I spoke to a friend in his seventies a few weeks ago who told me that he was frightened to pass too much of his wealth on to his children. Why? Because with inflation at 3-4% and likely to keep rising from here, he was worried that his investments were likely to lose purchasing power – and that he would need a much larger nominal sum to keep going than he had hoped.
He’s right to be worried. Our inflation problem hasn’t gone away. You can argue forever about whether quantitative easing (QE) causes domestic inflation or not, but what is absolutely clear is that it pushes down the value of sterling and so imports inflation: every time Mervyn King opens his mouth to talk down the pound the price of everything you buy from abroad goes up again.
How high will our annual price rises go from here? It is hard to say, but given ongoing QE here and everywhere else, I think I would have to agree with Alistair Darling who told a City dinner this week that it is soon likely to be “quite a big problem”.
So what can my worried friend do to protect himself? The financial industry, as ever, is not exactly short of solutions. You should buy equity income funds, they say. Look over the very long term and you will see that pretty much regardless of the starting point you choose, shares, representing as they do small slices of real assets, have protected investors from inflation.
You can buy property. It hasn’t been ‘all that’ in the last few years, and is still grossly overpriced by most historical measures, but if inflation really takes off, it should provide some small measure of protection.
You can buy other real assets and hope that they rise in nominal price, if not in real value as the Consumer Price Index rises.
And finally, of course, you can make sure that your assets are well diversified outside the UK – that way, however much the pound falls you will be covered by the corresponding rise in the other currencies you are effectively holding. That makes sense, because even while we pay our bills in sterling, a huge percentage of them are actually priced in foreign currencies anyway (energy and food, for example).
By now you will be thinking that this is all terribly straightforward. You just buy a couple of the asset classes I have mentioned above, and your work is done. Sadly, it isn’t so.
I have bad news for you. It is practically impossible in the UK for an investor with any real wealth to outrun inflation, whatever he buys. I repeat, whatever he buys. Why? Capital gains tax.
Imagine that you buy some gold, some gold shares or perhaps a gold ETF for £20,000. Over the next ten years, inflation averages 8% a year. Your gold does just as you hoped. It also rises in price at 8% a year. So the gold is worth £43,200. And £43,200, it now has the same purchasing power as £20,000 in 2013.
So in 2023 you sell it. You get £43,200. But you also get a capital gains tax bill. You’ve made a capital gain of £23,200 on which you will pay 18% or 28% (mostly 28%, given the way the bands are calculated) over the annual allowance.
You could assume that the allowance goes up with inflation. But as I think we all know, that isn’t going to happen (hello, fiscal drag), let’s assume it rises at half the rate of inflation in question. It’s now £10,600. So we can guess it at something like £16,000. So you pay CGT on £7,200, and you end up with £38,016.
Thanks to the fact that UK CGT is no longer indexed to inflation (it was until 2008) you have lost purchasing power regardless of your excellent investment choices. The key point here, however, is that the more money you have, the more purchasing power you are going to lose (unless you are cheating on your taxes, of course).
Let’s say you buy £200,000 worth of gold in the first place. Now you have £432,000. But you have no allowance left and you have to pay 28% on £232,000. You end up with £367,040. Your purchasing power – the value of your wealth – has just fallen by 8.5%. Make inflation 12% and you will find that on the same initial investment you end up nearly 20% down in inflation-adjusted terms after tax.
The point? Non indexed capital gains tax is effectively a wealth tax: the more inflation rises, the poorer UK investors will get. That’s regardless of how well they invest.
There are a few things you can do to mitigate this state-sponsored scam, of course. You can invest as far as it is possible via your ISA and SIPP. You can incur return-gobbling expenses every year in order to use up your CGT allowance. You can visit a dodgy accountant to try and create some tax losses to set against your gains (although the odds are a visit from HMRC will soon follow this). And of course you can buy an asset that comes free of capital gains tax.
You might buy a bigger primary residence (the lack of CGT on these is the primary reason why rich Brits are so obsessed with property). You could also buy a vintage car (these are classified as wasting assets and so are exempt) or some index linked bonds. And finally, you could buy gold sovereigns or Britannias (which are legal tender, and so CGT exempt) although they already trade at a hefty premium to the physical gold price. But that’s about it.
So there you go. Unless something dramatic changes in our tax system, it is not really possible for the well off to prevent the state, via a combination of tax and loose monetary policy, relieving them of a large percentage of their wealth as inflation picks up. Sorry.
• A version of this article was first published in the Financial Times