Nick Dewhirst wonders why tax shelters often make such poor investments
In a companion piece I described how the life assurance industry's success was built on marketing the most potent hot buttons in financial services - 'new', 'safe' and 'tax-free'. Now I shall apply this to other kinds of tax shelters to show how tax savings can be bad for one's financial health.
My first encounter with tax shelters was when I was a rookie US registered representative in Dusseldorf pitching for retail business a quarter of a century ago. Frequently my bids for a small slice of the Geman savings market failed when faced with the superior attractions of 'Zahnartzschiffe'.
Literally this translated as 'dentists' ships' in a culture where the German dentist was viewed as very much the same kind of easy prey as his better-known Belgian cousin. That is to say, hard-working and overpaid - so overpaid he generated huge surplus cashflow, and so hard-working that he did not take enough time off to study how to maximise the returns on this cashflow. Similar investment animals graze the fields of other countries.
As with other tax shelters, this was designed to subsidise a good cause, namely keeping West Berlin free by encouraging investment there by West Germans. Naturally that was a tough selling proposition because investment is usually fixed so cannot be taken to safety if the Russians imposed another blockade.
The financial alchemists of that era conjured their tricks by making such fixed investment mobile. They sold barges small enough to go through the canals of East Germany to Berlin. Once written off for tax purposes after a couple of years, the barges could be sailed back west, cut and shunted together again with an extra slice (the capital gain) welded into the middle.
Patriotic and profitable, with little risk, the scheme sounded too good to be true. Indeed it was too good to be true. Overpriced investment, upfront fees, management charges and illiquid markets proved to be a lethal combination for this scheme, as for so many other tax shelters.
The story is repeated with exotic investments in different countries round the world, including Scottish forestry, Hollywood movies, Oklahoma gas wells, British EZ and VC. Jargon plays its part in mystifying the prey.
The outlook can be especially bad when governments realise that a tax break has outlived its usefulness. In the UK that happened to the housing market in 1989. Then the British government announced that they would end tax relief on life insurance policies used to finance mortgages. This created a last-minute chance to buy in at the top before the market collapsed by 20% over the next three years.
The way that tax benefits drive up asset prices can best be shown by the annual British Pep and Isa ritual. While the tax benefits have been progressively whittled down so they are essentially only of use to a wealthy minority who have CGT problems, they are still widely sold to masses who do not have CGT problems, as an annual sop to their savings conscience.
The chart on the left shows average monthly unit trust sales, which are a good proxy, because they are designed for small lump-sum savers. Typically net monthly purchases rise to an April peak, culminating in a sales frenzy in the last few days before the 5 April fiscal year-end.
Pep and Isa funds do not have to be deployed immediately, but must be parked in the appropriate tax wrappers by that date, so this can also easily explain how momentum can keep the stockmarket's rise going for another month. On average investors lose 4% over the next six months.
This is not to suggest all tax-advantaged investments are necessarily a bad idea. Personally I have been a great fan of Peps, Isas and Sipps, but then I do have a CGT problem. Thank you, Darling, your plan to cut the rate from 40% to 18% may well persuade me that CGT is worth paying, for the freedom to make undistorted investments in the stockmarket.
I have one more relevant story to tell. A generation before EIS there was BES. I was such an enthusiast for these start-up companies that the word got about and I was invited to be a judge on the annual awards panel. Aided and abetted by the experts who I met, approximately 150 companies benefited from the Inland Revenue's largesse that I was empowered to redistribute personally.
The lemons duly ripened quicker than the plums, but both took seven - rather than the advertised five - years to harvest. Years later I totted up the results and calculated that I had made 9% per annum. Not bad, considering that included a recession. However, this performance was only achieved because I took an unusual strategy. I invested in the spirit of the law, because I suspected that most investors would be interested in washing pound notes through the tax system using asset-based investments.
- Nick Dewhirst is CEO of www.investors-routemap.co.uk.
Since November 2008
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