Inflation drain: tackling the inflation problem

by | Jul 5, 2022

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Sarah Wakefield, Business Development Manager, Oxford Capital

In the current environment, we’re being flooded with headlines on inflation. I recently read a study from the Institute for Fiscal Studies that really got me thinking – it read ‘Inflation rate for UKs poorest to hit 14% after price cap rise’, while the richest tenth could see rates of about 8%.

The current rate of inflation (CPI) is 9% this year (to April 2022) the previous month was 7%, the fastest growth rate in over 40 years. The Bank of England has stated that it expects inflation to increase to 10% this year and start to fall next year. There are many factors which have pushed inflation upwards including: the pandemic, the war in Ukraine increasing oil and gas prices, fuel prices increasing, VAT and a number of other factors.

Since the turn of the millennium, we have been used to a low and stable inflation rate at an average of around 2%. To the end of December 2019 CPI had fallen to just 1.3%. This exceptional increase is forcing advisers, and their clients, to reconsider plans and assumptions will need to take into account the impact inflation will have on client’s cash flow modelling and investment returns required to achieve specific goals. Investments, after tax, would need to beat inflation to provide a real return. It’s a bit like running a bath without putting the plug in and that plug hole has got a lot bigger.

Risk and reward

So, let’s get back to basics, real returns are investment returns, net of tax, over inflation. To use the above analogy, if water is going down the drain faster than the tap is flowing water in, then the bath is not filling up but emptying. On the basis that the plug hole is not going to get smaller any time soon, how can investors start to fill the bath?

According to the Office of National Statistics, 51% of adult ISAs are cash ISAs. That is over £300bn held in cash ISAs. I have yet to find a cash ISA that will beat inflation or for that matter even come close.

To achieve inflation beating returns investors will need to take some investment risk and ideally reduce tax risk as well. Many DFMs will target returns as CPI plus a margin, the margin depends on the attitude to risk an investor has.

Whilst many long-term investors will have experienced the gains and losses of the stock market, these are largely paper losses and are only a loss if realised. Investing in a diversified portfolio and riding the waves will, in most cases, recover the losses. I love the analogy of the market being like walking upstairs with a yoyo, people focus on the yoyo going up and down, while the real story is the consistent movement of the person up the stairs.

This analogy however doesn’t fit well with EIS, where the losses occur, this is realised, because the company is liquidated resulting in a 100% investment loss, before any gains are seen. However, an investment loss is not always a financial loss because loss relief can be claimed for UK income taxpayers based on the net investment. For example, a client holding shares, purchased for £10,000 on which they have already received £3,000 income tax relief, can also claim loss relief. For a higher rate taxpayer this means a further 40% on the net investment of £7,000 (£10,000 less the £3,000 already received) a further £2,800, thus in total receiving £5,800 back on their £10,000 investment. Thus, protecting the financial downside of an EIS investment which is not available to the main market.

Combine the available downside protection and unlimited tax-free growth, a diverse EIS portfolio can complement an investors existing portfolio – in particular, those who are reaching or have reached their lifetime allowance limit on their pension. Tax relief and tax-free growth, combined with diversifying into an asset not correlated to the main market could prove to be a inflation proofing strategy.

Tax risk

Another risk which takes a big bite from investors returns is the impact of tax. Whether it is income tax, capital gains tax or inheritance tax, tax can reduce returns significantly. Investing tax efficiently using ISAs and pensions is the foundation for most advisers’ financial plans for clients but there are also other investments that can offer multiple tax benefits including EIS.

EIS investments offer income tax relief, CGT deferral, tax free gains and business relief for inheritance tax purposes, as well as loss relief to protect downside loss. Whilst your investment is illiquid until exit (which is an unknown) this could be a significantly shorter time period than locking it into a pension. Whilst both pensions and EIS offer IHT efficiency and tax-free growth on the investment, pensions are taxed when benefits are taken.

The most obvious difference is that EIS investments carry a much higher investment risk. There is potential for complete investment loss. The various tax reliefs however will offer an income taxpayer an element of downside protection of up to 38.5%, reducing the financial risk.

Of course, the tax benefits of EIS are just one aspect of the inflation beating properties offered by such an investment. The investment returns have the potential to significantly beat inflation with no tax impact. Therefore, investors looking to beat inflation may want to consider the long term benefits of EIS.

Multiply your tax relief

Using EIS as part of a long term investment strategy may offer the opportunity for double (or more) income tax relief. The tax relief returned to investors who have invested, and funds deployed into EIS qualifying company shares can then be used for a pension contribution, thus obtaining income tax relief twice.

Another option could be to roll over any exits from an EIS into a further EIS obtaining additional CGT deferral and income tax relief or as a pension contribution to obtain income tax relief. Similarly, if an EIS company fails and the investor is able to claim loss relief, this could also be reinvested obtaining further income tax relief.

Combining strategies on longer term investments could lead to significant tax savings in addition to potential investment returns helping to combat the impact of inflation on an investors’ portfolio to beat the inflation drain.

One final thought, it used to cost 20p to inflate my tyres at the petrol station, now, would you believe, it is £1! I guess that is inflation for you!

 

Sarah Wakefield, Business Development Manager, Oxford Capital

Sarah is responsible for building and maintaining relationships with financial advisers. She has worked in financial services for over 25 years, the last 15 years has been spent building trusted relationships with IFAs supporting them with tax planning solutions. She is progressing towards becoming a chartered member of the CII.

 


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