Save yourself from an uncertain future

Tuck away some cash to see you through any difficult times that may lie ahead. By Rob Griffin

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Saving money is essential. Not only does it make sense to have some set aside for your longer term financial needs, it’s also a great way of increasing its value and keeping one step ahead of inflation. Banks and building societies usually pay an agreed rate of interest in exchange for holding money in accounts, while a range of other investments can be bought in the hope of providing a decent return over time.

It is a message that finally seems to be getting through to people. Brits saved £21 billion in the third quarter of last year, according to figures from the Savings Brake report, published by Unbiased.co.uk. At the start of 2010, this was only £18 billion. The question is how best to save. What products should be considered – and how can you choose between financial institutions? Are you willing to take a degree of risk with your money and what other downsides should be considered?

FIRST STEPS

However, before starting to tuck money away on a regular basis there is a very important job to complete, according to Andy Gadd, head of research at Lighthouse Group. You will need to pay off any existing debts, especially those expensive credit card bills. “Anyone who chooses to save rather than paying off debts will need to earn a return [after tax] from their savings that is greater than the interest they are paying on those debts,” he explains. “An analysis of both will need to be carried out. Those who are married and/or have a family should also consider the various types of insurance that is available to safeguard their family’s future – particularly life cover and critical [injury] insurance – before they start saving their cash.”

YOUR RISK APPETITE

Once you have cleared your debts and considered other financial planning requirements you can think about saving. According to Patrick Connolly, head of communications at AWD Chase de Vere, you will need to decide what you would like to achieve by putting your money away, how long you can do without access to it and the amount of risk that you are willing to take to receive potentially higher returns.

“If you are saving for fewer than five years – or need access to your money – then you should keep your money in cash,” he recommends. “You should certainly not invest in a wrapper which will tie your money up, such as a pension.” Understanding the risks involved is vitally important. The best way is to imagine what affect it would have on your quality of life if you lost that money. Are you prepared to see the value of your investments fall, especially in the short-term, and if so, by how much?

“Many people take on too much risk and don’t realise this until they see heavy falls in their investments,” adds Connolly. “They then panic and sell out at the bottom of the market after losses have been incurred.” Therefore, your savings should be divided into short- and long-term needs.

SHORT-TERM SAVINGS

The first step is to put together a rainy day fund, according to Mark Dampier, head of research at Hargreaves Lansdown, who recommends everyone has between three to six months’ worth of salary saved as a safety net in an easily accessible account. “People underestimate the importance of having cash behind them,” he explains. “They may feel [financially] well off, but the acid test is what would happen if they lost their job. Would they be able to survive financially until they found employment?”

There are a number of potential homes for rainy day cash. The most efficient is the cash individual savings account (ISA) – a tax-free savings vehicle into which you can currently place up to £5,100 of the total annual £10,200 ISA limit. This means that you do not have to pay tax on any income received or capital gains arising from investments held in this way, so you won’t have to declare anything to that effect on your annual tax return.

If you have already used up your ISA allocation then search for a decent easy access savings account. You can still earn money on deposits made despite the rock bottom interest rates, but you’ll need to scour the market for the very best deals.

Make sure that you pay particular attentionto the small print. Make sure you are not limited to a set number of withdrawals each year otherwise this will render as pointless the idea of having an instant access rainy day fund.

LONG-TERM SAVINGS

The average Briton should live to almost 80, according to the Office for NationalStatistics, which is five years longer than was being predicted in the early Nineties. The question, however, is how to fund these extra years. Proposed changes to pension regulations also mean people will have to work longer and harder before they can reap the rewards of their hard work – which is why it’s so important that we all start planning our retirement now.

The priority as far as longer-term saving is concerned should be a personal pension, because this is still the most tax efficient way of funding your retirement even though you won’t be able to access to until your mid-fifties. You pay income tax on your earnings before any pension contribution, but the pension provider claims tax back from the Government at the basic rate of 20 percent. This means for every £80 you pay into your pension, you end up with £100 in the pot.

So how do pensions actually work?

You will generally pay a regular amount to a pension provider, which invests it onyour behalf. This fund is usually run by a major financial organisation such as a bank, insurance company or a unit trust provider. When you retire, you can choose to take a tax-free lump sum from your fund and use the rest to secure an income – usually in the form of a lifetime annuity. The amount will depend on how much has been paid and how well the investments have performed. The earliest age you can take your personal pension is now 55 years old, but most people choose to wait until they are 60 or 65. You don’t have to retire to enjoy the benefits and you can even put it off for a number of years.

Pensions are not the only vehicles in which to save for the longer term. Your ISA allowance should be the next consideration. As mentioned, you are allowed to invest up to £10,200 each tax year in these accounts. No more than £5,100 can be in a cash ISA, but you can invest the remainder – or even the full amount if you so desire – in a stocks and shares ISA. Obviously these will invest in the stock market and can be volatile, but for anyone investing cash these are an essential first step.

Once your ISA allocation has been fully taken up, you can still invest outside of this lucrative tax wrapper in a range of investment funds, although it makes sense to consult a financial adviser who can help you choose those most suitable to your needs.

UNDERSTANDING INVESTMENTS

Alongwith cash investments there are three other main asset classes: equities (shares), bonds and property. If you invest in shares then you are buying a stake in a company in the hope of earning a return in the form of income – the payment of dividends, capital growth, or a mixture of the two.

With bonds you are effectively loaning money to a government or company in exchange for a fixed rate of interest over a pre-determined period, as well as the face value of the bond returned on a specified future date. Property, meanwhile, usually means commercial property such as shops and retail parks. The class is usually divided into direct investment – actually buying a particular property – or indirectly, such as through an investment in property-related shares.

HOW TO BUY THESE INVESTMENTS

You can obviously buy individual shares, bonds and even properties, but a popular way of getting exposure to them is via a pooled investment, because it gives you greater diversification and is a lot less risky. Take open ended investment funds for example. These are run by fund management companies and referred to as “open-ended” because the number of units increases and decreases in relation to the number of investors. Therefore, investors hope that the unit price will rise over time as the price of the underlying investments increases, as well as benefiting from dividends.

OTHER THINGS TO CONSIDER

A golden rule is to ignore fashions and trends, points out Andrew Merricks, head of research at Skerritt Consultants. These funds may enjoy short term periods of stunning performance but this can just as easily come to an abrupt halt.

Instead, you would be better off opting for managers and funds that demonstrate sound, longer-term investment goals that offer an acceptable level of risk. Merricks adds: “Marketing firms are good at coming up with branded portfolios, so make sure you know what they are trying to achieve.”

Then there are performance figures. Everyone warns against looking at them, but they can help to build a picture of the fund manager’s ability, says Mark Dampier at Hargreaves Lansdown. “The longer the track record, the easier it is to start forming a judgement about a manager,” he says. “They may show he [or she] has delivered over time.”

Regardless of where you want to put your money, a good method of investing it is to put it away monthly, suggests Darius McDermott, managing director of Chelsea Financial Services. This isknown as “pound cost averaging” and sees investors paying a set amount each month to buy units of a fund – at whatever price they are available. “If you regularly invest £200 into the fund and have been buying units at £8 each, when they fall down to £6 you will get more units for your money,” he explains. “You get an averaging effect and it’s a great savings discipline.”