Good-time PEP pill turns into a downer: Some personal equity plans may now be worthless

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The Independent Online
READ through the mountain of marketing literature promoting personal equity plans and nowhere will you find the words 'Unsuitable for Basic-Rate Taxpayers'.

Rarely either will you spot a mention that company dividends, the source of income for PEPs, have been faltering during the recession.

Stumbling company pay- outs, tax changes in the last Budget and continuing high fees have taken much of the gloss off many PEPs - except of course for the managers who collect the fees - and have made some PEPs worthless for basic-rate taxpayers choosing to invest now.

The chief attraction of a PEP is reclaiming the basic rate of tax deducted at source on dividends (the so-called tax credit). Unfortunately, one of Norman Lamont's last acts as Chancellor was to slash the credit from 25 to 20 per cent.

Pension funds and other tax-free institutional shareholders able to reclaim the credit duly kicked up an enormous fuss. But the sideswipe delivered to PEP plans was hardly noticed.

After the big rise in the stock market, the typical large company share yields 3.68 per cent gross, including the associated tax credit. So the investor receives a net dividend of 2.944 per cent - pounds 294.40p a year on a share portfolio worth pounds 10,000. Since the last Budget, the company running the PEP can now reclaim just pounds 73.60 on behalf of the taxpayer - 20 per cent of the grossed-up amount.

Unfortunately, many companies levy an annual charge of 1 per cent of portfolio value, even to investors in 'self select' PEPs who pick their own shares and so make no demands on managers' supposed investment abilities. The charge is therefore pounds 100 on the pounds 10,000 portfolio - enough to swallow up all and more of the pounds 73.60 saved by basic-rate taxpayers.

As a result, some investors would be better off without the PEP. If they stay in the PEP, only the PEP provider wins, while both the exchequer and the small saver lose out.

For basic-rate taxpayers who have chosen 'managed' PEPs, the situation can be markedly worse.

Barclays, which with PEP funds under management of more than pounds 1bn claims to be the largest provider, charges an annual administration fee on managed schemes of 1.25 per cent of the portfolio value. A basic-rate taxpayer with a pounds 10,000 share portfolio would pay pounds 125 a year in annual fees - far more, at current dividend yields, than his pounds 73.60 annual tax saving.

Most 40 per cent taxpayers still benefit from PEPs since by staying in they avoid the extra higher-rate tax payable on dividends. But even they must keep an eye on the impact of charges.

Many PEP providers charge a minimum annual fee of pounds 25. So on a small portfolio, the tax saving, even to a 40 per cent payer, is now rather modest. And the savings could disappear completely, eaten up by dealing costs, if the provider actively buys and sells shares in a managed portfolio.

Clive Hawkins, investment manager of Barclays Financial Services, admits: 'The incidence of charges is noteworthy in the early years of a PEP plan.' But he argues that in the years ahead, tax savings for PEP investors will outweigh the impact of charges.

However, this will be true only if dividends, and the associated tax credits, rise faster than share prices and the accompanying rise in management fees.

Indeed, for basic-rate taxpayers investing in the typical Footsie stock to show a profit, their dividends would have to rise by more than one-third - from around pounds 300 to more than pounds 400 net on a pounds 10,000 share portfolio. At pounds 400 net, the tax credit is equal to the typical management charge.

How many companies are likely to increase dividends by this much except over a considerable number of years? Many major firms are already paying out a very high proportion of their earnings in dividends. They are more likely to retain extra profits to repair their balance sheets than to make even more generous dividend payments.

The only other solution is to pick high-yielding shares - though big yields frequently go hand in hand with big risks. Even finding shares producing more than 5 per cent is tricky: according to Datastream, there are only six in the FT-SE 100.

Ladbroke tops the table but, as is often the case with such shares, the tempting 7.8 per cent yield reflects fears that the next step in its dividend will be down, not up. A cut in the pay-out hardly helps PEP investors.

Basic-rate taxpayers should therefore consider management charges more closely than ever before taking out a PEP. Asked why the promotional literature fails to highlight the pitfalls, the PEP industry's reply is candid but hardly reassuring. 'I think this would counter their marketing impact,' says Martin Dodd, liaison officer for the PEP Managers Association.

St James's Place PEP Progressive is the leading unit trust personal equity plan over three years with a rise of 135 per cent, according to Chase de Vere, the financial adviser. Its PEP performance charts, out last week, feature 550 unit and investment trust PEPs, as well as single company PEPs.

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