Discounted gift trusts and loan trusts: What your financial adviser doesn’t tell you: Key information for potential investors

The enclosed eBook is a must read guide for any investor contemplating an investment into a discounted gift trust or loan trust. Find out what your financial adviser probably doesn’t even know!

The title of this post and attached eBook is somewhat controversial. I think the days of financial advisers deliberately misleading clients in order to sell endowments and other high commission paying products has passed. The increased take-up of advanced professional exams and a move to a fee-for-service remuneration structure has changed the nature of financial advice. However, this eBook guide highlights an area where one of JF Kennedy’s “myths” persists (see quotation at the top of the homepage).

Discounted gift trusts and loan trusts are often recommended to clients as a means to save inheritance tax, yet retain some form of access to capital or an ongoing income. There is no doubt that some advisers treat these solutions as a panacea for all client situations and recommend one where the other is not suitable. But is this just a case of having two options and advising the client to use the option which is least unsuitable? I am concerned that this is the reality for many advisers who, in JFK’s words, “enjoy the comfort of opinion without the discomfort of thought”. This guide dispels some of the many myths surrounding discounted gift trusts and loan trusts. It covers when these solutions should be utilised and highlights alternative solutions that are often unknown to many financial advisers, accountants and solicitors.

Finally, an apology to those advisers who have invested the time and resources and evaluated the various schemes in the marketplace before forming a considered opinion of which schemes are worthy of recommendation to clients. I salute these advisers and hope that one day this will be the norm in the financial advisory world.

You can download the eBook here.

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Premier cru or vin de table – ARCH cru fund suspensions

The recent suspension of the ARCH cru Investment funds on 13th March has received considerable comment in the IFA press. Investors are prevented from selling their holdings because of liquidity problems with the funds’ underlying investments. These underlying investments are predominantly Guernsey listed closed ended funds which themselves invest in unlisted private equity investments.

What has struck me from cru’s recent press releases is the following point from the release of 31 March as stated by Mark Ainscough, the cru Managing Director.

“cru Investment Management plc is retained to distribute the ARCH cru Fund range to UK Intermediaries. cru has played no part in the underlying investment process, this being the responsibility of ARCH Financial Products LLP. The legal responsibility and accountability to the Financial Services Authority rests with Capita Financial as Authorised Corporate Director and administrator.”

This statement confirms one of my main misgivings on the Arch Cru funds – exactly what does cru bring to the investment process. According to the MD of cru, absolutely nothing.

This is in contrast to their marketing material. The CF Arch cru Investment Funds brochure of February 2009 states:

"The CF ARCH cru Investment Funds are managed by ARCH Financial Products LLP and they also benefit from our direct input regarding asset allocation and underlying holdings."

In reality, cru was simply a marketing company who were paid handsomely to persuade IFAs to recommend the Arch cru funds to their clients. With the fund suspension cru have laid off all their staff.

The question which I asked myself when I first attended a cru presentation was; if the underlying investment concept was attractive, why not cut cru out of the loop and go straight to ARCH? Why pay for crus marketing efforts? I did in fact decide to utilise one of the ARCH Guernsey listed funds for an element of client portfolios.

cru receive a 0.9% per annum fee on the total value of the ARCH cru funds (in addition to a 2% initial fee). IFAs may also receive a 1% per annum renewal commission as well as a 4% initial fee. These commission levels are not low.

Paying for professional investment management is a necessary cost, but many investment related costs are unnecessary. Minimising costs is one of the most successful methods to improve your net investment returns. You should not pay for the privilege of having funds marketed to you. It begs the question, ‘why do investments need marketing?’ Surely good investment managers/advisers will proactively select the best investments rather than be swayed by fund company salesmen?

The reality of the investment industry is that considerable sums are allocated to the marketing department. The marketing message is often directed at naïve investors and advisers who do not have the experience, investment knowledge or innate scepticism required to sort the wheat from the chaff. Few heavyweight private client advisers would have considered investing in the ARCH cru funds, but the cru message was mainly directed at smaller impressionable IFAs.

The cru brochure states:

“The key point for us is that private market investing can offer higher returns with less risk than public market investments.”

The idea that private market investments as an asset class can provide higher returns than their publicly listed equivalents seems illogical. Even if this were the case, one of the few immutable laws of economics and finance, is that returns go hand in hand with risk. The credit crunch has once again laid bare the fallacy that you can generate high returns with low risk. It may be possible to achieve this for short periods of time, but the relationship between risk and return invariably reverts to the long term norm.

A public market listing does not change the ‘value’ of an investment, but simply provides liquidity and a mechanism to effectively price investments in the real world. This real world valuation basis does not always tally with the valuations utilised by managers of unlisted securities. Liquidity issues are likely to disappear if the sellers are willing to accept a lower price – this is what public markets do, bring sellers and buyers together at the market price. This is a lesson that cru and IFAs utilising their funds are learning the hard way. There is no magic in private equity investments. This does not mean that they do not have a place in an investment portfolio, just that they should not compose the majority of a private client portfolio.

I sincerely hope that the ARCH cru fund suspension debacle is resolved in a satisfactory manner for the benefit of the fund investors, the people that matter. Whilst the suspension of the ARCH cru funds may not turn out to be disastrous for investors, it will surely prompt many IFAs to rethink their framework for making investment recommendations. Consumers would also be well advised to consult advisers whose remuneration is not set and paid for by the investment fund company that they recommend to clients.

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Are you relying on political aspirations for your estate planning?

Ken Clarke, the shadow business secretary, recently described the Conservative party proposal to raise the inheritance tax nil rate band to £1 million per person as “an aspiration” rather than a “priority” (read the transcript here). David Cameron swiftly countered with affirmation that “a promise is a promise”.

Whether the conservatives do gain power and raise the exempt level to £2 million for couples is speculation. However, many people are basing their estate planning on the hope that this will not only happen, but the new levels will survive future changes in government. Basing a long-term estate planning strategy on this course of events occurring is not without risk.

Mitigating IHT has always been a case of starting the planning process early and taking advantage of straightforward planning opportunities. The existence of the ‘potentially exempt transfer’ (PET) exemption, which allows gifts of unlimited amounts to escape IHT completely if the donor survives for seven years, is a particularly useful yet often underutilised opportunity.

Many people are loathed to make outright gifts of assets or capital for various reasons – concern about their own future financial security or fears that the beneficiaries will squander their newly received wealth. There are few planning solutions which are effective for IHT whilst ensuring the beneficiaries don’t receive any monies immediately and allowing potential access for the donor. The Flexible Reversionary Trust is the most useful mechanism to achieve these objectives. You can read a comparison of this planning with other alternatives in this Taxation Magazine article ‘A flexible friend'.

The Labour government introduced contentious new legislation in 2006 to curb transfers into trust. All transfers into trust were bought in line with the discretionary trust ‘relevant property regime’. Any transfer into trust in excess of the nil rate band (£312,000 for 2008/09) is subject to a 20% tax charge on any excess. However, this means that it is more important to start planning early, as each person can re-use their nil rate band every seven years. Using the Flexible Reversionary Trust you don’t have to relinquish access to the capital transferred and your beneficiaries do not have a right to receive the monies. Why gamble that the Tories will gain power, increase the nil rate band and future governments retain the raised levels when you can achieve the same result now with simple and uncontroversial planning?

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Avoiding Investment Torpedoes

Another day, another dollar …or should that read another day, another investment fraud exposed. On Tuesday the United States SEC froze the assets of Allen Stanford and three companies in his Stanford Financial Group. You can read the SEC press release here. Significant and sustained bear markets always expose the fraudsters and charlatans of the investment world. What is surprising in this current recessionary environment is the scale of the frauds perpetrated by such high profile public figures such as Bernard Madoff and Allen Stanford. Madoff was a former Chairman of the NASDAQ and Stanford courted the media with his cricket ‘benevolence’.

The details of these massive frauds will be picked over with a fine tooth comb over the coming months. What is immediately clear is that investors and particularly their professional advisers, should have heard the warning bells long before the frauds were finally exposed.

The regulators will never be able to prevent a determined fraudster from concealing their actions for a while, and investors should always understand that the best defence is to follow the well know maxim…caveat emptor, buyer beware. There is a simple test which I advise all investors to consider before following any investment advice or making an investment.

• Is there a sound theoretical basis for why an investment strategy will be successful going forward?


• Is there clear empirical evidence of how the investment strategy has performed historically?


• Can the concept be practically implemented to generate the theoretical returns available?

Surprisingly enough, few investment strategies pass all three tests. Making investment decisions within such a framework will also help investors filter out potential fraudsters and steer clear of schemes such as Stanford’s, which according to the SEC offered:

“…improbable and unsubstantiated high interest rates, supposedly earned through its unique investment strategy…”

Schemes that sound too good to be true invariably are.

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This is for information purposes only and you should always seek professional advice

Venture Capital Trusts - A lower risk investment opportunity

Tax advantaged investments such as Venture Capital Trusts (VCTs) are inevitably marketed in the run-up to the end of the tax year. Marketing material often focuses on the attractive tax incentives whilst playing down the high costs and high investment risks. Traditional venture capital investing is a very hit and miss affair, with the majority of good investment performance often coming from one or two incredibly successful start-up investments. Unfortunately these stars are often dragged down by the failure of the average venture capital investment. For this reason it is very hard to capture the average returns from the venture capture asset class as a whole. Most clients who want to access the higher expected returns from small companies, when compared to equity returns overall, would be better off gaining broad exposure to this market sector in a low cost diversified collective fund. You can view historical VCT performance here - VCT performance figures.

However, the VCT tax breaks can provide a good risk-adjusted investment opportunity when structured appropriately. VCT tax advantages for qualifying shares held for five years are as follows:

• 30% income tax relief on annual investments of up to £200,000 per person.



• Tax-free dividends.



• No capital gains tax within the VCT or on eventual disposal of VCT shares.

In the past I have not felt that many VCTs offered a compelling proposition. This year however, I think that the Triple Point TP5 VCT offers an excellent investment as it is geared to harvest the VCT tax breaks with the minimum amount of investment risk.

Triple Point TP5 will initially hold 100% of the trust assets in low risk fixed income investments, with this exposure reducing to approximately 30% within three years to meet the VCT qualifying rules. The reducing non-qualifying investments will be replaced by investments in companies whose revenues are guaranteed by contracts with financially sound counterparties, such as NHS and Local Government Authorities. The overall proposition is not one which will provide high returns, as it is structured to keep the risk of capital losses to a minimum. Most of the net returns available to investors will come through the tax relief gained at outset. You can read more about the structure of Triple Point TP5 and the potential returns here.

Triple Point themselves are unique in the marketplace and focus solely on this type of investment across various tax advantaged holding structures. They have an impressive line-up of tax and investment specialists who offer a far more compelling proposition than many of the ‘marketing’ driven investment companies.

The current economic climate does not really impact on the underlying investments, but low interest rates will reduce the headline returns as with other types of investment. Triple Point are aiming to raise £50 million, and this low risk structure will I think, prove very popular as investors search out any source of increasing their returns whilst avoiding equity market risk.

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This is for information purposes only and you should always seek professional advice

Using a flexible reversionary trust to reduce inheritance tax whilst retaining access to capital

The simplest method to reduce inheritance tax (IHT) is to make outright gifts to chosen individuals. The current recessionary environment will undoubtedly reinforce the natural tendency for people to hold onto their capital or assets to ensure they do not compromise their future financial security. Furthermore, many people are not comfortable passing outright control of assets to beneficiaries.

Therefore, the ideal solution would seem to be one where one can achieve the IHT savings of a normal gift, whilst continuing to have access to capital and ensuring that beneficiaries do not take immediate control of the capital. Unfortunately, governments at either end of the political spectrum have enacted legislation to prevent people ‘having their cake and eating it’. The ‘reservation of benefit’ and ‘pre-owned asset’ rules have severely limited the scope to make IHT effective gifts whilst retaining access to an income or capital. Discounted gift trusts and loan trusts are some of the few ways to achieve this goal, but usually by sacrificing future flexibility or with reduced tax efficiency. There is a third way, the ‘flexible reversionary trust’ such as the WAY Flexible Inheritor Plan, Canada Life Wealth Preservation Account and IOMA Estate Control Bond.

With discounted gift trusts you lose all access to your capital and any investment growth, whilst the income level is set in stone at outset. Few people would normally choose an investment with such restrictions, as is shown by the general antipathy to annuities which have similar features. Why commit to a fixed income and no access to capital when you don’t have to?

Loan trusts only remove any future investment growth from the estate, as the loan is repaid over a number of years. The paradox of loan trusts and discounted gift trusts is that the loan repayments and income payments are returned to the donor’s estate; unless these monies are spent the IHT liability will simply build up again. The flexible reversionary trust allows you to structure your future income and capital needs to your exact requirements, but more importantly provides the flexibility to change them in the future.

How does it work?

You can invest up to a maximum of your remaining nil rate band (£312,000 for 2008/09) per person into trust for specific individuals. You ‘carve-out’ a series of reversions which are due to be paid back to you during your lifetime, e.g. 10% of the initial investment plus any growth for 10 years. In the normal course of events, these reversions would be paid to you and the trust depleted after the ten years. The flexibility of this trust comes through the ability of the trustees (selected by you the investor) to defer any reversions to future dates. In this way, you are not committed to receiving a fixed ‘income’ from outset. Reversions can be deferred indefinitely allowing the trust fund to grow. If all reversions are deferred then after seven years the full trust value will be outside your estate, yet you will retain access to 100% of the trust value through future reversions. Importantly the trust is flexible enough for capital to be paid to any potential beneficiaries at any stage. This level of flexibility is simply not available from other planning solutions.

Investment flexibility

Discounted gift and loan trusts are virtually always offered via life assurance bonds as the investment. The flexible reversionary trust can be utilised with unit trusts or life assurance bonds. This offers significant tax planning opportunities as unit trusts can take advantage of the reduced capital gains tax rate of 18% whereas all growth within an offshore life assurance bond will be taxed up to 40% for a higher rate taxpayer. For a tax comparison of discounted gift, loan and flexible reversionary trusts please click here.

Conclusion

Flexible reversionary trusts have been utilised for twenty years and use tried and tested principles which are not inflammatory to HMRC, a key aspect of any tax planning exercise. A married couple can remove £624,000 (2008/09) from their taxable estate after seven years, saving potential IHT of £249,600, whilst retaining potential access to the gifted capital plus any growth throughout their lives.

It is always surprising that reversionary trusts are not utilised more often. My concern is that so many people end up with inflexible discounted gift trusts or relatively ineffective loan trusts, when they could benefit from the flexibility of a flexible reversionary trust. The reality is that some financial advisers, particularly those tied advisers who are restricted to selling the products of only one life assurance company, only offer a choice of a discounted gift or loan trust, and their clients end up with the option which is least unsuitable. The message should be clear; always consult a specialist independent professional who can advise you on all types of planning including the flexible reversionary trust.

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I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.

Now this is not the sort of statement that most investors expect to hear from their stockbroker or investment manager. In current market conditions clients are likely to be unnerved by such a statement and think that it may time to look elsewhere for more expert investment advice.

If you did look elsewhere, you would be sacking the most consistently successful modern investor, Warren Buffett. His investment company, Berkshire Hathaway, has outperformed the S & P 500 index by an average of 11% per annum over the last fifty years. This outstanding feat has been achieved during a period of incredibly diverse economic conditions.

The Easter break provided an ideal opportunity to reflect on the events of the past week. The week started with the US Federal Reserve stepping in to organise the sale of what was previously a titan of Wall Street, Bear Stearns. Bear shares had fallen by approximately 90% within a week as the company became the latest high-profile banking victim of the credit crunch. Investor confidence, already very low, plummeted and triggered considerable volatility in capital markets; the FTSE 100 fell by 3.8% on Monday alone.

Many investors are questioning what action they should take now?

The answer very much depends upon your investment beliefs. If your investment strategy is based upon continually trying to outguess the market over short periods of time, then you will either need to be an investment genius, employ the services of a modern day alchemist or have incredible luck. Warren Buffett comes as close as anyone to being an investment genius but if he cannot forecast and then take advantage of short-term market movements, what chance do you, your financial adviser or stockbroker realistically have?

The reason why experts like Buffett do not get drawn into trying to forecast market movements and adopt short term trading strategies, is that they understand that stock prices and thus market prices do not follow clearly discernible patterns. Random walk theory states that future price changes are independent of previous price changes, and therefore future prices cannot be forecast with any degree of certainty. Most amateur investors and many professionals refuse to accept the implications of random walk theory. These investors will continue to make investment decisions based upon hunches or at the other extreme, follow strategies based upon highly sophisticated computer analytical models which aim to find order and predictability in historical stockmarket movements. Understanding the lessons of random walk theory ensures you acknowledge the importance of not letting short-term market conditions dissuade you from adopting and remaining faithful to a sound long-term investment policy.

But this presupposes that a client has selected a sound investment policy, which is suited for their particular circumstances and risk tolerance, with diversification geographically and across different asset classes. Investors who are overexposed to individual securities or esoteric investments have much to be concerned about. It is unfortunate that the dangers inherent in poorly constructed portfolios are often only exposed in falling markets.

Conclusion

Charles Ellis, in Winning the Loser’s Game compares the phenomenon of investors’ decision making being driven by short-term events to mistaking the difference between the long-term climate and the daily weather.

“In choosing a climate in which to build a home, we would not be deflected by last week’s weather. Similarly, in choosing a long-term investment program, we don’t want to be deflected by temporary market conditions”.

Understanding the long term ‘climate’ of capital markets will not only help you make better investment decisions when you establish your portfolio, but also help you remain focused and unemotional during the inevitable down periods. Patient investors will be able see past the random short-term ‘weather’ conditions which will inevitably be replaced by more predictable patterns over long time periods when capital markets reward investors for accepting risk.

At Collins Ward, we structure investment portfolios across multiple asset classes to minimise the potential for capital losses, and also tilt portfolios to benefit from the higher risk premiums available from some market sectors. These premiums are not available every year, but consistently reward investors who hold firm to the investment policy over the long-term, in the same way as short-term weather patterns revert to the long term ‘climate’ average.

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