Episode 339 - On this week's show I discuss whether stock markets are expensive and which are the best value for investors right now. I reveal the emergency tax trap facing employees and those taking money from their pensions, plus how to avoid it. Finally, I explain "bonus sacrifice" and how you can use it to boost your pension and cut your tax bill.
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Abridged transcript - Episode 339
How do you know if a stock is good value?
Damien Fahy 04:32
People will sometimes look at markets, see how high they are and wonder whether it is a good or bad time to buy the stock market. Of course, that's the million-dollar question. One way you can try and discern that is to look at value; does something represent good value for money?
What is the 'PE' ratio?
It's a bit like the housing market. If you're going to buy a property, is it good value or will there be some kind of correction in prices along the way? So with stock markets, how do you discern value, whether something is good value or not? Now, interestingly, there are different measures, but one is the Price to Earnings ratio (PE). So you look at the price compared to the earnings per share of a particular stock or company. So, you look at the PE ratio, the amount you pay for a share compared to the earnings that company generates per share. If that is high then you're overpaying for what the company is actually producing in terms of earnings. So the lower that number, then that would obviously appear cheaper or better value.
The key is to look at that PE ratio in comparison to other stocks and companies within the sector, or similar companies. You can actually, therefore, start to get a relative interpretation of whether a company represents an expensive stock or a cheap stock, and whether it is good value for money. But of course, value investing is inherently difficult and there are traps. Some things are cheap for a reason, and they actually get cheaper along the way. But obviously, if you look at a point in time, there is a drawback with these PE ratios because as economic cycles change and flex, then the earnings of a company can change considerably, because of the sector they may be in, for example, they may be producing oil or gas. And if the economy is booming, then they will obviously earn more money and that will impact its PE ratios equally.
Stock markets do rally and fall so the prices go up and down. So that ratio at any given moment of time can be slightly misleading and can fluctuate quite a bit if you just base your decisions on that one PE ratio.
What is the 'CAPE' ratio?
One alternative measure is something called ‘CAPE’ and I've touched upon it before in the podcast and it stands for Cyclically Adjusted Price Earnings. So this was a ratio that was popularized by Nobel Prize winning economist Robert Shiller and it is designed to smooth out the variations that happen due to economic cycles. It effectively looks at the price compared to the earnings per share over a 10 year period, giving a 10 year average of inflation-adjusted earnings per share.
So straight away, you can visualize that that's going to give you something that's going to knock out those variations and give you something that's a bit more reliable. Now, what you would need to do is compare it to its long term average. You can then look at the long term average of a particular stock’s CAPE, compare where it is now, for example, let’s say its long term average is 16 and it's trading at 18, then you know that it's expensive compared to long term average.
The idea being that over time, there is a reversion towards that mean. If something is very cheap, then it might represent good value, the rest of the world might catch up with the idea that this is a good value stock and they might actually buy it and then it will revert back to that annualised mean. Equally, if something is expensive, then people might deem it expensive, sell it and on the way fundamentals catch up. That's the kind of idea and the reason it became quite popular is because Robert Shiller effectively predicted the market crash in the late 1990s using this method, because you can use it on wider indices. It doesn't have to be a stock-by-stock or company-by-company measure, you can use it for the US stock market, for example, or the UK stock market as a whole.
You can derive a CAPE ratio, and by doing so he said the market was expensive and it was due a correction in order to come back towards its mean, and that's effectively what happened. So people will use it sometimes as a measure to see if we're going to get a market crash. Now, there are Pros to it, it's easy to apply and understand, but there are Cons too. The cons are that it's not necessarily easy to calculate or find the data. In fact, if you try to calculate it, almost nobody who listens to this podcast will be able to unless you've got a background in economics. The other thing that's a negative of it is that it's not foolproof, but it does give you some information about whether something is expensive or not.
Now, as evidence of the fact that it's not foolproof is two years ago. I looked at how expensive stock markets were and the US stock market then was trading with a CAPE ratio of 27.74. Now the long term average is 16. So you can see it was massively expensive because normally they only fluctuate around their median. It's not normally so extreme, or that would suggest that we were going to get a pullback and well, we know what happened.
We did get a pullback because of the pandemic, but markets have kept pushing higher and higher and we're near all-time highs. If you look at the CAPE ratio for the US stock market now, so looking at the S&P 500, then it's 38.7. So it's even more expensive and it's actually more expensive than almost has ever been. So just because something is expensive, doesn't mean it won't go higher. So it's not foolproof, but it is useful.
So if you want to use it as a bit of information, maybe alongside your own views on investing, maybe it would be momentum investing, whatever you use to build a portfolio, CAPE is probably one of the ones that I like in terms of valuation metrics, because it is very easy to apply.
I'm now going to give people some insight into particular areas that are cheap or expensive. So, if you look at developed world equities compared to where they were two years ago, they are all broadly more expensive than they were. And that means on the CAPE ratio. I'm not just talking about price, I'm talking about looking at their long term averages.
Europe as well, if you strip out the US and Canada and you look at the EAFE region, which is broadly Europe, Australasia and the Far East, based on history, it is good value. So it's below its long term average in terms of the CAPE ratio, which means it's good value for money. The emerging markets are as well, but they're almost at par values, they're pretty much hitting their long term average. So that means that questionably people might say there’s a lot more upside, you'd have to wait and see.
But what you can do, you can use CAPE to look at countries as a whole and so broadly speaking, if you look at countries across the world, I'm talking about Australia, Brazil, Canada, all the way down through Poland, South Korea, UK and the US, we looked at all the different countries and they are all more expensive than they were two years ago.
Now interestingly, there are very few places that became cheaper and actually became classed as good value, ie cheap. The countries are China, Hong Kong and the UK. So the UK stock market is actually now trading below its long term CAPE average and so is classed asgood value for money.
So that will be interesting for some people who might buy into UK equities thinking that actually they're cheap, and there could be a mean reversion. Compared to say, US tech companies, which are incredibly expensive based on most measures, and including CAPE and that is why the UK is cheap, partly because of the lack of technology stocks in the UK and there is quite a significant exposure to things like oil and gas, but also Brexit.
If you look at the pandemic recovery and look at the main indices in the UK, they've not recovered to the same extent as what we saw in other countries. And what I like about CAPE is it does smooth out some of the stuff we've seen in the pandemic because obviously, earnings have been hit massively in the last year as share prices have fluctuated. So, what we've seen with the 10 year average, is that it has slightly smoothed out and so is therefore a useful measure.
On a sector basis, if you look at the US, for example, there are 11 sectors we looked at, and eight of them are classes expensive with only three below their long term median and they include cyclical sectors; things that would have been economically sensitive, which probably did take a bit of a hit as a result of the pandemic. Technology stocks are eye wateringly expensive and so if you're Robert Shiller, you'll probably think there's going to be some correction at some point in the future. But as I pointed out, it's not failsafe. It is a useful piece of additional information that's out there. So, if you are looking for a value metric that is interesting, then consider CAPE and I've mentioned a couple of areas there are relatively cheap, including the UK.
Andy Leeks 13:24
One thing that came to mind for me while you were explaining your research, was there anything that was deemed cheap, say a year or two ago that is now deemed expensive?
Damien Fahy 13:35
Yes, there are a couple of areas, but one in particular and you can read the full research for free by going a getting a free trial of 80 20 investor. German stocks were considered cheap two years ago, but they are now classes moving above their long term average and so are deemed expensive. So European equities weren't generally cheap two years ago, but they have seen an increase in their current CAPE measure. So they are now no longer cheap opportunities.
Andy Leeks 14:03
Okay, so moving on to tax then. We're going to be talking about a type of pension tax, labelled as a ‘Pension tax trap’.
How are you taxed when taking lump sums from your pension?
Damien Fahy 14:15
Yes, so there was a piece in The Times about a ‘pension tax trap’, and it's slightly scaremongering, but it was actually quite an interesting piece. It was talking about a man who retired and he had a SIPP, which would have been in drawdown. He took his full tax-free cash (if you want to understand how that works in terms of drawdown and go back to podcast 271 where we talk about the options under drawdown and how you can take your pension over time)
So, he took his 25% tax-free cash lump sum when he retired and then he decided to keep the remainder invested and he was going to derive income using that going forward. The way he decided to take that income was as lump sums every year, so he would take one-off lump sums of £25,000, every year and use that to live off and leave the rest of the pot invested.
So he wasn't taking monthly withdrawals, which a lot of people and probably most people do, he was taking a lump sum each year and using that money outside of his pension to live off, which is up to him.
The problem occurred when he started receiving his money net of tax and he realised he was getting hit by what is effectively an emergency tax rate and he paid an additional £5,000 extra tax a year as a result of him taking his pension in a lump sum. This is effectively a quirk of the pension and the taxation system that occurs that people need to be aware of.
There will be plenty of people who are new to retirement and who may want to take money out of their pension in excess of their tax-free lump sum, or there could be people listening to this podcast who have parents who are going to do so. They may be looking to take out say £20,000 per year, work out what they think their tax bill will be and how much they'll be left with and then I have a nasty shock.
What can happen when you take a lump sum from a pension that is taxable, is HMRC may put on a special tax code called a month one tax code. It is effectively an emergency rate tax, because you've got to think what happens with taxation is that if you have multiple pensions, you can have multiple tax codes for those pensions, and so HMRC doesn't necessarily know how much tax you're going to need to pay until it understands your full situation.
So when you end up drawing the money out of that pension pot as a lump sum, the system doesn’t know that the lump sum is going to cover the full year, for all they know, you could be drawing out £25,000 a month.
So, in our example earlier, the man was getting taxed at 40%. The problem is that this is impacting 30,000-40,000 people a year who are drawing lump sums from their pension and not realising it, and apparently, up to £750 million has been overpaid in taxes since 2015 when pension freedoms came in.
So in this guy's particular example, he got less money from his pension and so he had to then draw money from another pension to try and make up the shortfall. Typically, what he would do is he had been using his self-assessment, which can be up to almost 18 months later, because it's not the January of you taking the money, it'll be the one after that, that you end up filling out a tax return and you can then reclaim the overpaid tax.
This isn’t really a tax trap in terms of you lose the money forever, it is an annoyance because of the way the tax system works. This is something that Andy be well aware of having previously worked in payroll, because if you change jobs, or you get a bonus at work, you can be hit by an emergency tax code and end up paying a higher rate of tax than you thought you would have done?
Andy Leeks 18:05
Yes, absolutely. It's something that people just need to be aware of, in those situations, whether you're changing jobs or getting a large bonus, because if you think about it from HMRC point of view, they are trying to ensure that you don't get into a situation where you either owe them lots of money, or they owe you lots of money.
So there are certain assumptions that they will make and the only way they can really make this fair for everyone is by doing it on a month by month basis. So what they do is they look at your situation that month, they take a snapshot of it, and then they act accordingly.
So let's look at a scenario where you're changing jobs, the first thing that they will do is they want to understand what you've earned before the job that you're going to, and generally the way they will do that is they would like to see a P45 form.
That P45 will list your previous job where you worked and how much you earned. Now if your current employer that you moved to has access to your previous P45, that makes things really simple. Your new employer will input the information and tell HMRC exactly what's going on and they can switch you straight on to the correct tax code. In that situation, you won't have any problems. Where it does become a problem is when there's a delay with that P45 being issued.
There is something you can do to ensure that you don’t go onto month one emergency tax code and get automatically stung for a higher tax rate. If the P45 is delayed or lost you can fill in a P46 form. It's a simple form and to be honest, most new employers should know about this system and should actually be contacting you to let you know that you'll need to fill this in, but it is your responsibility. The employer can't do it on your behalf.
It's a simple form where you effectively tick a few boxes to say whether you've got another job, whether you're simply moving from one job to another and it enables HMRC to understand the situation in lieu of receiving the official P45. So always make sure you fill in one of those P46 forms when you move to a new job if you haven't got a P45. The ideal scenario though, before you move jobs is just to speak to your current employer and say, look, can I have my P45 on the day that I leave. Most employers will be able to sort that out for you.
There is another situation where people who receive regular bonuses or fluctuations in pay (commission etc) will be hit with a higher rate of tax. Again, it's very similar to the situation we've explained before where HMRC are working on a month by month basis, it's the only real way that they can keep on track of things.
So let's use a scenario and say you earn £36,000 a year. That's £3,000 a month gross when you run it through the calculations. You can do these calculations yourself, there's lots of calculators out there that will run the numbers through for you. You'll roughly pay in the region of £400 in tax. If you were to receive a £2,000 bonus in that month, that tax would actually jump up from £400 to £950. Now that doesn't really stack up. The reason it doesn't is because HMRC are looking at your gross earnings for that month and they assume that your new salary is effectively £5,000 per month, or £60,000 per year.
When you look at the tax thresholds, that pushes you well into that 40% tax bracket for the upper end of what you're being paid. But all is not lost, because what will happen is the following month when your pay reduces back down to the standard £3,000 per month, they will look back at the previous month and check and see where you’re at. Most employers use a system called Real Time Information, which will constantly check and amend what's been paid in the previous month. So in this scenario, you would probably overpay about £150 pounds tax on your bonus, but the following month, it would redress and you should see £150 pounds coming back. You won't see the £150 as a credit, what you'll see is overall, compared to two months ago, when you're expecting £400 tax, you'll get taxed roughly £250 because of the rebate.
Damien Fahy 23:37
So, going back to the pension point, you don't have to wait until your self-assessment to get the money back, which is what a lot of people don't realise, you can get the refund earlier. If you withdraw the money from the pension and you get an emergency tax code you can actually get a refund within 30 days.
There are three forms you can use. There is a P50Z, which is for people who have drawn all of their pension pot with no other income coming in. There's a P55, which is for people who've taken part of their pension and intend to take further payments and there is a P53Z which is where people have taken all their pension, but they have other income.
Those three forms enable you to be able to reclaim the additional tax that you paid on that large pension withdraw within 30 days, you just have to find out which one suits your circumstances. So speak to HMRC if you're not sure.
Finally, because of the way the system works, you could, in theory, take a small amount from your pension pot, say £5 or £10 and have the emergency tax applied to a much smaller amount. You can then go ahead and inform HMRC of your situation, get it rectified and then take a larger amount. So the message is don't be passive in this and remember, if you're starting a new job, make sure you're talking to your new employer to ensure you don’t pay emergency tax is something you can avoid.
Andy Leeks 26:25
Okay, and so for the final piece of the podcast, salary sacrifice is something most of us have heard of, but bonus sacrifice is something that you're going to concentrate on here and explain.
What is bonus sacrifice and how does it work?
Damien Fahy 26:36
Yes, so go back to podcast 85, where I talked about salary sacrifice and explained what it is. Essentially its where you can actually give up some of your salary in exchange for say, a pension contribution. People might think why would I do that, and the answer is because there's generally a tax benefit for doing so.
To give you an example, let's say somebody was earning £40,000 a year and they were paying 5% pension contributions into their company scheme, the employer was matching that with 5%. They’d get £2,000, after tax relief that they've paid into the employers pension scheme and the employer pays in £2,000. Of course, then, when you factor in their earnings and how much tax they've paid, including National Insurance, their take-home pay would be £29,262 pounds in a year. When you include the £4,000 pension contributions, the total benefit is equal to £33,262.
Now don't worry about all the numbers, I just want to use it to illustrate a point because they could instead decide to give up some of their salary, hence the word salary sacrifice). When working out the numbers, they could instead sacrifice their salary by £2,353 pounds per year, paying that into their pension as it works out exactly the same net pay of £29,262 per year. They end up with an extra £353 in their pension and that difference is effectively the 12% National Insurance saving that they make on the bit of salary that they've sacrificed.
So you can have a slightly reduced salary in exchange for a higher pension contribution. Those on higher salaries over £50,000 could do salary sacrifice in order to start receiving child benefit and they’ll also benefit from the National Insurance contribution saving into your pension.
Additionally, because the employer doesn't have to pay national insurance on the sacrifice salary as well, then that can mean that they can save up to 13.8% which, if they want to, they can also give it to the employees. There are companies out there that are happy to do that.
Now, for higher earners, the amount of National Insurance saving you get above £50,270 is only 2%, so isn’t that great, but the point is, salary sacrifice can be incredibly useful and I think it's going to become more popular as a result of the announcement of the increase in National Insurance. Next year, there's going to be a burden for employees and employers having to pay an extra 1.25%. So I wouldn't be surprised if we start hearing more about salary sacrifice.
Bonus sacrifice works in a similar way. The taxation principle is identical when you give up a bonus and put it into your pension instead and you could benefit from the National Insurance savings too. Now, one thing I want to point out is there are two types of bonuses out there. There are contractual ones, ones that are in your contract and where you are contracted to get them at specified points in time and there are non-contractual ones, ones which are generally just ad-hoc and should be seen as a genuine bonus if you get them.
Now, if you've got a contractual one, if you want to sacrifice that, then you have to have your employment contract changed or updated to allow for that to happen. If it's an ad hoc one, then you could go and speak to your employer's payroll department and arrange to sacrifice your bonus and maybe put it into your pension, which you could then benefit from that actual bonus and saving from National Insurance as can your employer.
There are drawbacks to salary sacrifice. If your employer has a death in service scheme, then your life insurance benefit is linked to your salary and so if you reduce your salary through salary sacrifice, your life insurance drops. Also it can impact some benefits you're entitled to including maternity and paternity pay. It may also impact mortgage applications and the amount you can borrow in the future so it's something to bear in mind.
Similarly, there are drawbacks for bonus sacrifice. Once it has been agreed, if it's contractual, then it might be difficult to revert your package back to what you had before. Also, very high earners might be caught out by the tapered annual allowance trap which means that if your income is above £240,000, then your annual allowance for your pension contributions is reduced by one pound for every two pounds of excess adjusted income.
So the point is if you are higher earner and you're going to start using bonus sacrifice, you should get financial advice because there could be something in it that you could shoot yourself in the foot.
Finally, low earners may be better off paying personal pension contributions rather than doing salary sacrifice because there may be no tax benefit to taking a reduction in salary.