved. 1.1 Long‑term socio‑economic trends 2016 2050 1. China 1. China 2. USA 2. India 3. India 3. USA 4. Japan 4. Indonesia 5. Germany 5. Brazil 6. Russia 6. Russia 7. Brazil 7. Mexico 8. Indonesia 8. Japan 9. UK 9. Germany 10. France 10. UK As the table indicates, PwC predicts that the UK will fall to number 10 by 2050. PwC states that the UK’s position in the 2050 rankings compares favourably with other advanced economies “despite the medium-term dampening impact on growth from Brexit” due to a larger projected working age share of the population. It notes, however, that this will depend on the country “remaining open to talented people from around the world after Brexit”. Purchasing power is a method of expressing the ‘value’ of a currency in terms of the goods or services that can be bought with one unit of that currency (eg pound, dollar, euro, etc). A decrease in purchasing power is due to inflation and an increase in purchasing power is due to deflation (see section 1.3.1). Inflation occurs over time due to increases in the money supply, but severe economic shocks or events, including those caused by political, natural or other factors, can cause excessive inflation (eg hyperinflation or hyperdeflation) whereby purchasing power jumps rapidly. Purchasing power parity adjusts exchange rates to allow for price level and income differences across different countries, and then uses this to adjust each country’s gross domestic product (GDP) to allow comparisons. It is felt by many experts to provide a more accurate comparison of different nations’ ‘real’ GDP and means that the gap between richer and poorer nations’ GDP is smaller than if we use pure GDP figures. So, for example, the cost of a pair of shoes in India and Britain should cost the same, relative to the incomes and economic situation in each country. The Big Mac index was invented by the Economist magazine in 1986 as a light‑hearted way of showing purchasing price parity. It is not particularly accurate because the price of a Big Mac is not solely determined by exchange rates, and the cost of a Big Mac is determined by the organisation in each country. However, it does give some indication of whether a currency appears to be overvalued or undervalued. For example, in January 2023, the price of a Big Mac in the USA was US$5.36, and £3.79 in the UK. The £:$ exchange rate based on those prices could be calculated as 5.36/3.79 = US$1.41 to £1, or 3.79/5.36 = US$1 to £0.71. At the same time, the official exchange rate was £0.81 to US$1, which means that the sterling was undervalued in the market by 12.9 per cent. Similarly, the euro was undervalued by 1.4 per cent against the dollar. Using the same method to establish the ‘true’ value of sterling against the euro, sterling was undervalued by 11.7 per cent against the euro. ©LIBF Limited 2024. All rights reserved. 129 1: The economic environment FACTFIND You can find out more about the Big Mac index at: www.economist.com/big-mac-index Globalisation means that low‑skilled, labour‑intensive economies in the developed world are at a disadvantage when competing with emerging economies that can produce goods more cost‑effectively. The same also applies to many service industries, where call centres and administrative functions can be outsourced to developing countries with skilled and well‑educated labour at much lower cost. 1.2 Business (economic) cycles As you will probably have experienced, business and the economy moves through phases of growth and decline over a period, typically around ten years. In most cases, the phases follow a pattern and together are called the business cycle. There are four common phases in the business cycle. 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. Recession – consumers become cautious and spend less, demand for goods declines, firms cut investment for future development, stock is reduced due to lost orders and some firms fail. Unemployment rises during a recession. Recession is usually defined as two or more successive quarters of falling GDP and can be described as a ‘small’ decline in the economy. Depression – a big decline, indicated by high levels of business failure, high unemployment and little money circulating in the economy. Recovery – the economy improves because people start to spend more, which means providers start to increase production and the level of employment rises. When an economy is in recession, the government will do all it can to stimulate the economy and so avoid a depression. Equity prices are very sensitive to the market view of the current state of the business cycle – 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 the economic prospects; if the market senses a recovery, prices will rise. A bull market is the term used to describe a period when investors are confident that prices will rise and adopt a ‘bullish’ approach to the market, by buying stocks to hold long term. A bear market is used to describe a pessimistic feeling in the market, with investors looking to sell stocks in the short term. A relationship can be seen between the economic cycle and share markets. Share prices are likely to falter during the boom, as interest rates are increased to control expansion. Share prices suffer at the start of a recession but begin to recover if the market senses the economy is starting to recover. Share prices fall during a depression as interest rates increase and corporate earnings decline. 130 ©LIBF Limited 2024. All rights reserved. 1.3 The macroeconomic factors that affect investment returns Share prices are strong during a recovery because interest rates stay low and corporate earnings improve. Share prices are sensitive to the way the market sees the current state of the business cycle – sometimes a share will be driven down as a result of perception rather than fact. 1.2.1 Stock market cycles We know that share prices are affected by ‘fundamentals’: company profits, the economy and so on. Cycle theory contends that share prices also move in response to cyclical forces over periods of time. 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 moved 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. 1.3 The macroeconomic factors that affect investment returns There are two terms you might have heard: microeconomics; macroeconomics. Individual economic units, such as businesses and families, can affect the economy as a whole by the decisions they take. For example, the amount of money a family spends on goods and services, and the nature of the spending, will affect the businesses providing those things. Increased spending on one item can limit spending on others. In turn, the businesses will need to make sure the prices they charge allow them to remain competitive and profitable. This ‘local level’ view of the economy is known as microeconomics. Macroeconomics looks at the bigger picture – the national or world economy. It considers the impact of microeconomics, what will affect the economy and how the government can control it. Macroeconomics includes: stimulating or calming the economy; controlling inflation; controlling unemployment; influencing exchange rates through government intervention. As an example, at the microeconomic level, property values have risen sharply. This has produced a number of undesirable effects, including: fewer first‑time buyers able to buy; increased borrowing against equity, leading to worryingly high levels of personal debt and the potential for negative equity if the market were to crash; ©LIBF Limited 2024. All rights reserved. 131 1: The economic environment increases in consumer spending based on borrowing rather than earnings. This might result in an increase in inflation. At the macroeconomic level, measures can be taken to slow the market down and reduce the risk. These might include: raising interest rates; enforcing borrowing limits (last used in the 1970s). Of course, the skill critical to successful economics is in using the right measure at the right time and to the right level. As you will realise, both micro‑ and macroeconomic factors will influence the individual’s ability and confidence to invest. In this section, we will look at the key factors, which are: inflation; interest rates; exchange rates; government policies. 1.3.1 Inflation Inflation is the term used for general increases in the price of goods and services over a period. If an article that costs £10 today were to cost £11 in a year’s time, it would have been subject to inflation of 10 per cent over the year. When talking about investment, inflation is often described as a reduction in the buying power of money. For example, if inflation were to run at 5 per cent over a year, an item costing £100 at the start of the year would cost £105 by the end of the year. This means that the original £100 would have been reduced to just over 95 per cent of its original buying power. In this situation, the investor would aim to achieve a rate of growth that exceeds the rate of inflation in order to protect the ‘value’ of their money. A moderate rate of inflation, perhaps around 2 per cent, is seen as desirable for a healthy economy. Disinflation is the term for falling inflation. It should not be confused with deflation because, with disinflation, prices still rise, but not at the previous rates. Deflation is a sustained period of price falls below their previous levels across an entire economy. Deflation generally runs alongside falls in output and demand, largely because buyers are prepared to delay buying to see if prices fall further. Stagflation is the term formed by combining ‘stagnation’ and ‘inflation’ to describe a situation where an economy is stagnant or in recession, there is relatively high unemployment and prices are increasing, which increases inflation. Stagflation is not very common because demand for goods tends to reduce during a recession, and so prices tend not to rise much. It presents a dilemma for politicians because the actions taken to increase employment are also likely to increase inflation further, while actions to reduce inflation are likely to increase unemployment further. 132 ©LIBF Limited 2024. All rights reserved. 1.3 The macroeconomic factors that affect investment returns 1.3.1.1 Measuring inflation It is important for the government to be able to keep track of inflation. There are a number of ways in which inflation can affect the economy and so a number of measures have been developed. 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. 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. 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. Average Weekly Earnings (AWE) measure – measures the rate of change of earnings. The AWE will generally increase more quickly than the RPI because wages tend to rise above inflation. In times of very high inflation, however, wages (AWE) may not keep up with the RPI. Consumer Prices Index (CPI) – in December 2003, the government confirmed that the RPIX was to be replaced by the Consumer Prices Index as the measure for inflation targets. The CPI is based on the standard European measure – the Harmonised Index of Consumer Prices (HICP). The UK has been using this index for some years, although not as a main measure, but it uses the name CPI rather than HICP to keep it in line with other indices with which the UK public is already familiar. The principle of the index is similar to the RPIX but some of the goods and services, and their weightings, are different. The CPI does not include house prices or mortgage costs. Since April 2011, most state benefits have been increased in line with the CPI, instead of the RPI. The exception is the basic state pension, which has only been uprated in line with the CPI from April 2012. The CPI was ‘rebased’ in January 2015, which means that from that date the base point for inflation was 100. This was a technical adjustment to ‘avoid rounding issues that could arise from small index values’ (ONS). The change does not affect the methodology or previous calculations of inflation. ©LIBF Limited 2024. All rights reserved. 133 1: The economic environment The calculation Use the following formula to calculate the percentage change in an index over a time period: current index – index 1 year ago × 100 = annual rate of increase in index index 1 year ago For example: The CPI in Q1 2022 was 115.5 and in Q1 2023 it was 125.9. The annual increase would be: 125.9 – 115.5 × 100 = 9% 115.5 1.3.1.2 The effect of inflation on individuals Inflation is not good for those who have fixed incomes or fixed‑rate savings. Those on benefits are likely to suffer most because their income will generally increase at a lower rate than those who are working, although in the recent era of austerity, pay freezes and economic difficulties, state benefit increases outpaced average incomes. In the past, pensioners also saw increases lag behind average incomes, but the introduction of the ‘triple lock’ saw pension increases of at least 2.5 per cent, which was above average earnings increases between 2011 and 2015. In April 2016, the basic state pension increased by 2.9 per cent, reflecting the rise in average earnings, but in April 2017 it increased by 2.5 per cent because earnings and prices were below 2.5 per cent. In April 2023, the pension rose by the CPI increase of 10.1 per cent, the highest of the three benchmarks. However, many pensioners rely on deposit‑based savings to supplement pension income, and the effect of inflation described below is of serious concern to many. Those who are saving in interest‑bearing investments, such as building society accounts and gilts, are also at risk from inflation. The real rate of return is the term used for the interest rate minus the rate of inflation. It shows the real ‘profit’ made on an investment. For example, if the interest rate is 4.5 per cent and inflation is 2.5 per cent, the real rate of return is 2 per cent. This is an approximate figure, which serves most purposes; economists will use a more complex calculation to arrive at an exact figure. When inflation is low, deposit‑based investment is likely to produce a positive real rate of return. In other words, the rate of interest paid will be slightly higher than the rate of inflation, meaning that the investor will make a small gain in the purchasing power of their investment. When inflation is higher, interest rates will often fall behind the rate of inflation. This leads to a negative real rate of return. Inflation figures released in June 2023 showed the CPI at 7.9 per cent, while easy access savings accounts were paying around 4 per cent. That resulted in a negative return of around 3.9 per cent. Things were worse in the 1970s. In December 1975, the value of a building society account (with interest added) had increased by 7.2 per cent over the previous 12 months. If we adjust that figure to allow for the RPI (the measure of inflation at the time) over the same 12‑month period, the real value dropped by 14.2 per cent – a negative real rate of return. This means that the investment was able to buy 14.2 per cent fewer goods. 134 ©LIBF Limited 2024. All rights reserved. 1.3 The macroeconomic factors that affect investment returns Some people benefit from inflation, particularly borrowers: the effect of inflation will reduce the real capital value of their mortgage or loan. For example, £1,000 borrowed in May 2013 (without any repayments made) was worth approximately £750 in real terms in May 2023, using the CPI as a measure. This means the debt would be lower in 2023 in relation to the borrower’s overall financial position. Put another way, it would take a lower proportion of their wages/wealth to settle the debt in 2023. By contrast, it would require £1,333 in May 2023 to maintain the same real value as £1,000 in May 2013 (Bank of England, 2023). FACTFIND Compare the value of the pound between different years at: www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator For the past few years, the UK has benefited from a sustained period of low inflation. This has led the UK regulators to reduce the assumed growth rates for investment products – pensions and so on. Investors should be advised of the link between returns and inflation, and that earlier expectations might not be realistic in a low‑inflation environment. Low inflation means lower equity returns and lower annuity rates. FACTFIND More information can be found at: www.ons.gov.uk/economy/inflationandpriceindices/bulletins/ consumerpriceinflation/previousReleases 1.3.1.3 Controlling inflation The Bank of England can control inflation to some extent. It can reduce inflation by increasing interest rates, which will reduce the amount of disposable income available to spend. Reduced spending will lead to lower prices. 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. 1.3.2 Interest rates Interest is paid on deposit‑based investments and charged on borrowing. The rate paid or charged will depend on the nature of the investment or the loan. Interest charged on borrowing is usually higher than interest paid on investments, although both will move in the same direction as rates change. 1.3.2.1 Interest on borrowing The interest charged on borrowing depends on the type of borrowing. In general, the higher the risk to the lender, the higher the rate. ©LIBF Limited 2024. All rights reserved. 135 1: The economic environment Mortgages and loans secured on property tend to charge relatively low rates of interest. Secured borrowing is less risky because there is an asset that can be used to settle the debt if necessary. Credit cards generally charge high rates of interest. The borrowing is not secured, the term is open‑ended and the providers must cover the cost of fraud protection and other requirements. 1.3.2.2 Interest on investments As a return, the amount of interest paid depends on the type of investment and the degree of risk taken by the investor. Building society deposit accounts pay low rates of interest – barely above inflation in most cases and sometimes below inflation. The rate moves up or down in line with interest rates in general. If the investor is prepared to tie their money in for an agreed period, the rate will increase and will often be fixed. While this may provide a degree of certainty, an increase in rates generally during the fixed period might lead to the real return falling. This risk is reflected in the higher rate offered. It is also important to consider taxation. If the interest rate were 4.5 per cent, any interest in excess of the personal savings allowance (PSA) of £1,000 would net down to 3.6 per cent and a higher‑rate taxpayer would receive an after‑tax rate of 2.7 per cent once their PSA of £500 was exceeded. If the rate of inflation was 2.5 per cent, the real rates of return would be 1.1 per cent and 0.2 per cent respectively. In 2017, the Office for National Statistics (ONS) adopted a new standard measure for inflation used in its reporting. Known as the CPIH, the measure includes the same calculation as the CPI with the addition of the notional costs of home ownership (less mortgage costs but including council tax). Although it is the ‘headline’ inflation figure published by the ONS, CPIH is not used by the treasury when calculating state benefits or setting the inflation target for the Monetary Policy Committee (MPC). 1.3.2.3 Influences on general interest rates A number of economic factors will influence interest rates. Fiscal policy – government spending, taxation and borrowing. When the government needs to raise money for public spending, it can either raise taxes or borrow. Borrowing is less likely to cause political problems but upward pressure is placed on interest rates when the government increases borrowing significantly. Higher levels of individual borrowing – rates tend to move up when there is high public demand for borrowing. Too much borrowing at an individual level is a worry for governments because money floods into the economy and prices creep up. If people are borrowing against the equity in their properties and buying cars and other luxuries, any interest rate increase can result in many people being severely overstretched financially. Monetary policy – the use of interest rates and the level of money supply to manage the economy. The condition of the domestic economy – if the demand for goods and services is above the level at which firms can produce and supply them, prices will rise. This will lead to inflation, which is controlled to a large extent by increasing interest rates. 136 ©LIBF Limited 2024. All rights reserved. 1.3 The macroeconomic factors that affect investment returns Foreign interest rates – the value of sterling against foreign currencies is affected by interest rates. When UK interest rates are higher than those abroad, the pound is popular and the exchange rate increases. This can have a negative effect on industry because UK goods become expensive abroad and sales may be affected. On the positive side, new materials are cheaper to import. World economic conditions and the demand for goods and services. Commodity prices – higher commodity prices can lead to a rise in the cost of living, which can lead to higher wage demands and higher inflation, requiring an increase in interest rates. 1.3.2.4 Interest rates and investments Low interest rates are usually good for equities. Businesses pay less to borrow and the public has more to spend on a business’s goods. This leads to increased profits, some of which will be paid as dividends to investors. Investors are also looking for opportunities to produce real growth. As a result, cuts in short‑term interest rates usually lead to an increase in share prices. High interest rates are not good for equities. Companies pay more to borrow and the public has less disposable income to spend on a company’s goods. This will reduce profits and the dividends paid; in turn, this will depress equity prices. Since investors can receive a good rate of interest on deposit accounts, they may decide share investment is not worth the risk. Increases in interest rates also affect the value of fixed‑interest securities: if rates increase, the value of gilts will fall; if rates fall, the value of gilts will rise. 1.3.2.5 The effect on the economy Changes in interest rates can have a number of effects on the economy. Falling interest rates usually indicate that the economy should expand in the short term, possibly reaching its peak in 12 months or so. Increasing rates are likely to lead to a contraction in the economy. Borrowing is cheaper when rates are falling; borrowers have more disposable income because their borrowing costs are lower, and company profits increase due to increased demand. However, as we have seen in recent times, this principle does not always apply in tough economic conditions. The recent ‘credit crunch’ has resulted in banks and building societies not passing on the full cuts to borrowers, primarily because they need to rebuild their capital reserves and pay savers a reasonable return. Increasing rates results in increasing borrowing costs. Company profits can suffer due to reduced demand. Falling rates provide less income for those reliant on interest from savings, while increases increase their income. Bond and gilt prices are generally linked to interest rates, increasing when rates fall and decreasing when rates rise, in order to bring the yield in line with the new market interest rates. Share prices generally fall as interest rates increase, partly because investors can achieve reasonable returns without taking the additional risk and partly because of the reduction in profits and dividends resulting from increased borrowing costs. ©LIBF Limited 2024. All rights reserved. 137 1: The economic environment Prices tend to increase as interest rates fall because profits and dividends improve due to lower borrowing, and potential returns seem attractive compared to low interest rates. It is important to bear in mind that the points made generally apply in normal economic conditions; they may not apply in difficult economic circumstances such as the UK has experienced in recent years. 1.3.3 Exchange rates The exchange rate is the amount of one currency that can be bought with another currency. For example, if £1 will buy €1.14 – €1 is worth 87.7p. The rate of exchange between one currency and another will fluctuate daily: the euro has been worth as much as 98p and as little as 55p in recent years. There are a few currencies that are either fixed against a specific currency (usually the US dollar) or pegged against it within a narrow range; an example is the East Caribbean dollar, which is fixed against the US dollar. Exchange rates are affected by the following. Inflation – high inflation in a country will generally lead to a fall in its exchange rate. Interest rates – a rise in interest rates in one country will usually strengthen its currency against others. This may not always be the case when inflation is also high. Income growth and economic growth in the relevant countries. The balance between imports and exports (the balance of trade) – where a country imports significantly more than it exports, the value of its currency might decline if it is unable to attract foreign investment to balance the books. A balance of trade deficit can lead to more borrowing from abroad or to the government selling more of the country’s assets. The government – it is sometimes necessary for a government to intervene in the currency markets. A strong currency can make exporting difficult, while at the same time it can encourage cheap imports. In this situation, the government might sell its own currency to reduce its exchange rate. Conversely, it might buy its own currency to increase the exchange rate, although it is doubtful that a government would have sufficient reserves to do this for long. Confidence – the poor state of the UK economy and pessimism regarding the future can lead to an exchange rate that is lower than might be expected based on other factors. During the early 1990s, as part of the move towards European monetary union, EC member states participated in the European Exchange Rate Mechanism (ERM). Under the ERM, their currencies were supposed to move against each other within a very limited range. In 1992 the UK currency fell outside its permitted range, and the government raised interest rates dramatically in an effort to halt the slide in the value of the pound. It then spent billions buying sterling to try to keep the value of sterling within the range, again to no avail. The government was forced to pull out of the ERM. This example shows that government intervention does not always have the desired effect, particularly since speculators now have a major influence on exchange rates. Currency fluctuations can affect the economy as a whole. If the pound increases in value, imports become cheaper, leading to an increase in imported goods. This can be of significant benefit to those companies that import raw materials for manufacture. UK goods, however, become more expensive abroad, due to the strong pound, and so become more difficult to sell. 138 ©LIBF Limited 2024. All rights reserved. 1.3 The macroeconomic factors that affect investment returns 1.3.3.1 Exchange rates and investment The investor who holds assets in another currency is taking a risk. For example, an investor holding units in a Japanese unit trust might see the fund assets grow in value by 6 per cent in a year. If, however, sterling were to rise in value against the yen by more than 6 per cent over the same period, they would actually lose assets due to exchange rate fluctuations – in sterling terms, their holding will be worth less than it was at the start of the year. The reverse is also true. In the period after the Brexit referendum, many UK investors and funds holding overseas equities saw the value of their investments surge by more than the increases in the market value of those investments. In other words, the currency movement magnified the gain. Much of the total increase resulted from sterling weakening significantly, particularly against the US dollar and the euro, which increased their value in sterling terms. For example, if a US share increased in value from US$2 to US$2.25 over a week, that would equate to an increase of 12.5 per cent. However, if the sterling: US dollar rate was £1:US$1.4 at the start of the week and changed to £1:US$1.3 by the end of the week, the sterling value would have increased from £1.43 to £1.73, an increase in sterling terms of 21 per cent. Essentially, a decrease in sterling would mean that the dollar would buy more sterling. This is the opposite effect to those holding debts in another currency, for whom a rise in sterling will reduce the sterling equivalent debt. 1.3.4 Government policies 1.3.4.1 Economic growth If we add together all of the individual income earned in the UK, we arrive at the national income: the higher the national income, the higher the potential for spending it. When national income is high and spending increases, businesses are likely to produce more goods and services to satisfy the demand, leading to a healthy economy and higher living standards. This is, of course, a simplified explanation of a complex subject, but does outline the general principle. The growth in national income is referred to as economic growth and is a target for governments. As you will appreciate, 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. 1.3.4.2 Monetary policy Monetary policy is the use of interest rates and the money supply to control macroeconomic variables – mainly inflation. Responsibility for monetary policy in the UK has been passed to the MPC of the Bank of England; many other countries have a similar arrangement with their central bank. The MPC can ease monetary policy by reducing short‑term interest rates. As long as the financial markets have confidence in the Bank’s view of future inflation, this should reduce longer‑term interest rates. As a result, assets such as bonds, shares and property ©LIBF Limited 2024. All rights reserved. 139 1: The economic environment should increase in value. Borrowing and spending should increase as a result of the increase in wealth, lower borrowing costs and the ‘feel good’ factor, all of which will stimulate the economy. Confidence is the key factor in the equation. In 2009, with the UK in recession, the Bank of England base rate was reduced to 1 per cent and then 0.5 per cent as part of a financial stimulus package; however, most people were saving or paying off debt rather than spending, and banks were reluctant to lend, which did little to help the government’s actions in the early stages. If the economy is expanding too fast and causing inflationary pressures, the MPC can seek to control the situation by increasing short‑term interest rates; in other words, by tightening monetary policy. Long‑term interest rates should increase as a result, leading to a reduction of asset values and to lower spending and borrowing. Financial markets can have a significant impact on the effect of monetary policy. If the market expects further rises or reductions in interest rates, it can exaggerate changes in longer‑term rates. The MPC’s primary objective is to meet an inflation target of 2 per cent, as measured by the Consumer Prices Index. If the rate is more than 1 per cent above or below the target, the governor of the Bank of England must provide the chancellor with a written explanation of the reasons for the problem and the action proposed to bring it back on target. This may not be a simple process because it can take between 12 and 18 months for a change in interest rates to affect the rate of inflation and perhaps longer for it to have maximum effect. Exchange rates can either be fixed against another currency or currencies, or can ‘float’ against other currencies. Where a nation has a floating currency, monetary policy is the main way to run the economy. When long‑term interest rates increase, the pound exchange rate is likely to increase, which will restrain growth in the economy. When interest rates fall, the pound exchange rate tends to fall, which will help the economy to expand. 1.3.4.2.1 The money supply Economists measure variables in order to understand the workings of the economic system as a whole. The money supply is a fundamental economic identity that is closely linked to other variables such as inflation and interest rates. It is important to measure the size of the money supply and also the speed of its growth. Money is used as a medium of exchange, and the amount of money in circulation must be related to the value of the goods and services that form the basis of transactions. If the money supply exceeds the real value of goods and services, inflation ensues, which results in general price increases. So the money supply should increase only if the volume of goods and services also increases. This close relationship between the money supply and the rate of inflation makes it necessary for a country to measure the amount of money in circulation, so that it can control the growth of the money supply and indirectly influence the rate of inflation. The Bank of England’s role is to implement monetary policy to control the money supply. The Bank needs to ensure that there is enough money to enable all of the desired transactions to take place, but it also needs to stop the money supply from growing too fast and so causing increased inflation. Before we look in more detail, we need to understand two key measures used by the Bank. M0 – known as narrow money, M0 measures the cash base in the UK. It comprises the notes and coins in circulation and the operational balances of banks held at the Bank of England; 99 per cent of M0 is held in notes and coins. 140 ©LIBF Limited 2024. All rights reserved. 1.3 The macroeconomic factors that affect investment returns M4 – known as broad money, M4 measures bank and building society deposits, and new money created by loans and overdrafts. Since it is credit creation that results in new money, the Bank is very interested in the amount of bank and building society lending and it publishes figures for what it calls M4 lending. The Bank can manipulate interest rates to control the amount of new credit being created. When making its interest rate decisions, the Monetary Policy Committee considers the performance of various economic indicators; among these are the money supply and its growth rate and also the growth of M4 lending. 1.3.4.3 Fiscal policy We have looked already at the government’s approach to inflation. This section will look at fiscal policy – the government’s approach to spending, borrowing and tax. Monetary policy acts on the economy as a whole, currently through changes in the general level of interest rates. Although fiscal policy can also have an overall macroeconomic effect on the level of activity in the economy, it has microeconomic effects and can be targeted to particular areas of the economy. For example, tax incentives can be given to manufacturing industries to boost employment in what is a declining sector, or government grants can be given to firms that move to relatively underdeveloped geographical areas. Fiscal policy and monetary policy are not applied in isolation but are closely linked, and governments generally use a combination of the two to achieve their economic aims. The effect of a change in fiscal policy can be measured by the change in balance between government spending and receipts; this is referred to as the budget surplus or deficit. The balance can also be affected by the economic cycle, making The macroeconomic factors that affect investment returns it difficult to establish whether the results are due to fiscal policy or the economic cycle. When an economy expands beyond expectation, receipts from taxation will be higher than anticipated, leading to lower unemployment costs and a lower budget deficit. When economic growth is slower than expected, or there are recessionary pressures, lower tax receipts and higher spending on unemployment will lead to an increased deficit. Most western economies now aim for low budget deficits and a consistent ratio of public sector borrowing to gross domestic product. 1.3.4.3.1 Government spending Local and national government spending is a major factor in the national economy – think of all of the public services available and the money needed to provide them. The government can use this spending to influence the economy – increasing public spending will create more jobs and higher incomes, but a side effect might be increased inflation. 1.3.4.3.2 Government income In a perfect world, the government would raise all the money it needs for its spending plans from taxation and payments received for services. Unfortunately, this is not usually a practical approach – high taxes are politically unpopular and can be a demotivational factor in the economy. If government spending requirements exceed income, the alternative ©LIBF Limited 2024. All rights reserved. 141 1: The economic environment is to borrow to fund some of the spending. The amount of borrowing is known as the public sector net borrowing requirement. The government will not be keen to finance a significant amount of its spending from borrowing because it will have to pay interest. One way for the government to stimulate the economy is to cut taxes. This creates more disposable income and increases spending – it might also increase inflation. The tax ‘take’ will, however, reduce and more borrowing will be needed to pay for government spending. As an alternative to borrowing, the government may reduce public spending. 1.3.4.3.3 The balance of payments The balance of payments is the record of one country’s trade with the rest of the world; in the case of the UK, it is calculated in sterling. Money coming into the country is known as a credit and money going out is known as a debit. The current account records trade in goods and services. Goods are known as visible trade and services as invisible trade. The balance on the current account is simply the credits minus the debits. Where the credits exceed the debits, the account is in surplus; where the balance is negative, the account is in deficit. A deficit can be corrected by discouraging imports and encouraging exports, through: borrowing foreign currency; increasing interest rates to encourage overseas investment; imposing tariffs and import quotas; imposing exchange controls. The capital account works on the same principle, but this time looks at capital transfers – the inflow and outflow of capital. This will include investment, grants, borrowing and so on. 1.3.4.3.4 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, which increases 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. Many experts suggest that high top rates of tax actually lead to a reduction in the tax received by the government as higher earners pursue strategies to reduce their tax. The argument is that lowering the top rates of income tax, or even setting a single rate of income tax, could result in a higher overall tax take, as higher earners have less need to adopt potentially expensive and complex tax-saving measures. 1.4 Investment and the economy The UK economy is driven, to a large extent, by investment. Companies raise money by attracting investors; even the government raises money by attracting gilt investors. 142 ©LIBF Limited 2024. All rights reserved. Topic summary 1.4.1 Primary markets When a company wants to raise capital, it will issue shares through the primary market. These shares are issued through a variety of methods, including offer, tender and placing. Gilts are issued in a similar way. The primary markets perform a vital function in matching investors with companies needing capital. 1.4.2 Secondary markets Once a share or gilt has been issued, it can be traded on the secondary market. It is on the secondary market that ordinary investors will buy and sell. It is important to realise that trade on the secondary market does not directly benefit the company whose shares are traded – it raised its initial capital on the primary market – but a good performance on the secondary market will help to attract further investment when needed. The secondary market carries a wide range of shares and is very fluid. For relatively low cost, the investor is able to adjust their portfolio as the need arises, both in terms of stocks held and amounts invested. 1.4.3 General Developments on the political front can have a significant effect on both the economy in general and investment markets. As we have seen in recent times, often just the anticipation or expectation of political changes or initiatives can have an impact. For example, merely the prospect of a change of government or a hung parliament can lead to market changes. Similarly, an expectation of interest rate or taxation changes can have an effect. Government decisions may also assist or restrict business and competition, perhaps by introducing trading restrictions or taxes on imported goods to protect the country’s industry. Many experts think this ‘protectionist’ approach is counter‑productive because it may lead to a trade war, in which other countries take similar action in response. Topic summary The economic environment and the condition of a country’s economy has a significant effect on the performance of investments based in that country. It is important for an adviser to be aware at least of the basic factors that could play a part. In this topic we looked at: — long‑term socio‑economic trends and economic cycles; — macroeconomic factors; — government policy. ©LIBF Limited 2024. All rights reserved. 143 1: The economic environment Review questions and activities The following questions and activities are designed to consolidate and enhance your understanding of the material that you have just studied. The review questions are designed to enable you to check your understanding of the topic. Completion of the activities will give you an opportunity to develop your understanding of the key themes in the topic. Answers to the questions are contained at the end of this book. Please note that the activities are open‑ended and that therefore model answers are not provided. Review questions 1. What is meant by the term ‘dependency ratio’, and why is the predicted increase in the next few decades of concern to the UK government? 2. Explain the difference between the terms ‘microeconomic’ and ‘macroeconomic’. 3. In country A, general prices increased by 2 per cent over a 12-month period and by 5 per cent over the next 12 months following that. In country B, general prices have increased by 2 per cent over a 12-month period, compared with an increase of 4 per cent in the previous 12 months. In country C, general prices have decreased by 1 per cent over a 12-month period. What term is used for the situation in each country? How would savers in country C be likely to benefit compared with those in the other countries? 144 ©LIBF Limited 2024. All rights reserved. References 4. David lives and works in London and has no overseas income. He bought an apartment in Spain for €150,000 three years ago when the exchange rate was £1 = €1.40, putting down a large deposit and raising the balance with a €100,000 interest‑only mortgage with a Spanish bank at a variable interest rate of 4 per cent. Assume that the exchange rate is currently £1 = €1.14 and the bank’s interest rate is 3 per cent. Explain how the current position will have affected David’s debt and monthly mortgage payments in sterling terms. 5. Explain briefly the difference between monetary and fiscal policy. Activities Go to the website of the Bank of England (www.bankofengland.co.uk) and download the minutes of the latest meeting of the Monetary Policy Committee. Check the main conclusions and find out the reasons for the latest decision. Read through the document ‘What is quantitative easing’ at: www.bankofengland.co.uk/monetary-policy/quantitative-easing. References Bank of England (2023) Inflation calculator [online]. Available at: www.bankofengland.co.uk/monetary-policy/ inflation/inflation-calculator Jenkins, B. M. (2023) Consequences of the war in Ukraine: the economic fallout [online]. Available at: www.rand. org/blog/2023/03/consequences-of-the-war-in-ukraine-the-economic-fallout.html PwC (2017) The world in 2050 [pdf]. Available at: www.pwc.com/gx/en/world-2050/assets/pwc-the-world-in- 2050-full-report-feb-2017.pdf ©LIBF Limited 2024. All rights reserved. 145 146 ©LIBF Limited 2024. All rights reserved. Topic 2 Deposit‑based investments Learning objectives After studying this topic, you will be able to demonstrate an understanding of: how deposit‑based investment works; the main providers of deposit‑based investment products; the range of deposit‑based products available; how deposit‑based investments are taxed; the suitability of deposit‑based investment. 2.1 Introduction With deposit‑based investments, the original capital does not grow but the provider pays interest on the investment. The following deposit‑based investments are considered in this section: bank and building society accounts; National Savings and Investment products; offshore deposits; credit unions. Investors place money in deposit‑based savings accounts for a number of reasons. Some consider their capital to be secure. This is true in two respects. Their capital is not at risk from investment fluctuations. The original capital remains in the account and will not reduce over time. If the investor deposits £100 today, they will receive £100 back whenever they choose. The Financial Services Compensation Scheme (FSCS) protects cash invested with authorised deposit takers. This scheme provides compensation to deposit holders in a bank or building society that defaults, with compensation up to predefined levels. FSCS limits apply per institution, so many investors spread their investment across a number of institutions ‘just in case’. It is important for investors to realise that many deposit takers are part of a larger financial services group, often comprising a number of deposit takers. In this case, the limit may be applied to all money held within the larger group, rather than to an individual institution. The FCA website provides details of the organisations to which this might apply. ©LIBF Limited 2024. All rights reserved. 147 2: Deposit‑based investments Temporary high balances as a result of certain specified circumstances may be protected in full for a period of time. FACTFIND Find out the current FSCS compensation limits at: www.fscs.org.uk/what-we-cover/ There is one downside to deposit‑based investment: inflation will reduce the real value of the deposited capital over time. This is because inflation reduces purchasing power – one ‘unit’ of currency (eg pound, dollar, euro, etc) will buy fewer goods and services in the future compared to the present in an inflationary environment. For those using the interest to supplement their income (eg in retirement), this will mean that the value of the capital will be eroded and the interest received will produce a diminishing income in real terms. Example If inflation averages 3 per cent over the next five years, what costs £1,000 today would cost £1,159.27 in five years’ time. If that £1,000 were placed in a savings account today that paid 0.5 per cent interest, the money would only earn £25.25 interest over the same five-year period, resulting in an effective loss of £134.02. Source: HSBC UK (no date) The Debt Management Office provides access to historic gilt yields and prices on its website. These can be explored at: dmo.gov.uk/data/gilt-market/historical-prices-and-yields/ In periods of low inflation, interest rates are often above the rate of inflation, which leads to a small positive real return. In periods of high inflation, however, interest rates tend to fall behind inflation. A prolonged period of high inflation, like that in the UK throughout the 1970s, can have a devastating effect on deposits. In 1975, for example, interest rates averaged 7.1 per cent while inflation ran at 24.2 per cent (The World Bank, no date). Over the longer term, deposit account returns have proven unattractive when compared with asset‑backed investments. One study showed that cash generated a real return per annum (after inflation) of –4.12 per cent over the ten years to December 2020, compared with 2.32 per cent for UK equities (FTSE 100) and 7.53 per cent for global equities (MSCI All Country World) (Moneyfarm, 2023). Another study on the US stock market showed that nominal returns on US equities up to 2020 for periods ranging from 5 years through to 200 years have been between just over 8.5 per cent and just under 12.25 per cent, compared with 10 year US Treasury bills, which have typically returned around 4 or 5 per cent with a few exceptions (Deutsche Bank Research, 2022). Some fund managers produce forecasts of future returns. For instance, Schroders ten- year return forecasts (2023–32) estimated in December 2022 that ten‑year cash returns in the UK between 2023 and 2032 will be 2.2 per cent compared with equity returns of 9.7 per cent (Schroders, 2022). (This, of course, was during the Russian invasion of Ukraine and may not reflect global interest rate rises during the first half of 2023. The 2024–33 review could be significantly different.) 148 ©LIBF Limited 2024. All rights reserved. 2.2 Bank and building society accounts If the reason for saving or investing money is for a short‑term purpose – next year’s holiday, or a new car, perhaps – or the investor does not want to risk the volatility of shares, then a deposit‑based savings account is a sensible place for the money. It is important for individuals and investment institutions to have part of any investment portfolio easily accessible for emergencies or unexpected needs, usually in a short or no‑notice deposit account. 2.2 Bank and building society accounts Before we move on to look at the different types of account offered, we will have a quick reminder of the two main providers of deposit‑based accounts. Banks are proprietary organisations, owned by their shareholders and subject to company law. Their activities are driven by the need to satisfy the shareholders and they have the freedom to raise funds from any legitimate source. Building societies are mutual organisations, owned by their members. Investors holding share accounts qualify as members of the building society, as do mortgage borrowers. Deposit account holders do not qualify as members. The use of the terms ‘share’ and ‘deposit’ can be confusing in this context because both are actually deposit‑based and operate in similar ways. The main differences are that share accounts usually pay a higher rate of interest than deposit accounts, but share account holders would be behind deposit account holders for repayment if the building society were to be wound up. The Building Societies Act 1986 limits the ways in which building societies can raise funds and the types of activities in which they can engage. They raise the majority of their funds from savers, but can also raise funds equalling no more than 50 per cent of their total liabilities on the wholesale money markets. The Building Societies (Funding) and Mutual Societies (Transfers) Act 2007 (known as ‘The Butterfill Act’) introduced new rules with regard to funding. Although the maximum wholesale funding for building societies remains at 50 per cent, an increase in this limit to 75 per cent may now be effected by the Treasury without passing further primary legislation. However, such an increase is unlikely in the foreseeable future given the current financial climate and the fact that it was heavy reliance on wholesale funding that brought down Northern Rock at the beginning of the credit crunch. A number of building societies demutualised in the late 1990s, allowing them to expand their activities and raise capital. These societies are now banks, owned by shareholders. Traditionally, banks tended to offer current accounts and some savings accounts, while building societies focused on a range of savings accounts. Today, most ordinary customers would not notice a great deal of difference between a bank and a building society. Both offer a range of savings accounts and many building societies now offer current accounts. 2.2.1 Deposit accounts Deposit accounts are the most straightforward types of account. For the purposes of this study text we will use the term ‘deposit’ account to include building society share accounts because, apart from the legal difference, the two types of account operate in similar ways. Depositors can generally invest from as little as £1 into deposit accounts, with no maximum, and receive a return on their investment in the form of interest. ©LIBF Limited 2024. All rights reserved. 149 2: Deposit‑based investments Interest is normally variable and is likely to increase or decrease broadly in line with the Bank of England base rate. It is calculated daily and added to the account on a periodic basis, usually quarterly, half‑yearly or yearly. Some deposit accounts are tiered, offering higher interest rates for higher deposits. Many firms offer accounts that pay higher interest in return for a specified notice period for withdrawals from the account. Typical notice periods are 30, 60 or 90 days, with the interest rate highest for the longer periods. If the investor cannot wait for the notice period, money can usually be withdrawn in return for a penalty, usually equal to the interest that would have been earned over the notice period. In addition, some banks and building societies may offer monthly income facilities for those prepared to meet a higher minimum level of investment, typically between £1,000 and £2,500. With these accounts the interest is added and distributed monthly. Basic deposit accounts are ideal for emergency funds or short‑term needs. 2.2.2 Fixed‑interest accounts Most banks and building societies offer fixed‑interest deposit accounts, where the rate of interest is fixed for a stated period, typically between one and five years, and may be tiered to give higher rates for higher deposits. Fixed‑interest accounts offer savers a higher rate of interest than a deposit account in return for the saver losing instant access to their money. It is important for the investor to check the terms of a fixed‑interest account carefully because they come with a range of restrictions and benefits specific to the account. The restrictions may include: no access to the cash during the fixed term; penalty‑free access to a limited sum during the fixed term; access to the funds subject to an interest‑based penalty. Fixed‑interest accounts are suitable for those seeking higher interest rates and not wishing to have access to their funds during the fixed term. 2.2.3 Interest‑bearing current accounts Interest‑bearing current accounts provide an investor with immediate access to their funds without loss of interest. These accounts provide a range of services such as a chequebook and guarantee card, cashpoint facilities and overdrafts. Interest‑bearing current accounts for the mass market are quite new and have developed as a result of increased competition between the banks and building societies. Many accounts do not have charges for those who remain in credit. In general, interest bearing current accounts pay very low rates of interest – often as low as 0.10 per cent – although increased competition has led to some banks offering rates close to those offered on savings accounts on balances up to a specified amount. Most banks have – for several years – offered high‑interest cheque accounts. As the name implies, higher rates of interest are available with these accounts, which tend to have higher minimum levels of investment – typically from £1,000 to £10,000. These accounts are normally free of charges subject to the minimum balance being maintained. Some accounts allow only a limited number of cheques to be drawn without charge in a given period. 150 ©LIBF Limited 2024. All rights reserved. 2.2 Bank and building society accounts 2.2.4 e‑accounts With the rapid development of the internet, most banks and building societies now offer their savings and current accounts online. The opportunities presented by the internet have also encouraged many new providers to enter this market. Some banks, such as Smile and Intelligent Finance, operate exclusively online. The interest rates available on so‑called e‑savings accounts are typically higher than those on comparable accounts offered through the branch network. The reason for this is that an internet account can be administered more cheaply than one operated through the branch network. 2.2.5 Other providers In recent years many other providers have started to offer deposit‑based accounts similar in nature to those described above but offered through the internet or by post. Organisations such as the AA, Saga, supermarkets and insurance companies have entered the market in this way and can often offer higher rates of interest due to lower operating costs. In many cases the services are offered through a partnership with a high street bank. 2.2.6 Taxation of deposit‑based accounts Interest on deposit accounts is treated as savings income, and interest received from most sources will be paid gross. This includes: interest received from banks, building societies, credit unions and National Savings; interest from gilts, corporate bonds and permanent interest bearing shares (PIBS); interest distributions from non‑equity unit trusts and open ended investment companies (OEICs); the interest element of purchase life annuities; gains from certain investments, such as discounted bonds, where the gain is treated as interest; and interest from peer‑to‑peer lending. Interest from these sources is paid gross, without the deduction of income tax, and any tax due on interest received will either be collected by adjusting the individual’s PAYE tax code or through the new digital tax accounts. Personal savings allowance: Basic and higher‑rate taxpayers benefit from a personal savings allowance (PSA) of £1,000 (basic rate) and £500 (higher rate). Interest received within the PSA is not taxable, although interest above that amount is taxable at: 20 per cent for basic‑rate taxpayers; 40 per cent for higher‑rate taxpayers. Additional‑rate taxpayers are not eligible for the PSA and have to pay tax at 45 per cent on all interest received. ©LIBF Limited 2024. All rights reserved. 151 2: Deposit‑based investments Net adjusted income When calculating the level of PSA, it is the individual’s net adjusted income that is used. This is their income less any reliefs such as trading losses, pension contributions and gift aid donations. They are treated as follows: trading losses – the loss is deducted from income; occupational pensions contributions paid gross – the gross payment is deducted from income; pensions paid net of basic-rate tax relief – the net contribution is grossed up (divided by 0.8) and then deducted from non-savings income; gift aid – the contribution is grossed up (divided by 0.8) and deducted from income. FACTFIND The standard personal allowance and income tax bands for the current tax year can be found here: www.gov.uk/income-tax-rates Examples Assume a standard personal allowance of £12,570 and that the higher rate of tax applies on taxable income above £37,700 for the following examples. Aisha has employed income of £47,650 and receives savings income of £2,000 and dividends of £3,000. She contributes £80 a month to a personal pension. Her net adjusted pay would be £47,650 – £1,200 (£960/0.8) = £46,450. This gives her taxable non‑savings income of £46,450 – £12,570 = £33,880. Savings interest and dividends are then added to her taxable income to determine if she is a basic‑ or higher‑rate taxpayer. Savings income and dividends take her total taxable income to £38,880, which means she will be a higher‑rate taxpayer and receive £500 PSA. Jane has earned income of £28,500 and savings interest of £2,000. Her total taxable income is within the basic‑rate tax band, so she will have a personal savings allowance of £1,000. The £1,000 balance of her savings interest will be taxed at 20 per cent. Caroline has earned income of £48,750 and receives £2,000 interest from a savings account. She will be taxed as follows: The first £12,570 of her earned income will be tax free because it falls within her personal allowance. The balance of her earned income (£36,180) will be taxed at 20 per cent, because it is taxable earned income within the basic‑rate band. Her savings interest, when added to her earned income, puts her into the higher‑rate band. This means that her personal savings allowance will be £500, because she is a higher‑rate taxpayer. Only the first £500 of her interest will be tax free. 152 ©LIBF Limited 2024. All rights reserved. 2.2 Bank and building society accounts Her savings interest will be taxed as follows: — £500 – within the PSA and not taxable, but forms part of her basic‑rate band; — £1,020 – within her basic‑rate band so taxed at 20 per cent. Her basic‑rate band is now used up; — £480 – in the higher‑rate band, so taxed at 40 per cent. Alice has earned income of £50,000 and receives £1,000 interest from a savings account. As she is already a higher‑rate taxpayer, she will have a PSA of £500. The first £500 of her interest will be tax free and the balance of £500 will be taxable at 40 per cent. The PSA is included in the individual’s basic‑rate tax band. This means that, although it will not be taxable, interest within the PSA will be added to the individual’s earned income to determine whether they should pay basic‑ or higher‑rate tax on interest exceeding the PSA. Investment bonds and the PSA No UK tax is deducted from funds held in offshore investment bonds, and gains are treated as income for tax purposes. As a result, gains on non‑qualifying offshore life assurance policies qualify for the personal savings allowance (after all other types of interest have been offset against the PSA). This means that the first £1,000 or £500 of chargeable gains each year could fall within the PSA, depending on the investor’s circumstances. Onshore investment bonds have 20 per cent tax deducted in the fund, which means the PSA is dealt with through a tax credit for the investor – see Topic 11 for details. Starting‑rate band There is a starting‑rate band of £5,000 for those with low income who receive savings interest. For the purpose of initial explanation, we will assume a standard personal allowance of £12,570 applies. The starting rate applies to those with total earned and non‑savings income below the standard personal allowance plus the £5,000 starting‑rate band, which in this example would be £17,570 (£12,570 + £5,000). Where an individual’s earned/pension income is below the standard personal allowance: savings interest that takes their income up to the personal allowance limit uses up their personal allowance and is not taxable; savings interest that takes their income above the personal allowance but still within the additional £5,000 starting-rate band will be subject to the starting rate of nil; the next £1,000 (or £500) of savings interest will be within their personal savings allowance and not taxable; savings interest that takes their income above the personal allowance plus the £5,000 starting-rate band, plus the £1,000 personal savings allowance will be taxed at the basic rate, or the higher rate in the unlikely event that it takes their income above the higher-rate threshold. Where the individual’s earned/pension income is above the standard personal allowance but within the additional £5,000 starting-rate band: ©LIBF Limited 2024. All rights reserved. 153 2: Deposit‑based investments basic-rate tax is payable on earned/pension income between the personal allowance and the starting-rate band – eg £12,570 – £17,570; savings interest taking their total income up to the personal allowance plus the starting-rate band will not be taxable; the next £1,000 of savings interest will be within their personal savings allowance and not taxable; savings interest that will take their total income above the personal allowance plus the £5,000 starting-rate band, plus the £1,000 personal savings allowance will be taxed at the basic rate and, possibly, higher rate. An individual with earned/pension income above the personal allowance plus the starting-rate band is not eligible for the starting-rate band. Examples Assume a standard personal allowance (PA) of £12,570 for the following examples. Andrea has pension income of £11,500 a year. She also has savings that produce gross interest of £4,600 a year. Andrea’s total income is £16,100 a year. Her pension takes up the first £11,500 of her personal allowance, and £1,070 of her interest uses up the rest of her allowance. The £3,530 balance of her interest sits within the starting‑rate band, so she will pay no tax on her savings interest. Graham has pension income of £14,500 and receives building society interest of £6,000 a year. His taxation status is calculated as: No tax on the first £12,570 of his pension – within his PA. He will pay basic‑rate tax of £386 on the £1,930 balance of his pension. He will be eligible for the starting‑rate band on the part of his interest (£3,070) taking his total income to £17,570. As a basic-rate taxpayer, he will be eligible for the personal savings allowance on the next £1,000 interest. That leaves £1,930 of his interest subject to basic-rate tax at 20 per cent. The starting-rate band is included in the individual’s basic‑rate tax band. This means that, although interest in the starting-rate band will be subject to a tax rate of nil, interest within it will be included in the individual’s total income to determine whether they should pay basic‑ or higher‑rate tax on interest exceeding the starting-rate band and personal savings allowance. Scotland The Scottish Parliament has devolved powers to set income tax rates and bands for non-savings and non-dividend income. The personal allowance and rates for savings and dividend income are set by the Westminster government and remain the same as the rest of the UK. The Scottish government has set different rates for non‑savings and non‑dividend income, as well as making changes to the income tax bands. It is important to understand that the changes have major implications for Scottish taxpayers, as follows: The personal allowance, savings starting rate and personal savings allowance announced by the Westminster government continue to apply in Scotland. 154 ©LIBF Limited 2024. All rights reserved. 2.3 National Savings products The Scottish government has introduced five income tax bands for non‑savings and non‑dividend income. Current rates are available at www.mygov.scot/income-tax- rates-and-personal-allowances. The Scottish government does not set its own rates for savings and dividends, which are the same as the rest of the UK. The individual’s status as a basic-, higher- or additional-rate taxpayer for savings and dividends depends on the UK income tax bands, as does the amount of personal savings allowance available. The UK higher‑rate threshold applies to savings interest, dividend income and capital gains. A Scottish taxpayer could pay higher-rate tax on some of their earned income, due to the difference in tax thresholds, but not on investment income. A Scottish taxpayer is defined in simple terms as someone who lives in Scotland. Individuals may also pay Scottish Income Tax if they move to or from Scotland, live in a home in Scotland and one elsewhere in the UK (eg for work), or do not have a home and stay in Scotland regularly (eg offshore oil workers) (GOV.UK, no date). This means Scottish and other UK employers may have to apply different tax rates and bands for different employees, depending on where they live and work. As you can see, this development has complicated matters significantly. Wales Wales also has devolved tax powers. HMRC collects income tax due and makes a payment from the revenue to the Welsh government for spending on Welsh public services. The Welsh government sets Welsh Income Tax rates. FACTFIND Welsh Income Tax rates can be found here: www.gov.uk/welsh-income-tax 2.3 National Savings products The National Savings Office was set up in 1969. It was previously known as the Post Office Savings Department. National Savings was rebranded as National Savings & Investments (NS&I) in 2002. The products available are described below. Direct ISA. Direct Saver. Income Bonds. Investment account. Junior ISA. Premium Bonds. NS&I has also launched ‘green’ versions of some of its products, such as Green Savings Bonds, which contribute to green projects chosen by the government. ©LIBF Limited 2024. All rights reserved. 155 2: Deposit‑based investments 2.3.1 Premium Bonds Premium Bonds offer a monthly draw for tax‑free prizes. Premium Bonds can be bought by anyone aged 16 or over. Parents, guardians, grandparents and great grandparents can invest on behalf of under‑16s. The prize money available each month is calculated as a percentage of the total value of bonds issued, with the percentage re‑assessed at regular intervals. Each month there are two £1m prizes plus more than one million other prizes, with a minimum prize of £25. The bond can be cashed in for its original value at any time without penalty. The minimum purchase price is £25 as a single investment or by monthly standing order. Purchases above the minimum must be in multiples of £10. The maximum holding is £50,000. All prizes from Premium Bonds are tax‑free. Total prizes equate to an annual interest rate of a percentage of the value of all the Premium Bonds held. Bonds become eligible for the prize draws once they have been held for a full calendar month following the month in which they were purchased. The bonds can be encashed without penalty at any time and payment will be received within eight working days of the request. 2.3.2 Income Bonds Income Bonds offer regular monthly interest payments and are available to those aged 16 years or over. Interest is variable and paid on the fifth day of each month. Interest is taxable and eligible for the PSA. The minimum investment is £500 and the maximum is £1m. The income bond may be held for an initial period of ten years. Bonds can be cashed in at any time without notice and without penalty, although at least £500 must be in the account to keep it open. Income bonds should not be confused with Guaranteed Income Bonds, which offer a guaranteed rate of interest for a set period. 2.3.3 Direct ISA National Savings & Investments offers a cash new individual savings account. It provides investors with a tax‑free savings account under ISA rules and is available to investors aged 16 or over. The minimum opening deposit is £1, with a maximum investment equal to the annual ISA contribution limit. Further investment (minimum £1) can be made. There is also a monthly standing order facility. The maximum that can be invested is the full ISA allowance for the current tax year (see www.gov.uk/individual-savings-accounts). 156 ©LIBF Limited 2024. All rights reserved. 2.3 National Savings products Interest is calculated daily and paid annually. The Direct ISA cannot accept transfers from other providers’ cash ISAs. Money can be withdrawn without penalty; the minimum withdrawal is £1. The account can only be managed online or by phone. 2.3.4 Direct Saver NS&I Direct Saver pays a variable rate of interest, credited daily and paid annually. The interest is taxable and eligible for the PSA. The account can be opened by anyone aged 16 or over and is available on a single or joint basis. NS&I Easy Access Savings Account holders can open a Direct Saver by transferring their funds. Direct Saver can be opened and operated by phone or via the internet, and requires the saver to nominate a bank account to receive withdrawals. The minimum deposit is £1 and the maximum holding across all Direct Saver accounts is £2m per person (or £4m for joint accounts). Deposits can be made by standing order, debit card or BACS transfer. Withdrawals (minimum £1) can be made online or by phone, with the money paid to the nominated bank accounts by BACS. No notice is required and there are no penalties for withdrawals, although at least £1 must remain in the account. 2.3.5 Junior ISA The Junior ISA can be taken out by a parent or legal guardian for children under the age of 18, or by children aged 16 to 18. The minimum investment is £1 and investments are permitted up to the maximum for that tax year. The JISA is an online account only and no access is permitted until the child reaches 18. At that point, the fund will automatically be transferred into a standard NS&I ISA and the child will have access to, and control over, the account. FACTFIND Check the current savings limit for the Junior ISA here: www.gov.uk/junior-individual-savings-accounts 2.3.6 Green Savings Bonds The Green Savings Bond is a three-year fixed interest online investment, with interest paid at the end of the term and taxable in the year it is paid. The minimum investment is £100 and the maximum is £100,000. There is no access to the money until the end of the term. The intention is that HM Treasury will allocate an amount equivalent to the funds raised from Green Savings Bonds to its chosen green projects within a specified timescale. 2.3.7 Guaranteed Growth Bonds The Guaranteed Growth Bond is a lump‑sum investment with a one-year term. The minimum deposit is £500; the maximum is £1m. ©LIBF Limited 2024. All rights reserved. 157 2: Deposit‑based investments The interest rate is guaranteed and calculated daily. It is paid at the end of the 12-month term. Interest is eligible for the PSA and the starting rate, where applicable. The bond cannot be cashed in before the end of the term. At the end of the term the investor can: take the money; reinvest in another issue; reinvest in another NS&I product. 2.3.8 Guaranteed Income Bonds The Guaranteed Income Bond is a lump‑sum investment that pays a fixed rate of interest monthly. Interest is taxable but paid gross. Eligibility, terms, conditions and investment limits are the same as for the Guaranteed Growth Bond. 2.3.9 Investment account The investment account is not currently marketed by NS&I but is available by request. The interest rate payable is very low in comparison to other savings accounts. The investment account pays a variable rate of interest on a minimum deposit of £20 (maximum £1m). This account may be opened by anyone over the age of 16 years; a parent or legal guardian may open the account for those under the age of 16. The investment account is a postal only account. Account applications, deposits and withdrawals are made by post, and in the case of withdrawals the account holder will be sent a warrant (like a cheque). No notice is required for withdrawals and no penalties apply. Interest is paid annually on 31 December each year and is taxable. 2.3.10 NS&I products not currently available to purchase NS&I has withdrawn a number of products from sale in recent years. Although they are not currently available to new investors, those people with maturing products may be able to re‑invest in new issues. NS&I has the ability to launch new issues to the general public at any time. 2.4 Credit unions Credit unions are classified as industrial and provident societies (financial co‑operatives) run for the benefit of their members, who are all linked by a ‘common bond’. In many ways they are similar to the original building societies and friendly societies. The common bond is an essential legal condition of

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