Now that investors can no longer make additional contributions to a Pep, intermediaries may find it ...
Now that investors can no longer make additional contributions to a Pep, intermediaries may find it hard to convince their clients of the need for active management by using Pep transfers. The Pep transfer market offers considerable opportunities for investors to maximise the potential of their portfolio through active management, and for IFAs to seek out managers with funds and terms to suit. However, the twin issues of costs and the perception of underperformance may give the investor cause for hesitation.
As ever, shifting stock market conditions and changing personal circumstances will each influence the investor's choice of investments. But in a world which demands customisation, it has become increasingly important to choose a product provider which has funds suitable for a variety of situations, and one with a plan that can deal easily with changing circumstances.
Transferring a Pep from one plan manager to another can prove costly. When an investor considers a switch within a Pep, the typical cost is around 2%, comprising commission, stamp duty, reserve tax, registrar's fees and a small margin for the fund manager. A 2% charge for advice on the switching strategy on investments would not be unusual. However, the combination of relatively low interest rates, the anticipation of lower returns on equities, the psychological effect of using 7% rather than 9% as an assumed rate of growth for the purposes of illustrating the effect of charges on returns, and the public perception of Cat standards on Isas, all serve to give the impression that the cost of switching funds is expensive.
Timing is everything and so the cost of Pep transfers can mount as a result of the investment risk arising during a transfer from one provider to another, which may take weeks rather than days. This is particularly significant during bull market runs, and may prove costly. Conversely, if the market were to weaken, it may be to the investor's advantage, but one might question why an investor would invest in a Pep if he did not believe that the market was going to rise over the long term.
Reasons for change
A key question is "What drives an investor to switch his Pep in the first place?" Historically, this has been down to the performance of the Pep fund. When a fund performs well, the tendency of most is to do nothing at all rather than take the profits and look elsewhere. But dissatisfaction over poor performance is more likely to cause investors to move. The paradigm is that the combination of costs and poor performance can significantly erode the value of a Pep.
To state the obvious, as an investor's personal situation changes, so do their financial needs. But to meet changing needs, IFAs have their work cut out to avoid costs. Investors may be better off looking beyond the performance of individual funds and considering product providers which offer investment products with a diverse range of investment products. Few providers offer Pep funds that include low risk growth investments and high income funds, as well as more adventurous funds: most have a standard range of equity funds based on traditionally geographic asset allocation without the attributes that investors may require as they transit life stages.
The fundamental reason for changing Pep manager therefore may not be current performance, but the future suitability of funds that can be selected to suit the investor's imminently changing risk profile and personal circumstances.
Trusts and funds
Given that most conventional funds do not meet the changing needs of investors, where can investors get more clear-cut product benefits and funds to match their objectives? Split capital investment trusts and funds investing in their various share classes are an obvious sector, which extend the scope of the financial planner. In recent years the popular choice for the investor aiming to build up capital through Peps has been to match the performance of the stock market by investing in index tracking funds.
However, if the investor believes that the stock market is likely to rise, he/she will benefit more from a fund that has the potential to outperform the index in such circumstances. Capital shares of split capital investment trusts do just that. These shares produce a 'geared' return on the underlying assets, so if the market rises they tend to rise faster, but they are higher risk and if the market falls they will fall faster.
Similarly, investors seeking high income investment funds may turn first to the UK corporate bond sector where there are 31 Pep funds yielding over 6% each year. However, a search among other sectors reveals a further 24 fully qualifying Pep funds yielding over 6% a year from the UK equity income, UK equity and bond income, and UK other bond sectors.
Most income shares in the split capital investment trust sector can also offer yields well above 6%. For the income seeking investor, the key to obtaining a high quality income is through diversity, and a portfolio can be constructed to include a mixture of equity-based and fixed interest trusts, providing a secure high quality income with some prospect of a rising income stream.
Perhaps a more significant opportunity for investors is the choice now available of lower risk funds. For the low risk investor who wishes to guard against the risk of falling markets, there have been few Pep-able investments.
Guaranteed Peps were perceived as expensive. Isas have the benefit of a cash component which can accrue interest as growth in a falling market. For the Pep investor, there is one asset class which can be used to great effect and is, perhaps, one of the most attractive sectors at present, the steadily growing zero dividend preference share sector (zeros). This comprises more than 60 stocks with a market capitalisation of over £2.5bn.
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