You and Your Money – August 2009

In the last of our four-part series, Johnny McNamara looks at the danger of counter party risk and shows you how to minimise the external threat to your own personal economy.

In previous articles I have developed the concept of managing and controlling your own personal economy. The key to achieving this is to identify the areas of your finances that are in your control and to recognise the areas that are outside of your control. Where you identify an area that you have no control over, this becomes a risk to your personal economy and so, it is vital to minimise these risks every way you can.

One of the biggest risks to our wealth today is known as “counter party risk.” This can be defined as the risk to each party of a contract that the other party will not live up to its contractual obligations. In most financial contracts, counter party risk is also known as “default risk.”

Counter party risk is apparent in almost all aspects of our financial lives from our savings and investments right through to our pension arrangements. The effects of counter party default have been particularly evident in the current economic climate, which has seen the collapse of many large financial institutions both here and across the world. This has led to the images we have all seen of people queuing outside banks for fear of losing their money.

So how do you remove counter party risk from your personal economy? Unless you are going to store all your wealth in gold bullion and carry it around with you, it is impossible to remove all elements of counter party risk. However, the key to gaining more control is to remove as much counter party risk as possible.

In my last article I developed the concept of taking ownership of your pension funds. Taking ownership of all of your assets – whether they be in pension or any other form – is the first step in helping to eliminate counter party risk. Once you have been able to establish ownership, the next question must be: what asset classes should you look to invest in to further remove the threat of counter party risk?

A good starting point is to look at the concept of ownership versus loanership assets within your personal economy. To understand this concept fully, we must identify the difference between ownership assets and loanership assets or in other words, real assets versus financial assets.

A real asset is a tangible or physical asset that will only ever appear on one side of the balance sheet, i.e. the asset on one side does not create a liability on another balance sheet. Therefore a real asset does not carry any form of counter party risk as it is direct ownership. Gold is a prime example of a real asset that is tangible and has a value in its own right due to its scarcity and people’s desire to own it.

A financial asset is an asset that is essentially a contract between two or more parties that merely represents an asset. The financial asset itself has no intrinsic value because it is not a tangible or physical asset, but merely a representation of one. A financial asset therefore sits on both sides of a balance sheet. For one party entering in the contract there will be an asset (bonds, share certificates etc.) and on the other hand, the other party will have a liability (repayment of bond, value of share etc.)

This is where counter party risk is generated, as the asset owned is only as good as the other party’s ability or willingness to honour their side of the contract.

When you bring in other financial assets that include debt derivatives, you often find that this increases the amount of counter parties involved and so, increases further the risk of default somewhere along the chain. A great example of this can be seen from what happened with the sub-prime mortgage market, where the debt was repackaged further and further away from the real asset until eventually the chain collapsed. If you are at the end of the chain, you are the one who suffers most financially from the counter party risk and subsequent default.

Many people have been fooled into thinking that financial assets should be considered as savings. However, as we have seen over the last few years, through counter party default these assets can become worthless very quickly. When looking at where to invest, it is important to remember that real investment brings with it real assets and real capital formation, which is the cornerstone on which future wealth is built.

With this in mind, what can you do now to take back ownership of your personal economy? It is my opinion that a significant part of your wealth should be invested in real assets through structures in your ownership and control. The amount to which you hold your wealth in real assets will come down to your faith or lack thereof in the financial system as it currently stands. Recently we have seen a massive amount of mistrust generated in our financial systems – both locally and globally – which has already seen a shift in investment towards real asset classes.

Counter party risk is evident in every part of our financial lives and represents a big risk. One of the biggest counter party risks out there is what’s happening in the global economy. We know that we cannot control factors at play in the global or local economy, but we need to understand how they affect us so we can plan for the future. However, we also know that there are factors that can be controlled through ownership. It is only through ownership that you can gain control and it is only through control that you can gain the ability to manage your personal economy.

To arrange an appointment with McNamara & Associates, call 01 230 9000.

Control of your personal economy is vital in protecting against external threats such as redundancy and can also allow you to take advantage of the opportunities that may arise, writes Johnny McNamara.

The current downturn in the global economy has created an environment with an ever-increasing level of threats to all of us. These threats are often outside of your control and therefore, there is little or nothing that you can do to stop them affecting you. However, the degree to which these threats affect you can be limited by taking ownership over the factors that you can control.

Identifying the threats to your personal economy is the first step in taking more control. For example, one of the biggest threats to many people today is the threat of redundancy and given the fact that we cannot control a redundancy, what can be done to manage your finances through this threat?

First things first

The first thing that you can do is to act now and seek to protect yourself against the threat of redundancy. At present, there are policies available that can provide you with a replacement income in the event of involuntary unemployment. There are also products, such as mortgage repayment protection, that can cover your mortgage repayments in the event of redundancy. These products do not pay out indefinitely, but can help you to manage your way through a potential cash-flow crisis in the initial period after redundancy.

Obviously, there is a cost involved in taking out one of these policies, so it is important to identify how this cost may affect your current cash-flow position. That said, this kind of protection can help you get through the initial stages of your redundancy and allow you the financial freedom to plan for the future. In turn, by limiting the immediate effects on your cash-flow, it can give you an opportunity to reassess your career path and may also allow you the opportunity to re-skill for an entirely new career.

Already redundant?

If it’s too late to protect yourself against the threat and you are faced with the reality of redundancy, you need to understand all of the implications this has on your personal economy so that you can adequately plan the road ahead.

The tax treatment of redundancy payment is the first area that you need to manage and control. There are a number of reliefs available to you on a redundancy payment that can help reduce your tax liability. The relief option you choose is not always a straight-forward case of selecting the largest relief, as in some cases you may be waiving your rights to a tax-free lump sum from your pension on retirement. So although you may receive more now, you may be forfeiting a lot more in the future. Therefore, selecting the appropriate relief is vital and it is important that you take independent advice to ensure that the right decision is made.

There is also a further relief called ‘Top Slice’ relief that is available to you in the year of redundancy. Many people tend to overlook this relief due to that fact that you can only claim it at the end of the tax year. In many cases, by not claiming Top Slice relief people can miss out on substantial tax rebates. This is valuable money needed to help you financially following a redundancy and could be lost if you do not know how to claim it back.

Taking control of your pension fund

The next area that must be looked at in the event of redundancy is your pension. If you have been in pensionable employment for a number of years, it is likely that you have built up a substantial pension fund within the company pension scheme. This is a valuable part of your personal economy and it is therefore vital that you make the right decision in relation to this. The event of redundancy can often result in an opportunity for you to take ownership and control of your pension fund. In certain circumstances, it is now possible to take ownership of the fund that you have built up within the company pension. Ownership in this case does not simply mean giving you the ability to choose where your money is invested pre-retirement, but also involves the ownership of the money post-retirement.

In a typical company pension scheme, owning the pension fund post-retirement is not possible as in most cases, you will be forced to buy an annuity or income for life. This involves giving away the fund that you have built to an insurance company who will pay you a certain amount for as long as you live. The key unknown in this equation is how long you are going to live.

If, by taking ownership of the pension fund, you can keep control of the total value of the fund, you now open up new possibilities post-retirement. It also means that you no longer have to give away your fund to a third party, but can now control and manage your asset in retirement.

By taking ownership of your pension fund, you now have the ability to bring another part of your personal economy under tighter control and possibly open up options that would not have previously been available to you. Many times it can be the event of redundancy that opens up this option for you.

You can now see that even the event of a redundancy can present opportunities for you once you manage your finances carefully. The key to managing your finances in any economic environment is to take control and ownership of as many areas as you can. The more areas of your finances that you control and own, the less of a threat the outside factors become.

If you are faced with or worried about redundancy or any other area of your finances, call McNamara & Associates on 01 2309000 to arrange an appointment or visit www.personaleconomy.ie.

Next issue… We look at the concept of real ownership within your personal economy.