Service Costs

The management of your money is enabled by an industry – the Financial  Services Industry (FSI). It stores your money, enables you to spend it, gives you access to savings and investments, invents and supplies special products to help you, and offers advice on all aspects of your money management.

This industry works like any industry under capitalism – it works very hard to find things you want to buy and services you can be persuaded to want at a price that gives it a profit. Also, like any industry, it works to make as much profit as possible, and that means charging you as much as it dares but restrained by competition and the necessity of maintaining a good reputation. These charges are your ‘service costs’.

A cast of thousands make their living out of this money chain. You can learn about them here.

Ad Valorem Charges

This describes a method of charging. It does not describe any particular service you might be charging for. This means ‘annual charges as a percentage of your savings’. It does not describe any particular service you might be charging for. We will also use the phrase ‘percentage charge’.

You need to be aware that quite small percentage charges can accumulate, over time, to quite big effects on your wealth. Here’s one example as an introduction:

• Say you make an investment of £1,000 at age 20 that earns 4% per annum. It will accumulate after 40 years to £4,800 (trust us).

• Suppose an ad valorem charge of 1% per annum is applied (say for services in managing the investment). Then the return would be 4%-1% = 3%.

• It would have accumulated to just £3,250.

• £4800 minus £3250 is £1,550. You would have lost £1,550 - i.e. 30% of your money.

This is your first example of…..

Compounding Magic

You don’t need to understand compound interest. And anyway we promised no Maths. But you need to develop a feel for its effects. And they are important:-

Over any longish period , and for almost any percentage charge, it will be significant.

• You got your first example in the previous paragraph (30% lost through a 1% charge).

• Suppose the charge was increased to 2%? Then you would lose 55% - more than half your savings.

• Suppose the period was shorter, say 20 years instead of 40? Then the loss reduces but it’s still significant - 20% instead of 30% for a 1% charge.

An ad valorem charge will take the same proportion of your money however large the underlying return.

Suppose the underlying return was 10% instead of 4%, surely the effect of a 1% charge would be smaller, proportionately? No, amazingly (we think) the loss stays at around 30% for a 40-year accumulation.

• £1,000 at 10% for 40 years accumulates to £45,000

• £1,000 at 9% for 40 years accumulates to £31,000

• £31,000 is 70% of £45,000 - 30% lost

As we said, you don’t need the maths. What you need is to understand that minimising percentage costs for long-term saving is vital. This depends on your choices of service providers and how they are rewarded.

There is more to help you on this in Compounding Effect but we link to it at any particular place in the course. It’s important for helping you with decisions on spending or saving at any level. But it’s not easy. Take your time.

Tax

In money management there can be many ways of doing what you want to do, sometimes taxed in different ways. It is vital that you chose the cheapest, for you.

This is particularly true of saving for retirement. There are opportunities to shelter your savings in tax free wrappers which you must be careful not to miss, particularly when you are young. Because if you chose to put money aside at age 25, say, and do not use one of the tax-free wrappers available, you are losing tax relief on the investment income from that money for 40 years, plus you are losing an extra contribution from the government (in some cases), plus you are losing the extra investment income that would have been earned over 40 years on the tax ‘saved’. And that’s a lot of money.

And it affects your life choices. Because if you have to chose between taking a ‘use it or lose it’ tax-free pension saving allowance at age 25 and taking an extra holiday instead, doesn’t that affect your decision?

‘Compounding Magic’ above applies. Tax relied can be an ad valorem benefit.

Find a friend or pay a reliable accountant to help you.

Inheritance tax

Usually abbreviated to IHT.

If you are lucky enough to have the ‘problem’ of transferring wealth on your death there are tax-efficient ways of doing it. Unfortunately they all come with consequences; the rules change frequently; and your actions can be irreversible.

Worse, the ‘right’ action for you depends on very personal judgements about an event that could be a long way in the future. Maybe your charming 5-year-old grandson turns into a 25-year-old druggie. Maybe your daughter’s husband dies unexpectedly and she re-marries a charming but devious drunkard.

Take advice early.

Service providers generally

Pay attention to this warning about US healthcare. ‘At its worst, private healthcare is a system in which doctors are incentivised to keep people sick’.