Interest rates are rising...
Source: Bank of England
Interest rates in the UK have started to move upwards sharply. Until 16 December 2021, the Bank of England’s Base Rate was 0.1%. By early August 2022, after six consecutive increases, it was 1.75%. Across the Atlantic, over the same period, the USA central bank, the Federal Reserve, moved its main rate four times, from 0.00%-0.25% to 2.25%-2.50%.
Why Are Interest Rates Rising So Fast?
There is a one-word explanation of why the Bank of England and its counterparts around much of the world are raising interest rates: inflation. In the UK, CPI inflation reached 10.1% in July 2022; a year earlier it had been 2.0%, which just happens to be the Bank’s central target. In the US the corresponding figures were 5.4% and 8.5%, while in the Eurozone they were 2.2% and 8.9%.
Those jumps in the rate of inflation caught the central banks by surprise. At first the Bank of England, like its US and European counterparts, thought that the higher inflation would be ‘transitory’, a result of the supply chain difficulties that came with the end of COVID-19 restrictions. By the end of 2021 it became clear that waiting for the transitory spike to disappear was the wrong strategy and talk turned to interest rate increases, with the Bank of England making its first move just before Christmas.
The mistaken belief in transitory inflation explains why rates are now rising so rapidly. Had the central banks made the right call in summer 2021, they would have started pushing up rates back then. Now they are, to use a well-worn phrase of the economic commentariat, behind the curve. That means larger than normal rates increases are now needed to regain lost ground.
How High Will Rates Go?
The Bank of England is avoiding any forward guidance on rates, preferring to adopt a common central bank mantra that it will be guided by the data. In part that is down to experience when guidance had to be abandoned when events did not unfold as expected.
Although the Bank is not offering any forecasts, in August the money market’s view was that the base rate will peak at 3% around the end of the year and then decline by 0.5% over the next two years. Whether or not the Bank thinks that picture is correct, it uses those market numbers as assumptions for its economic projections. At first sight 3% looks like a low peak, especially when The Bank of England forecasts that inflation will reach over 13% in the final quarter of 2022. However, economists are generally agreed that, after more than a decade of near-zero rates, the days of double-digit rates have long since passed. A further factor is that the Bank’s central projection is that inflation will fall sharply after 2023 and be back at 2% in two years’ time.
How Higher Interest Rates Affect Your Finances
The Bank of England’s action is focused on short term interest rates, but longer-term interest rates have also risen. For example, the benchmark ten-year UK Government bond offered a return of 0.97% at the end of 2021. By early August 2022, the same bond had seen its price fall to the point where the yield was just over 2%. Rising interest rates at all terms have several effects:
The most obvious is that mortgage rates are rising. If you have a fixed rate mortgage, like five out of six borrowers, you will be unaffected until your fixed rate expires. As most fixed rate mortgages have terms of two and five years, one estimate is that, within the next two years, about 40% of borrowers will have to replace their fixed rate loan, probably at a higher rate, or fall back on their lender’s standard variable rate (SVR). SVRs have already followed the base rate upwards – for example, Halifax’s SVR is now 5.24%.
Deposit rates are rising, with the best instant access accounts now paying around the current base rate. Unfortunately, many deposit takers have seen the higher rates as an opportunity to increase their profit margins. You can still find High Street names offering a miniscule 0.01% on easy access deposits of less than £50,000 (and only 0.1% above). National Savings and Investments have increased their rates, but they remain relatively unattractive – for example, the once highly popular Income Bond now pays 1.2%, 0.55% below the base rate.
Higher interest rates are not a reason to increase the amount you hold on deposit. The hard truth is that, at a time of high and rising inflation, deposits are a guaranteed way to lose buying power.
The rise in long-term rates has led to a marked increase in annuity rates, which are underpinned by long term fixed interest securities. The mathematics of annuities means that the increases have been significant. For example, based on a 65-year old, today’s rates are nearly a third higher than those available early last year.
Inheritance Tax Paid Nearly Doubles In Ten Years
Source: HMRC
Inheritance tax (IHT) is the tax that often wins pole position in surveys of the UK’s most disliked tax. One of the common criticisms of it is that it represents double taxation – you pay tax all your life and then IHT repeats the process at death..
A Long History Of Changes And No Changes
IHT has its roots in Capital Transfer Tax (CTT), which was introduced nearly half a century ago to replace Estate Duty. Since CTT was reformed and rebranded as IHT in 1986 it has undergone many technical changes, most of which have been designed to raise more revenue. However, IHT has also been a curiously unchanging tax:
The annual exemption of £3,000 has been unchanged since 1981, the era of CTT.
The small gifts exemption has been stuck at £250 for one year longer.
The limits on marriage gifts have not been increased since the introduction of CTT in 1975.
The nil rate band has been frozen at £325,000 since 2009 and is not due to increase again until 6 April 2026.
The residence nil rate band, introduced in 2017, has been frozen at £175,000 since 2020 and it too is not due to rise again before 6 April 2026.
The freezing of the exemptions and nil rate bands means that IHT has steadily gained a larger audience of taxpayers and those caught are paying an increasing amount of tax. For example, average house prices have risen by over 75% since the nil rate band was frozen, according to Nationwide.
The graph shows the overall effect: between April 2012 and April 2022, prices increased by 25%, but IHT payments to the Exchequer came close to doubling.
And The Future…
It was notable that during the recent campaign to become the new Prime Minister, neither of the final two candidates made any reference to IHT, despite the focus on taxation policy. That might be because, compared to income tax, IHT raises a small amount of revenue and effects many fewer people. It is also a highly efficient tax from the Treasury’s viewpoint: in 2021/22, the average IHT-paying estate suffered a tax charge of just over £250,000.
A recent review of IHT was undertaken by the Office of Tax Simplification (OTS). Its proposals, including a rationalisation of annual allowances and lifetime gifting, were almost entirely dismissed by the then Chancellor, Rishi Sunak. The OTS reports joined those of several think tanks that have suggested wider ranging reforms. The proposals in many of these would raise more tax by, for example, treating a gift or legacy as income of the recipient, subject to a single lifetime exemption of £125,000. It is conceivable that such a new form of IHT – more obviously an inheritance tax than the current version – could be introduced after the next general election.
IHT is a tax that rewards long term planning. History suggests it is also a tax that will continue to become increasingly relevant to families, if only because of successive Governments’ reluctance to update the value of exemptions and nil rate bands. If IHT is a concern to you, then the sooner you start planning, the better. If you already have an estate plan, make sure it is regularly reviewed to keep up with changes (and non-changes) in the law and your personal circumstances.
Capital Gains Tax And Divorce
Draft legislation has been published to introduce a new regime for capital gains tax (CGT) on divorce or separation.
In summer 2020, the OTS was asked to review CGT by the then Chancellor, Rishi Sunak. The request came as a surprise to tax professionals who speculated that there were plans afoot to bring CGT and income tax rates closer together as a way of raising more revenue. In the event, the OTS did propose a greater alignment of rates, along with a reduction in the annual exemption from the current £12,300 to a de minimis figure of just £2,000-£4,000.
The Chancellor rejected both suggestions, but not before CGT receipts had been boosted by some investors taking what proved to be unnecessary pre-emptive action. However, Mr Sunak did accept a range of technical changes put forward by the OTS, one of the most important of which related to the interaction of CGT and divorce.
The Current Rules
The general rule is that transfers between spouses and civil partners are deemed to be on a no-loss, no-gain basis. The result is that that the receiving spouse/partner acquires the transferred asset with the base cost that applied to the transferring spouse/partner, so no gain or loss arises. The snag faced by separating or divorcing spouses/partners is that this rule only applies in a tax year during which the couple have lived together.
That means, for example, if you separate in January, then you have only until 5 April before CGT starts to be a consideration in any rearrangement of the ownership of assets. As the OTS noted in its report, ‘The average time between applying for and securing a divorce in England and Wales in 2020 was 53 weeks. Separating and starting the legal process of divorce are not the same thing.’ The OTS proposed that a more reasonable timeframe would be for no-loss, no-gain to apply for up to two tax years after the tax year of separation.
The Draft New Rules
Draft legislation published in July goes one better than the OTS proposal and gives couples up to the earlier of:
three tax years after the tax year of separation; and
the date on which a court grants an order for divorce, the dissolution or annulment of a civil partnership, judicial separation, or separation in accordance with a separation order.
Any transfer arising as from a formal divorce agreement will also be treated as no-loss, no-gain, with no time limit applying.
The draft legislation covers two other CGT-linked areas where the OTS proposed reform:
A spouse/civil partner who retains an interest in the former joint home will have the option to claim Private Residence Relief when it is sold; and
Individuals who transfer their interest in the former home to their ex-spouse/partner and are entitled to receive a share of the proceeds on eventual sale, will be able to adopt the same tax treatment to those proceeds as applied when the original transfer occurred.
The legislation should become law from 6 April 2023 and will only apply to disposals from that date.
Automatic Enrolment: A Successful First Decade
Source: ONS
1 October 2022 will mark the tenth anniversary of the introduction of automatic enrolment (AE) into workplace pensions. At a time when Government effectiveness is being called into question in the UK and beyond, AE is an interesting success story.
A Little History
AE’s introduction in 2012 marked the end of a prolonged gestation period. In 2002 the DWP set up a Pensions Commission to review the UK private pensions system and long-term savings, assess its effectiveness and make reform recommendations. The Commission published two reports, in 2004 and 2005, followed by a final statement in 2006. Detailed legislation followed thereafter, but when the Labour Government was replaced by the Coalition Government in 2010, a review of the proposals was triggered. It was quickly decided that AE should go ahead and, in October 2012, a phased process began, with the largest employers in pole position.
Roll out was gradual and it was not until April 2019 that contributions reached their final level of 8% of qualifying earnings (broadly annual earnings between £6,240 and £50,270). As the V-shaped graph demonstrates, AE produced a substantial rise in the number of people covered by workplace pensions, reversing a pattern of decline.
So Far, So Good, But…
In terms of increased private pension provision, AE has been a success. However, one disappointment has been that, for many employees and workers, the minimum statutory contribution has remained the only contribution. Most pensions experts reckon that the 8% minimum (split 5% individual, 3% employer) needs to increase if adequate funds are to be accumulated by the time of retirement. For example, the Association of British Insurers recently proposed a gradual increase to 12% (split equally between individual and employer).
The self-employed were left outside AE from the outset. Since then, various suggestions have been made to introduce a similar system for this sector of the working population, but nothing has even neared the statute book. That is a big gap, given that the self-employed number nearly 4.25 million people – about one in eight of the working population – and only 16% currently save into a private pension. Sadly, that is less than half the percentage of ten years ago.
Past performance is not a reliable guide to the future. The value of investments and the income from them can go down as well as up. The value of tax reliefs depend upon individual circumstances and tax rules may change. The FCA does not regulate tax advice. You could lose your home of you do not keep up mortgage payments. This newsletter is provided strictly for general consideration only and is based on our understanding of current law and HM Revenue & Customs practice as at 25 August 2022. No action must be taken or refrained from based on its contents alone. Accordingly, no responsibility can be assumed for any loss occasioned in connection with the content hereof and any such action or inaction. Professional advice is necessary for every case.