A Tale Of Three Friends – And Tax Efficient Investing

financial independence in london?

Today, let me ask you to suspend your disbelief while I tell you a little story. 

Thirty-four years ago, three good friends moved to London.  They had all just graduated from the University of Bristol and were drawn in by the big city lights, the opportunity to pursue exciting careers and the chance to make a name for themselves. 

Their names were Emma, Henry and Charles. 

The year was 1985.  Margaret Thatcher was about to send shockwaves through the City of London by deregulating the financial markets, also known as the Big Bang. 

Life in the City would never be the same, and opportunities abounded.  

I won’t bore you with the highs and lows the three friends have experienced over the next thirty-odd years.  Suffice it to say that Emma, Henry and Charles have all been reasonably, if not incredibly successful. 

They earned enough money over the years to buy houses, raise families and enjoy many of the things London has to offer (and which are probably out of reach to many people these days). 

Early on, they realized the importance of building their nest egg and investing for the future.  As soon as they landed their first full-time jobs, they each decided to put away £100/month, every month.

Emma, the most practical of the lot, chose to invest in her workplace pension. 

When she read the details of her pension plan, she realized that between employer matching and government tax breaks, her £100 contribution would double in size. 

Emma wasn’t sure whether or how the rules would change in the future.  Nonetheless, it just seemed like too good of an opportunity to pass up.

Henry, the more adventurous of the three, chose what was a relatively unknown product at the time.  It was called an ISA, a tax efficient investing vehicle.  While no one topped up his investments, all the income and capital gains they generated were tax-free, forever

Henry rejoiced in the knowledge that the money was his and he could withdraw it anytime he wanted (though he never did). 

Charles didn’t exactly have a lot of time for the topic of personal finance. 

Luckily, over a bottle of wine one evening, Emma and Henry convinced him to start saving for retirement.  To give credit where it’s due, Charles was very diligent in putting money aside. 

However, he just didn’t have the patience to explore the various investment vehicles available to him.  The words “tax efficient investing” sent him running for the hills. 

At the end of every month, Charles simply deposited £100 into his HSBC account and used it to buy stocks. 

Surprisingly, both Emma and Henry were ahead of their times when it came to passive investing.  They chose to use their savings to buy a simple index tracker for the S&P 500.  As ever, Charles didn’t bother to do any research and went along with what his friends were doing. 

Let’s now let our three friends live their lives while we sit back and fast forward to the present.

Three Investment Vehicles, Three Decades Later

They say it’s better to be lucky than smart.  I can’t comment on the intelligence of our characters, but they sure were lucky. 

Since 1985, the S&P 500 has delivered a Total Shareholder Return (capital gains and dividends) of about 3,219%.  That’s right, three thousand, two hundred and nineteen percent. 

On an annualized basis, it works out to roughly 11.1% per year. 

There were some nasty stretches, of course.  At the end of 1998, Emma’s pension pot was worth £158k.  Ten years later, its value was £157k. 

It’s tough to keep investing at 45 when the world is falling apart and you realize your stock portfolio hasn’t made any progress since you were in your mid-thirties.  

It’s even tougher when you realize you have also contributed £12k of new money in the meantime.   But Emma plowed on.  So did Henry and Charles, who took a similar hit, but also stayed the course. 

In the end, all three were rewarded handsomely.  Emma’s long-suffering portfolio almost quadrupled in size over the next decade, growing to just under 600k by the end of 2018. 

Henry and Charles ended up with about £292k in their investment accounts. 

For those of you who live for the detail, below is a snapshot of how the three investments have performed over 34 years:

tax efficient investing

It would be an oversight, of course, to compare the numbers on a headline basis only.

After all, 75% of Emma’s pension pot is subject to tax upon withdrawal.  Assuming she stays in the basic 20% tax band, you could say that after tax, her pension pot is only worth about £497k.

Of course, that still leaves Emma miles ahead of Henry, whose ISA, while tax-free on withdrawal, has only grown to £292k.

And Charles… well, Charles still needs to do his taxes but it’s pretty safe to say his lack of planning cost him quite a bit. 

Because he has to pay Capital Gains Taxes when he sells his stocks, Charles’ net proceeds will likely be much lower than the £292k currently sitting in his HSBC account. 

Nonetheless, all three university friends can rest easy knowing that they’ve got a decent pot of money to supplement their state pension, the equity in their home and the retirement savings their spouses have been building up. 

What Can We Learn From This Story?

The best stories are the those that help us prepare and plan for the future.  And as you have already realized, this story is really about the future – your financial future.

This is why I hope my readers will excuse some of the financial inaccuracies as clearly neither pensions or ISAs existed in their current form back in 1985 (and I don’t even want to start thinking of the stock trading fees HSBC charged back in 1985…)

The journey that Emma, Henry and Charles have made over 30+ years holds three crucial life lessons for all of us: 

1. Consistency is the mother of success

Saving money is never easy.  Neither is staying the course.  But I would be shocked if you weren’t able to save and invest £100/month (that’s only £23 per week by the way) if the prize was the ability to de-risk your retirement. 

Can’t cut spending any further?  Then work a few extra hours a week.  In the age of the gig economy, there can be no excuses. 

And if you really want to do yourself a favour, set the savings bar much higher. 

2. Educating yourself is key

Learning the basics of personal finance is probably the best investment of time you could possibly make. 

Information is no longer the domain of the privileged few.  The web is literally bursting with an abundance of high-quality information about saving and investing for retirement.  And it doesn’t take very long to learn the basics. 

Please do yourself a favor and read up before it’s too late.

3. You have got to keep things simple

It’s very, very tough to go wrong with tax efficient investing – all while someone else is offering to top up your contributions. 

Yes, the government may change the rules on you.  And yes, a time may come when interest rates are at an all-time low and yet you are forced to buy an annuity. 

But the set of constraints imposed upon you needs to be incredibly onerous to wipe off the advantage of having your savings turbocharged on the spot – and then watching them grow tax-free for over three decades. 

I hope that the three lessons above come in handy as you look down the runway of your life between now and retirement and plan for the future.   And if you are ever in doubt, choose a tax efficient investing strategy. 

About Banker On Fire

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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.

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