Topic 15

Question 1

Why is budgeting important?

Answer 1

Budgeting is essential for ensuring that there are sufficient funds to cover daily necessities and for planning for larger expenses, leisure activities, and retirement. It also helps in managing future expenditure and avoiding financial strain, especially with the impact of changes like increased mortgage interest rates. Budgeting helps clients avoid overburdening their income with unnecessary expenses and borrowing.

Question 2

What are some of the family protection needs that clients might have?

Answer 2

Family protection needs include provisions for the financial consequences of death, serious illness, accident, sickness, or unemployment. Many people fail to make adequate provisions due to unawareness of the risks or the belief that they cannot afford protection. Protection products can provide coverage for loss of income, health, or the financial impact of unforeseen events.

Question 3

Why is life insurance important for the family’s financial security?

Answer 3

Life insurance is crucial for families as it can replace lost income upon the death of an earner, ensuring the family maintains their standard of living. State benefits usually cover only basic needs, and without additional income, the surviving family members might struggle to meet mortgage payments or other expenses. The insurance can also cover the financial needs of a non-earning spouse who may need to stop working to care for young children.

Question 4

How does protection against accident, sickness, or unemployment differ from life insurance?

Answer 4

Protection against accident, sickness, or unemployment focuses on covering the financial consequences of long-term illness or job loss. This includes providing an income to replace lost wages, covering medical care costs, and paying for lifestyle changes like home adaptations. Unlike life insurance, the likelihood of illness or unemployment is higher, and the financial impact can be severe, often requiring more comprehensive coverage than life insurance alone.

Question 5

What factors should be considered when determining the amount and type of cover for sickness or unemployment?

Answer 5

Key factors include the client’s eligibility for state benefits, the number and age of dependants, the client’s employment situation (whether the employer covers salary during illness and for how long), and the support the client can rely on from family and friends. The likelihood of long-term illness or job loss and the associated financial implications must also be considered.

Question 6

What protection needs might businesses have?

Answer 6

Businesses need protection against the financial consequences of losing key employees or business partners due to death, injury, or long-term sickness. Life or sickness insurance can mitigate the financial impact by providing funds to cover losses in productivity and profitability.

Question 7

What is the impact of the death of a key employee on a business?

Answer 7

The death of a key employee, especially in small businesses, can severely impact the company’s profits and operations. Key personnel might include managing directors, skilled engineers, or salespeople. Determining the level of coverage can be done by using a multiple of the employee’s salary or calculating the contribution of the key person to the business’s overall profits.

Question 8

How is the level of cover for the death of a key employee determined?

Answer 8

The cover level can be determined by using a multiple of the key person’s salary (e.g., five or ten times) or by estimating their contribution to the business’s profits. This can be calculated by multiplying the company’s annual profit by the ratio of the key person’s salary to the overall wage bill, and then factoring in the recovery time, often assumed to be five years.

Question 9

What is the process of setting up life insurance for a key employee?

Answer 9

A term assurance can be taken out for the expected period the employee will remain a key person, such as until retirement or project completion. If the term is five years or less, the premiums are typically considered a business expense and can be deducted from corporation tax. However, any policy proceeds would be taxed as a business receipt.

Question 10

How can businesses protect against the death of a business partner?

Answer 10

A partnership agreement should be in place to specify how the deceased partner’s share of the business will be handled. Life insurance can provide the necessary funds for the remaining partners to buy out the deceased partner’s share. There are several methods for structuring this, such as the automatic accrual, buy-and-sell, and cross-option methods.

Question 11

What are the different methods of handling the death of a business partner?

Answer 11

Automatic Accrual Method: The deceased partner’s share is divided among the remaining partners, with the family compensated by life insurance proceeds. This typically qualifies for business relief from inheritance tax (IHT).
Buy-and-Sell Method: The remaining partners are obliged to buy the deceased partner’s share using life insurance proceeds, but IHT relief is not available as it involves a cash transaction.
Cross-Option Method: This method gives the deceased partner’s estate the option to sell their share to the remaining partners, with the partners having the option to buy it. This method may qualify for IHT relief as it involves business assets.

Question 12

How can shareholder protection be structured in a private limited company?

Answer 12

Shareholder protection can be structured similarly to partnership protection. Surviving shareholders can buy the shares of a deceased shareholder to keep the ownership within the existing group. The buy-and-sell or cross-option methods can be used in this context to provide the necessary funds for the surviving shareholders to purchase the shares.

Question 13

How can the sickness of a key employee affect a business?

Answer 13

If a key employee falls sick and is unable to work, it can significantly impact the business’s profitability, similar to their death. The company may need funds to recruit and pay for a temporary or permanent replacement. A critical illness cover plan can help provide financial support in such cases.

Question 14

What financial protection can a business partner have if they become too ill to work?

Answer 14

A sick partner may continue to draw income from the business despite being unable to contribute to its earning capacity. To prevent financial strain on the partnership, income protection insurance can provide replacement income. If the partner is unable to return to work, the remaining partners may wish to buy out their share, which could be funded using critical illness cover.

Question 15

How does illness affect a self-employed sole trader?

Answer 15

A sole trader typically handles key aspects of their business, including operations, decision-making, and finance. If they fall ill, their income may stop almost immediately, and they risk losing customers to competitors. This financial pressure can also slow down their recovery. Income protection insurance with a short deferred period can ensure they continue receiving income while unable to work.

Question 16

Why is affordability a primary consideration when taking out a mortgage?

Answer 16

A mortgage is a significant and long-term financial commitment. If a borrower fails to maintain repayments, they risk losing their home. The FCA’s MCOB rules require mortgage affordability to be stress-tested over at least five years to account for potential interest rate changes.

Question 17

What are the risks of choosing the wrong mortgage product or lender?

Answer 17

Choosing an unsuitable lender or interest scheme can result in higher costs. Additionally, selecting an inappropriate investment vehicle for an interest-only mortgage can lead to a shortfall, leaving the borrower unable to repay the loan at the end of the term.

Question 18

Why is it important to protect mortgage repayments?

Answer 18

Failure to protect repayments against sickness, death, or redundancy can leave the borrower’s family in financial distress or force them to leave their home. Many clients underestimate these risks and the ease with which they can be mitigated.

Question 19

How has rising individual debt affected mortgage affordability?

Answer 19

Low interest rates and rising house prices have led to increased borrowing, with many people dedicating a higher portion of their income to mortgage repayments. A rise in interest rates or a reduction in income could leave borrowers struggling to meet their obligations.

Question 20

What is a consolidation loan, and what are its advantages and disadvantages?

Answer 20

A consolidation loan (often a remortgage) combines an existing mortgage with unsecured debts (e.g., personal loans, credit card balances) into a single loan. This reduces monthly payments due to lower interest rates and a longer repayment term. However, it converts unsecured debt into secured debt, increasing the risk of home repossession if repayments are not met. It may also cost more overall due to extended interest payments and potential arrangement fees.

Question 21

What options are available for borrowers struggling with debt?

Answer 21

Borrowers unable to maintain repayments can seek help through:

The Debt Respite Scheme (Breathing Space)
Debt Relief Orders (DROs)
Individual Voluntary Arrangements (IVAs)
Bankruptcy (as a last resort)
Specialist organisations such as Citizens Advice and StepChange Debt Charity offer support and guidance on debt management.

Question 22

What are the two main reasons why people invest?

Answer 22

People invest either to provide an income (now or in the future) or to build a capital sum.

Question 23

What are some common reasons for requiring income or capital?

Answer 23

Common reasons include:

Short-term emergencies
Retirement funds
Specific purchases
Education fees
Loan repayment
Buying a business
Gifts to children

Question 24

What are the two primary ways people invest money?

Answer 24

Regular savings: Small amounts saved regularly from disposable income (e.g., ISAs, unit trusts, pension plans).
Lump sum investment: Investing a large amount at once, often from a legacy, windfall, or switching between investments.

Question 25

How does risk impact investment choices?

Answer 25

Low-risk products (e.g., bank deposits) offer stability but lower returns. Higher-risk investments (e.g., stock-market-related products) carry potential for higher returns but also the possibility of capital loss. There is a direct relationship between risk and reward—higher risk often means higher potential returns.

Question 26

How does accessibility vary between different types of investments?

Answer 26

Some deposit accounts offer instant access or require short notice for withdrawals. Investments like gilts and corporate bonds have a fixed maturity date, though they can be sold before redemption. Shares and some fixed-interest investments are irredeemable, meaning they must be sold to another investor if access to funds is required.

Question 27

What are the main taxes affecting investors in the UK?

Answer 27

Income tax: Payable on income received from investments. Capital gains tax (CGT): Payable on profits from selling investments like shares and unit trusts. Some investments, like gilts and corporate bonds, are taxed on income but exempt from CGT.

Question 28

Why is tax efficiency important in investment decisions?

Answer 28

The tax regime of an investment should be considered alongside an investor’s tax position. For example: A non-taxpayer may not benefit from an ISA’s tax-free status. A taxpayer can benefit from tax-efficient investments like ISAs.

Question 29

What is the ‘real rate of return,’ and why is it important?

Answer 29

The real rate of return = Investment return % - Inflation rate %. If inflation is higher than the return, the investment loses value in real terms.

Question 29

How does inflation impact investment returns?

Answer 29

Inflation reduces purchasing power over time. Investments must at least match inflation rates to maintain value in real terms. Equity-linked and property-based investments historically provide returns above inflation.

Question 30

What is the ‘money illusion,’ and how does it affect savers and borrowers?

Answer 30

Savers: May take on riskier investments seeking higher returns, potentially harming financial security. Borrowers: May take on larger mortgages, misjudging affordability if interest rates rise.

Question 31

Why is retirement planning becoming increasingly important?

Answer 31

The UK’s ageing population makes it harder for the state to fund pensions at sustainable levels. The state pension is only about one-third of average earnings, which is inadequate for anything beyond basic living. Many people reach retirement with little or no private pension provision.

Question 32

What challenges do lower earners face in retirement planning?

Answer 32

Financial constraints: They often prioritise immediate expenses over long-term savings. Lack of awareness: Many are unaware of products like stakeholder pensions. Distrust in pensions: Concerns over high charges and past mis-selling deter them from investing.

Question 33

What is the ‘pensions crisis’ in the UK?

Answer 33

Many people are not saving enough for retirement, creating a significant savings gap. Employers are shifting from final salary schemes (defined benefit) to money-purchase schemes (defined contribution), increasing individual risk.

Question 34

How has the UK government tried to address the pensions crisis?

Answer 34

Introduction of stakeholder pensions to encourage low-cost retirement saving. Auto-enrolment: Employers must enrol eligible employees into a workplace pension scheme. State pension reform (April 2016): Simplified the system for new retirees. Pension freedoms (April 2015): Greater flexibility in accessing defined contribution pensions.

Question 35

Why is financial advice important in retirement planning?

Answer 35

Retirement options are complex, and individuals need help navigating them. Pension freedoms provide more choices but also increase risks, making guidance essential. Advisers help clients ensure they achieve an adequate income in retirement.

Question 36

What are other key financial planning issues in later life?

Answer 36

Long-term care insurance (see section 12.5). Estate planning (see section 15.7). Power of attorney (see section 16.7).

Question 37

What are the two main questions an adviser should consider in estate planning?

Answer 37

Has the client made a valid will? Has the client taken steps to mitigate Inheritance Tax (IHT) liabilities?

Question 38

Should a financial adviser draft a will for a client?

Answer 38

No, but they should strongly advise the client to consult a legal adviser. The financial adviser can provide a document outlining financial objectives the will should help achieve.

Question 39

What are the two main approaches to handling IHT?

Answer 39

Avoid paying it by reducing the estate’s value below the nil-rate threshold. Make provision to pay it when due (e.g., through life insurance).

Question 40

How can a client reduce their estate value for IHT purposes?

Answer 40

Make tax-free or potentially exempt gifts during their lifetime. Place assets in a trust, as trust property is not part of the estate.

Question 41

What restrictions exist on gifting property while continuing to live in it?

Answer 41

Gift with Reservation (GWR) rules: If a person gifts their home but continues living in it, it still counts as part of their estate. Pre-Owned Assets Rules (2005): If a person gives away property but still benefits from it, they may face an annual income tax charge on its rental value.

Question 42

How do married couples and civil partners benefit from IHT rules?

Answer 42

They can combine their nil-rate bands, allowing property to be passed tax-free. Unused nil-rate band from the first death can be carried forward. Residence nil-rate band (2017) further reduces IHT if property is inherited by direct descendants.

Question 43

How can life assurance help in estate planning?

Answer 43

A life insurance policy can cover the estimated IHT liability. To avoid it becoming part of the estate, the policy should be written in trust for beneficiaries.

Question 44

How should tax impact a financial product recommendation?

Answer 44

The tax implications should be considered in context with other product features. Tax efficiency should not be the sole reason for recommending a product (e.g., pensions).

Question 45

Should financial advisers handle complex tax-planning schemes?

Answer 45

No, complex tax matters should be left to tax experts. Advisers should focus on choosing appropriate products to complement the client’s tax situation.

Question 46

What are some tax-efficient investment options for clients?

Answer 46

ISAs, pensions, and friendly society policies → offer tax-free income or growth. Offshore bonds → free from UK tax, beneficial for non-taxpayers. Gilts and corporate bonds → CGT-free options for those exceeding their annual CGT exempt amount.

Question 47

Why might a non-taxpayer prefer an offshore bond over a UK investment bond?

Answer 47

UK investment bonds → gains taxed at 20% within the life fund, which cannot be reclaimed by a non-taxpayer. Offshore bonds → no UK tax on fund growth, so they can be more tax-efficient.

Question 48

How are unit trusts taxed?

Answer 48

Unit trust managers are not taxed on gains within their funds. Investors may owe CGT on profits when selling units but can use their CGT annual exempt amount to reduce liability.

Question 49

What tax planning should be considered when emigrating or immigrating?

Answer 49

Before moving, individuals should assess whether to encash or retain investments. The decision depends on which option provides the most favourable tax treatment in the new country.

Question 50

Why is it important to regularly review a client’s financial plan?

Answer 50

A client’s financial needs and circumstances can change quickly due to life events. Reviews ensure financial plans remain aligned with current objectives.

Question 51

What life events might affect a client’s financial situation?

Answer 51

Births, marriages, civil partnerships, and divorces. Moving home, changing or losing a job. Deaths in the family or receiving an inheritance.

Question 52

How should advisers prepare for potential changes?

Answer 52

Recommend products that offer flexibility where possible. Schedule regular reviews to reassess the client’s situation.