FOOL'S EYE VIEW
Why Everyone Should Have A Tracker

By Cliff D'Arcy
March 4, 2004

My wife had to make two important decisions at the end of last month. The first was what to do with her annual bonus, which is paid at the end of this month. In recent years, her employer has been exceeding its growth targets, so she stands to receive a hefty lump sum (despite having been on maternity leave since September, the lucky lass!).

As far as I can see, the only problem with receiving a windfall such as this is that the taxman hits her with a large bill. Every penny of her bonus will be taxed at 40%, which means that only 60p in the pound ends up in her hand. However, she can dramatically reduce her tax bill by paying more into her pension.

Mrs D is a member of a final-salary company pension scheme, which is something of a rarity these days. Membership costs her a mere 1% of her income at present and, by law, the maximum that she can contribute in total is 15% of her gross salary and company benefits (car allowance and so on). She already makes additional voluntary contributions (known as AVCs) of over 5% of her income, so she can pay in almost 9% more.

By doing this, she saves thousands of pounds in tax and gets to keep almost all of her bonus out of the taxman's grasp. She's a smart cookie, so she prefers £100 in her pension to £60 in her hand. Even though a chunk of her bonus has gone into her pension and can't be touched until she's at least fifty, she knows it remains her money.

Put the lot into a tracker!

The second important decision Mrs D has to make is where to invest this money, plus all of the money she's contributed so far. Her company has fiddled with its company pension scheme a few times in her fifteen years with the firm, so she currently has two separate pots. Unfortunately , her early AVCs are being held hostage inside Equitable Life's with-profits fund, which has gone into near-terminal decline in recent years. However, the remainder of her AVCs are invested in a balanced managed fund with Schroders (LSE: SDR).

As it happens, this fund has done pretty well over the years, which is probably more down to luck than skill. In reality, the vast majority of fund managers don't outperform the stock market over the long term. Thanks to their high charges (the 'Ferrari Factor'), nearly eight in ten actively managed funds (79%) failed to beat the benchmark FTSE All-Share Index over the twenty years to the end of 2002!

That's why we at the Fool prefer to invest in index trackers, which passively track the stock market's rises and falls, with little human involvement. Trackers don't employ highly paid stockpickers, which means that their charges are lower than those of most investment products. Of course, the attraction of low-charging funds is that you get more of your money working from day one, which gives you a huge long-term advantage.

My wife's company - a global giant - has also noticed this underperformance by fund managers, and has decided to close several funds and sack several fund managerment groups, many of which have repeatedly failed to beat their benchmarks.

Her pension trustees have decided to replace these closed funds with a range of index trackers that follow indices in the UK, US and globally. Because of the company's buying power, it has negotiated incredibly low annual management charges: just 0.07% a year for a FTSE All-Share tracker. That's about a fifth of the fees levied by even the cheapest UK index trackers!

Mrs D is strongly attracted to low-charging investment products, partly because she's seen how our endowment's high charges have crippled its growth! She's decided to invest all her future AVCs, plus her existing pot, into a FTSE All-Share tracker. Her employer bears all switching costs, so this transfer won't cost her a penny.

Thus, my wife benefits from belonging to an attractive final-salary scheme that is fairly financially solid (the pension fund's assets are greater than the value of all but around fifty of the UK's largest companies). In addition, she's paying the maximum AVCs allowable, which will help boost her retirement income dramatically, or allow her to retire early if she wishes.

So, trackers are great for retirement saving, and can be used in both company and private pensions, but their usefulness doesn't end there...

Saving for children

You can use a tracker to save for young children, so long as you're planning at least five - and preferably ten - years ahead. My wife has decided to use a cheap UK tracker to save for our son's early adulthood, which may include university fees.

By putting this tracker into a bare trust, this money will be in our son's name, despite the fact that my wife is funding it. What's more, he is entitled to several of the tax allowances that adults enjoy, which will help to reduce the impact of tax on his profits.

When our little boy reaches eighteen, he is legally entitled to this money, but we'll help him to budget carefully so he doesn't blow it too quickly, and show him how to take maximum advantage of his annual allowances to decrease his tax bill.

Trackers can also be used for other financial planning needs, including investing to pay for future school fees. You can learn more about saving for children here.

Tax-free saving

Whatever your medium- or long-term financial goals, you can use a tracker to build capital. One of the best ways to do this is to put your tracker into a tax-free Individual Savings Account (ISA). For higher-rate taxpayers (those paying tax at the 40% rate), having an ISA is a no-brainer.

That's because any profits don't attract capital gains tax, plus there is no extra tax to pay on the income received from trackers. For basic-rate taxpayers, the only benefit is the freedom from capital gains tax. CGT calculations can be a complete horror so, if there's no extra charge for putting your tracker into an ISA, you should use one.

Note the above figures refer to the next tax year, which begins on 6 April. However, it's not too late to open an ISA for the 2003/04 tax year and put up to £7,000 into a tracker. This limit falls to £3,000 if you have opened a cash mini-ISA or insurance ISA during 2003/04.

One parting observation: according to a recent Financial Times article [subscription required], only about 3% of funds sold to consumers by independent financial advisers (IFAs) are trackers. However, institutional investors - the banks, insurers and other big players - put around a quarter of their money into trackers. Perhaps IFAs steer clear of trackers because they don't pay the generous commissions that actively managed funds do?

As John Shuttleworth, actuarial partner at giant accountancy firm PricewaterhouseCoopers comments in the aforementioned FT article, "Anybody who knows anything about finance knows that trackers are the way to go." I second that!

More: Visit our Index Tracker centre | Trackers Beat Fund Managers Yet Again | Is It Worth Paying Fund Managers' Fees?