Arb's HYP 11th year - Impractical Question

[Alaric]

Time to move on.

Changes to the dividend tax rules make a high equity income approach less attractive outside of ISAs and SIPPs. If you have £ 50,000 and are making 4%, you will use up the dividend allowance from the next tax year.

[Gengulphus]

Changes to the dividend tax rules make a high equity income approach less attractive outside of ISAs and SIPPs. If you have £ 50,000 and are making 4%, you will use up the dividend allowance from the next tax year.

Less attractive than it once was (*), certainly. But the basic/higher/additional tax rates of 7.5%/32.5%/38.1% are still more attractive (or less unattractive) than the 20%/40%/45% rates on other types of income. And the alternatives you can invest in for income only include ones that generate income taxable under the new dividend taxation rules or the non-dividend taxation rules, not income taxable under the old dividend taxation rules!

So basically, it's a good idea to compare high-yield equities as investments with the practical alternatives, not with pipe dreams - even if those pipe dreams were practical only a couple of years back...

(*) The important change in the rules was the removal of notional tax credits on dividends and introduction of the 'dividend allowance' on 6 April 2016, so I really do mean "was", not "will have been". The reduction in the dividend allowance from £5k to £2k due on 6 April 2018 makes the effect of that previous change more painful and changes the amounts involved in decisions/plans/examples/etc based on it, but it doesn't fundamentally change the nature of what's going on. E.g. your example only needs to be modified by changing £50k to £125k to make it currently true.

Gengulphus

[kempiejon]

It does somewhat chime with the point raised on one of the threads on the Portfolio Review board, maybe HYP is not so great in a build phase where income is being reinvested and therefore TR is the objective. Maybe better to accumulate by other means and then at the point where the income is required look at HYP as an option.
Terry.

Ah, but, if you have another option that is better at TR than HYP why not stick to that strategy and just harvest some capital to supplement any natural yield. It's all money afterall and what should that other better strategy be? Collectives IT/ETFS OEICs as we've previously mentioned - if so which ones and how do we pick them. The HYP is not the "best" strategy but it is suitable for my purposes, I suggest that some times the best strategies cease to be so and there's a "new best" strategy along to replace that; one may as well stick with a "good enough" HYP. Or of course have more than just one strategy.

[Itsallaguess]

The HYP is not the "best" strategy but it is suitable for my purposes, I suggest that some times the best strategies cease to be so and there's a "new best" strategy along to replace that; one may as well stick with a "good enough" HYP. Or of course have more than just one strategy.

It's almost a shame that sometimes we need to remind our collective-selves that HYP was never really *sold* as 'the best strategy' in terms of TR or any other quantifiable measure. It was sold as a 'simple-enough' strategy that could be picked up by an almost complete investment-novice, and will hope to deliver returns that are adequate for the effort involved.

On a very wide-ranging investment bulletin-board, of course we may get much more experienced investors suggesting that there are 'better' alternatives to HYP, but that really shouldn't be too contentious a point - the real point is that it's *good-enough* for the type of people it was meant to be picked up by.

I should add that of course people picking up HYP as an income-strategy might well turn out to see investment-doors open up as they use the strategy over a number of years, and people may well begin to see suitable alternatives to HYP over time, but that still doesn't diminish HYP as a great starting point for the people who initially decide to use it as a strategy.

If the alternative might be to stuff wads of cash into the mattress, then the HYP strategy doesn't need to be the *best* strategy, it just needs to be *better*.....

Cheers,

Itsallaguess

[tjh290633]

It maybe is time to look at income growth from an HYP, compared with some ITs.:

.             Unitised             Change            
         .   Ordinary    RPI      Ordinary    RPI   
Year to      Divs/unit            Divs/unit         
05-Apr-88         2.83   101.80                     
05-Apr-89         2.25   114.30     -20.38%   12.28%
05-Apr-90         3.40   125.10      51.11%    9.45%
05-Apr-91         4.67   133.10      37.21%    6.39%
05-Apr-92         5.94   138.80      27.25%    4.28%
05-Apr-93         5.52   140.60      -7.12%    1.30%
05-Apr-94         5.31   144.20      -3.81%    2.56%
05-Apr-95         6.45   149.00      21.55%    3.33%
05-Apr-96         6.27   152.60      -2.85%    2.42%
05-Apr-97         7.13   156.30      13.74%    2.42%
05-Apr-98         7.55   162.60       5.93%    4.03%
05-Apr-99         7.92   165.20       4.93%    1.60%
05-Apr-00        10.79   170.10      36.11%    2.97%
05-Apr-01        11.39   173.10       5.61%    1.76%
05-Apr-02        12.46   175.70       9.36%    1.50%
05-Apr-03        11.68   181.20      -6.22%    3.13%
05-Apr-04        11.13   185.70      -4.70%    2.48%
05-Apr-05        13.03   191.60      17.01%    3.18%
05-Apr-06        14.21   196.50       9.11%    2.56%
05-Apr-07        15.18   205.40       6.78%    4.53%
05-Apr-08        20.19   214.00      33.01%    4.19%
05-Apr-09        21.60   211.50       6.97%   -1.17%
05-Apr-10        11.91   222.80     -44.84%    5.34%
05-Apr-11        16.28   234.40      36.67%    5.21%
05-Apr-12        19.15   242.50      17.62%    3.46%
05-Apr-13        20.92   249.50       9.23%    2.89%
05-Apr-14        21.35   254.80       2.07%    2.12%
05-Apr-15        22.43   258.00       5.05%    1.26%
05-Apr-16        22.78   261.40       1.57%    1.32%
05-Apr-17        25.38   270.60      11.42%    3.52%
05-Apr-18        26.61   275.80       4.86%    1.92%

The last year is incomplete, of course. 5 more dividends to come, from AZN, BLT, RDSB, ULVR and BP. before 5th April.

Looking at the last FRCL annual report, the dividend rose by 86% between 2006 and 2016, and for FCI (perhaps more comparable) they rose by 58% over that period. WTAN rose from 9.2p to 19p, 206% over the same period. ATST rose from 104p to 169p over the period from 2008 to 2016, an increase of 62%. My increase from 2006 to 2016 was 60%, and from 2008 to 2016 it was 12%.

TJH

[taken2often]

The difference between income and growth may be more relevant if you are going to pay IHT on your estate. Two years ago when I hit 70 I started to have a notional death each year and back tracked 7 years. With the IHT 400 form plus guidance you find out what HMRC are looking for. 7 Years income and expenditure. If you keep this fine otherwise it could be an expensive exercise if using a solicitor.

Dividends transferred to your bank is income, and you can gift excess without IHT problems. Or you can pay some of it back to your trading account which turns it into capital.

Selling stock and using the funds to live off, is the sale of capital and only £3000 per year is IHT free.

Once stock is sold,it is gone. With income stock the value may be less, therefore IHT less. After IHT the income could roll on without liquidation costs.
If 20% of the income can be reinvested each year you could have your own indexed annuity.

To help prove that you are living off income HMRC look for 7 years expenses to prove that you have excess income to gift. So you need to keep weekly, monthly and annual lists of living costs. Takes little time if done this way. So 7 years of bank and credit card statements. Large cash payments need a note on the statement what it was for. Six or seven years down the line very difficult to remember, so may be added back in.

They also wish to see 7 years gifts and who got them. Any excess over is added back into the estate and taxed. In the event that the executor will not pay the IHT on the gifts. HMRC will claw back from the recipients.

One last tip the executor should not try to make the estate fit the IHT allowance, unless it is very very accurate. A mistake that can start an audit

Bob

[tjh290633]

I make regular gifts to my grandchildren, using payments by DD to their respective IT accounts. It can easily be demonstrated that these gifts come out of income and that they do not affect my standard of living.

Likewise gifts to charities which attract Gift Aid fall into the same category.

My investments are virtually all inside ISAs, so CGT or Income tax are irrelevant there.

TJH

[Gengulphus]

Selling stock and using the funds to live off, is the sale of capital and only £3000 per year is IHT free.

Rather confusing, because the £3k/year IHT allowance is never relevant to funds raised by selling stock and used to live off - you can do that as much as you like without running into any IHT limits.

The £3k/year IHT allowance instead essentially applies to funds raised by selling stock (or any other funds of a 'capital' nature) and given away (other than as an IHT-exempt gift, e.g. to one's spouse or to charity). I say "essentially" because the test isn't what actually happens to the funds - it is instead simply that gifts of up to (income) - (normal living expenses) can be exempt from IHT under the normal-expenditure-out-of-income exemption, which effectively means that gifts are deemed to come out of income-after-normal-living-expenses before capital regardless of where they actually come from.

That's important because it means that some apparent loopholes involving keeping income and funds of a 'capital' nature separate from each other don't work. For example, some bright spark who relied on the descriptions above might come up with the idea of holding all their shareholdings in registered form (certificates and/or in a CREST account) and opening a separate bank account that they mandate all the dividends into and that they only fund in that way and by getting other clear cases of income (e.g. pensions) paid into it, never by transferring money in from elsewhere. Then they take all their living costs from their other accounts (i.e. 'elsewhere') and make gifts from the separate bank account, and reckon that since they can now prove they're not living off their income and that all the gifts come from income, and so reckon from the above that their executor(s) will be able to prove that everything is either irrelevant to IHT (the living expenses taken from 'capital') or exempt from it (the gifts taken from income) when the time comes. And they will indeed be able to prove the facts underlying that view - but IHT will basically say "So what?" and apply the actual test!

And that's not the only aspect of the normal-expenditure-out-of-income IHT exemption where it's important to get the details right. For example, only 'normal' gifts can be exempt under it - gifts for which there is an established pattern of making them. And that brings me on to the real point of this post: if you want to try using it, make certain you get the details right, either by thoroughly understanding how it works (*) or by employing a tax adviser who specialises in the area - or preferably both!

(*) Which is not a topic for this board, and indeed I may be stretching the limits of an acceptable aside from the board's topic with this post, so this will be the last I say about it in this thread.

Gengulphus

[taken2often]

TJH I was talking about IHT. True if you are married and first to go then no IHT problem with an ISA. I am not married so I, do as my ISA rises by about 45k a year, not counting any growth from compounding etc.

Gengulphus you have complicated my simplistic view, and as you say more suitable for another Board.

Income or capital. True the first £3000 gift allowance can come from anywhere, after that it is best that you have clear documentation as to where the higher amounts came from. My income comes from DWP Pension and dividends and interest transferred from my taxable portfolio. I do not touch my ISA income at present. For capital purchases I may sell shares with the minimum amount of capital gain or within the allowance and have a clear audit trail to the purchase. My understanding is if there is any doubt, sums are added back into the estate for IHT. So seven years of good records are essential.

And please remember a HMRC Audit is pure gold to your professional executor/accountant, and its always your fault.

Bob

[Degsy67]

Well, the evidence seems to be building that over the last six or seven years HYP has not been as good a strategy for accumlation as ITs / OIECs / ETFs.

Terry.

There is some evidence to support that, but only certain IT/ETF/OIECs of course; now what to buy for the next 6 years? Perhaps we are seeing that some HYPers or disillusioned HYPers are really good at picking collectives for accumulation? In my own investing my FTSE250 value strategy is beating my HYP income strategy on a capital and total return basis but the income is lower than my HYP.

My experience of HYP is that it is a strategy which is higher risk than many strategies based around collective investments involving ITs and ETFs. That is not to say that it is high risk or not a good strategy for those for which it sits comfortably inside their risk tolerance and who are predominantly seeking income. The HYP philosophy is based around ignoring the capital value of the portfolio and simply focusing on the income. This equates to training the HYP investor to ignore volatility.

As HYP is a higher risk strategy, it should / could generate higher returns under the right UK market and UK economic conditions. These conditions don’t exist forever. HYP fundamentally relies upon mature companies generating excess profits and returning them in the form of dividends on the basis that the company does not need to retain profits to fuel growth or reinvestment in the company to maintain its market position. However, these conditions vary for each individual company in the HYP. The more holdings in the HYP, the more individual company risk is mitigated.

Risk vs reward is a fundamental investment concept. HYP masks some of the risk by expecting investors to turn a blind eye to capital values (share price) to focus on underlying individual company profitability (dividends as as share of profits). When a company is no longer profitable (Dixon’s, Carillion etc) or is discovered to be less profitable than it presented itself as (Tesco), it blows up in your face. In contrast to this, when economic conditions change leading to undervaluing particular sectors of the market (eg, housebuilders in 2006-08), there can be a significant upside as profitability returns based on the shift in economic conditions (eg, easing of lending conditions). These are the fundamental risks which HYP investors need to understand and tolerate otherwise they move on elsewhere to lower risk strategies which fall inside their risk tolerance and which can deliver similar average returns across multiple economic cycles at lower levels of volatility.

I’m not sure that HYPers become disillusioned. I do however believe that if you hold a HYP for long enough and compare it against alternate strategies, including those based around ITs and ETFs, you gain a much better insight into your own risk tolerance which could lead to a switch in strategy as and when a better fit is found. That has been my own experience.

Degsy

[Gengulphus]

My experience of HYP is that it is a strategy which is higher risk than many strategies based around collective investments involving ITs and ETFs. ...
...
Risk vs reward is a fundamental investment concept. HYP masks some of the risk by expecting investors to turn a blind eye to capital values (share price) ...

I don't think that's a significant difference between HYPs and ITs/ETFS. Given e.g. a 'classic' HYP that buys high-yield, large-cap UK shares, and an IT/ETF with the same focus (*), they'll share many of the same holdings, and those holdings will suffer exactly the same capital fluctuations regardless of whether it's an individual HYPer or an IT/ETF manager who holds them. The actual difference is that the HYP exposes those capital fluctuations to the investor, whereas the IT/ETF doesn't - essentially, the capital value of a single IT/ETF is the equivalent of the capital value of an entire HYP, not of the HYP's individual shareholdings. Or if you like, the HYP expects the investor to turn a blind eye to capital values, whereas the IT/ETF more-or-less forces the investor to turn such a blind eye...

That does of course produce a psychological difference for the investor - there's a lot of truth in the old saying "Out of sight, out of mind"! And there are other significant differences: the amount of work needed to achieve a given level of diversification (just one IT can be as diversified as an entire HYP), trading costs, management fees, expertise of management (**), degree of control one has over exactly what one is invested in, feasibility of investing in some investments (including derivatives used in managing the risk), personal satisfaction about a good investment choice, and doubtless quite a few others... So I'm not saying that HYP and IT/ETF strategies are the same thing - just that they don't fundamentally differ about capital values.

(*) A similar comparison can be done for many other types of investment focus, of course - there's nothing preventing one running a HYP strategy for any investment focus that includes high yield, though some are liable to end up just being plain silly - e.g. a HYP start-ups strategy!

(**) But don't necessarily assume that investment is an area in which a high degree of expertise leads to a high degree of success!

Gengulphus