While 2006 was a bumper bonus season for many in the City, with payouts hitting a record £8.8bn, experts are expecting a more modest approach from City firms this year as the effect of the US sub-prime mortgage market fallout makes its mark on Square Mile pay packets.
Forecasts released by the Centre for Economics and Business Research (CEBR) in October showed it expects bonuses this year to drop by around 16 per cent, to closer to £7.4bn.
The CEBR says City institutions have seen a large increase in their costs due to sub-prime book write downs and the drying up of the inter-bank market, leaving firms looking to cut costs, with bonus-slashing one of the easiest ways to achieve it. The CEBR believes investment banks and hedge funds will bear the brunt of the cuts due to their highly incentivised structures.
Furthermore, it predicts bonuses will drop further still to £6.2bn in 2008 – the lowest level since 2003 – before rising again from 2009 onwards to reach £10.5bn by 2012. However, the CEBR points out that even £6.2bn is till a significant bonus cheque.
Meanwhile, the London real estate market is already bracing itself for the effects of lower bonuses, with estate agency Savills saying it expects City buyers not to be in a rush to spend their bonuses on residential property this year. It estimates that while 60 per cent of the bonus pool went into property last bonus season, this figure is likely to halve this time around. The combined effect of lower bonus payouts and a lower percentage of those bonuses being spent on property means Savills is estimating it will see 60 per cent less of the gross bonus pool going into residential property in comparison to last bonus season.
As a result of current uncertainty levels, for many financial advisers the key word this year is cash.
“My view is a big dollop of cash and then a straight-forward equity portfolio,” says Mark Dampier, head of research at Hargreaves Lansdown.
“If I favoured one area it would probably be the riskier areas, somewhere like Russia and Eastern Europe – because the ratings there, especially in Russia, are still quite low. But I have to say, you don’t put 25 per cent of your portfolio there. It’s a 5 per cent sort of area,” he says.
In times of uncertainty Dampier says he also likes gold and “a good dollop of the UK”.
“I still like emerging markets, but I think we’re probably on the final leg of the bull market. But I think it will probably be the most explosive and most rewarding ride – as long as you remember to get off,” he says.
Nick Bamford, joint managing director at Informed Choice has also been promoting the merits of cash to clients. “At the moment keeping it in a bank account earning interest strikes me as being the place to be if you want to sleep at night. I’m only being half flippant if I say if you’ve got a big bonus from this well paid job you’ve got in the City then why not keep it in cash, the bit that you’re not spending.”
Phillip Wood, wealth advisory team director at PricewaterhouseCoopers is expecting clients to do one of three things with their bonuses this year. Like Dampier and Bamford, he is recommending the first should be keeping their money on deposit because of nervousness about property and equity markets.
“Secondly, they’re probably repaying debt if they have any and thirdly we’re seeing people take advantage of the new pension rules. Where previously people have been restricted to a much lower level of the amounts going into pensions, the new rules obviously do make it much better for higher earners to put larger amounts in,” he says.
Far from advising clients to take a punt on more exotic investments with their bonuses, Nicholas O’Shea, director at Pharon IFA is also sticking to financial planning staples.
“One of the first things we’re looking at is the use of salary sacrifice for pension contributions,” he says.
A lot of those receiving bonuses would have occupational pension schemes which until April last year when concurrency was abolished, they would have been restricted to, he says.
“The employer makes an additional contribution into a Self Invested Personal Pension (Sipp) and then we structure some investment portfolios around that,” O’Shea says.
This has the advantage of saving the employer’s National Insurance Contributions (NIC) and sees the pension contribution gross up by 12.9 per cent.
Peter Ashby, a director at Grant Thornton also describes pensions as one of the best routes to tax efficient use of bonuses. He says it is becoming increasingly difficult to structure bonuses in a tax efficient way. “The Revenue are very clear that any time anyone brings in a scheme which will reduce the tax or the NIC on bonuses, they’re going to outlaw it – retrospectively to Dec 10, 2004 if they think it’s a particularly nasty one,” Ashby says.
However, he highlights the tax benefits open to those domiciled outside the UK.
“It is still possible for some of the non-doms who’ve got separate contracts of employment to effectively put money from offshore contracts into pension plans which don’t come within the tax jurisdiction of the UK,” Ashby says.
“If it’s an offshore contract and money goes into an offshore pension plan and they don’t retire in the UK, it is possible to structure it in a way that reduces the UK tax to nil,” he says.
As well as pensions, Pharon IFA’s O’Shea is also looking at other financial planning basics for its City clients – including ensuring their mortgage arrangements are structured properly.
“A lot of these guys that we see with big bonuses, they dip into them throughout the rest of the year to support their spending,” he says.
As a result O’Shea looks to make use of offset mortgages, which effectively gives the client the benefit of receiving an interest rate equivalent to their mortgage rate, but without having to pay tax on it.
“They can then draw on that if they need to throughout the year,” he says.
When it comes to property, O’Shea does not actively encourage residential property investment to his clients.
“What I do encourage is the purchase of commercial property. But we’ve just got to make sure it’s for the right reasons,” he says.
“It could also be that at some point they want to start their own business, so they could look to buy an office to rent back to themselves. Or it could be that the spouse wants to run a business. There are lots of different reasons,” he says.
Other tax-effective options advisers suggest include ensuring clients are making use of Isas, making pension contributions for a spouse and transferring cash into the name of a non-tax paying spouse, as well as investigating the possibilities that Venture Capital Trusts and Enterprise Investment Schemes might offer.
So, while some City highfliers may be tempted to treat themselves to some more exotic investments this year, their financial advisers will be firmly suggesting they play it straight and stick to the basics this year.
As Wood says: “I think the wine should probably be for enjoyment at this time of year, not investment.”
Case study – Bloomsbury Financial Planning
“You can actually create a situation where you have two payment input periods in one year”
Jason Butler, branch principal, Bloomsbury Financial Planning
There may be little that can be done to minimise the effects of tax on the bonuses of those on PAYE these days, but Bloomsbury Financial Planning is ensuring its clients wring maximium benefit from their bonuses this year by doubling up on pension contributions.
“Although pensions are a bit restrictive, you’ve got to save for them,” says Jason Butler, branch principal at Bloomsbury.
Under the new pension rules, clients can contribute up to 100 per cent of their earned income to a pension, or up to £225,000 into a pension this tax year and £235,000 next year, Butler says.
“But you can actually create a situation where you have two payment input periods in one year,” he says.
This is achieved by making a contribution of up to £225,000 now, before writing to the client’s pension provider to ask that the next payment input period end date be brought forward. This means that instead of the end date being April 5, 2008, it becomes – for example – December 31, 2007.
“As soon as you’ve done that, on January 1 or thereafter you can make another annual contribution of the amount equal to the payment input period that ends in the following tax year. So you could do £235,000 – as long as the two payments together don’t exceed 100 per cent of earnings.”
It also needs to be ensured that the lifetime allowance has not been breached and no other pension contributions have been made in these timeframes.
The overall result is that high-net worth clients are able to gain tax relief of 40 per cent on up to £460,000 in one year. The particular benefit this year is that the contributions paid in will be net of basic rate tax at 22 per cent – meaning only 78 per cent needs to be contributed. However, with the basic tax rate dropping to 20 per cent next year, clients will have to pay in 80 per cent. Higher rate is then rebated.