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What to do with a lump sum

Congratulations, you’ve landed a windfall! What do you do next?
March 2, 2023

It could be you. The overwhelming odds are that it won’t be. But that’s unlikely to have stopped you – along with everyone else at some idle moment – from pondering how to use a huge lottery win.

After working out how many staff you’ll need to run your private island, the musings soon drift to the more mundane. Who gets a cut? Who can know? What does the weekly budget look like now? Do you quit your job? Reassess your values? And how do you invest what’s left?

The chances of winning the lottery are low. But the probability of coming into a decent chunk of change at some point is far higher. Property sales, inheritances, trust access, bonuses, redundancy payments and other assorted one-off paydays are a real prospect for many.

At least one source of windfalls is becoming more and more expansive. As hinted by rising UK inheritance tax receipts, up a fifth so far this year, we are living through the largest ever inter-generational transfer of wealth. The freezing of the inheritance tax threshold until 2028 not only means that the state’s take is likely to increase, but that incentives to pass on or liquidate estates without incurring heavy duties will, too.

If handled well, one-off cash piles can be life-enhancing. If lottery prizes do in fact lead to years of improved overall life satisfaction – as a 2020 survey of Swedish jackpot winners suggests – then there is no obvious reason to believe similar effects can’t occur with lump sums.

But the choices facing those who by design or circumstance find themselves with a wad of cash can feel very different – ranging from the straightforward to the dizzyingly complex and the emotionally taxing. The situation is also full of pitfalls. A 2012 study of family inheritance in the US, for example, found that just half of all money inherited is saved, and half is eaten up by spending or failed investments.

So how much are we talking? The figures will, naturally, depend on circumstance, even if they fall shy of the €240mn EuroMillions jackpot (to deal with which you’ll need not only legal advice, but a bodyguard). Still, the subject is worth taking seriously. How, then, should you invest a lump sum?

 

First steps

While each situation has its nuances, it is also important to know that lots of people, regardless of expertise or qualifications, will have their own ideas of what you should do with a large amount of money. The starting point for anyone wondering how they might use a lump sum, therefore, is to take control of the process or seek help if someone tries to take that control without your consent.

With this principle established, it’s time to ask yourself two questions. First, what does life look like today? And second, where do you want to get to?

Everyone will have different priorities and needs, and the ability of a fixed amount of cash to meet these will depend on both the size of the lump sum and the scale and definition of any goal. But for many, obvious considerations include changes in day-to-day spending, property purchases, debt reduction, setting up a business, financial independence, charity or supporting family members.

“These are the questions to build a plan around and work out what role money will play,” says Robert Schwarz, a financial planner at First Wealth. “Once you’ve got the plan, you can work up to strategy and deployment.”

Simply adopting this attitude doesn’t determine a course of action. If, after much careful thought, you arrive at a goal to live at the Ritz for the next year, then a £300,000 lump sum will facilitate it. Conversely, parking the same amount in the bank and hoping it funds your retirement is not a plan.

Getting a lump sum can also be an opportunity to examine your own cash flows and balance sheet.

If you don’t already have one, setting up an emergency fund is one starting point. If the funds allow, this might be one or two years' worth of typical cash expenditure for someone out of work, or up to six months' worth if you are employed. As the fund needs to be both stable and liquid, risk is a no-no, meaning easy-access savings accounts or premium bonds are both sensible options.

Another big consideration is debt. If you have £75,000 left on a mortgage and inherit £100,000, clearing the loan might seem like the smartest use for the cash. For those who constantly worry about the trajectory for interest rates, becoming debt-free has a psychological attraction.

“There’s a lot to be said for that,” notes Schwarz. “If you’re going to feel stressed about stock market returns when your debt isn’t coming down, that might not be a good balance. But for lots of debt, there shouldn’t necessarily be a big rush; not all debt is bad, or of the payday-loan variety.”

Many mortgages, especially those with low and long-term fixed interest rates, fall into the category of ‘good debt’. Early payments can also come with big charges and may overlook inflation’s erosive effects on borrowing amounts over the course of the loan.

Here ends stage one. Hopefully, even after completing this financial health check, a big pot of cash is left. That still leaves plenty of options, variables and traps between a lump sum and your goals.

Something to show for it?

Most people will be familiar with the line, attributed to US psychologist Abraham Maslow, about how “if the only tool you have is a hammer, it is tempting to treat everything as if it were a nail”.

Fewer will recognise how this cognitive bias often plays out in our personal finances.

“Property is the default option for almost everyone, no matter their circumstances, financial literacy or age,” says Kanishk Swarup, founder and principal adviser at Compound Wealth Planning, a St James’ Place partner firm. “I am always finding myself battling the perception that property is the answer to an individual’s financial options, especially when a lump sum is involved.”

If you opt to take £300,000 in cash from your pension, it is natural to think of what £300,000 could buy. Because, in many parts of the UK, the answer to that question is ‘a property’, many will intuitively gravitate towards buy-to-let investing, without much thought for investment returns, opportunity costs, risks or the work that comes with being a landlord.

In his three decades as a financial adviser, Hanley has seen how property is “often the first instinct” for individuals looking to deploy lump sums, often despite limited understanding of the myriad potential downsides of buy-to-let.

“First, it’s illiquid, so if you need to make a withdrawal, you can’t,” notes Philip Hanley, of Philip James Financial Services. “Second, your income is only as good as your tenant, meaning it’s not a given you’ll get a reliable income. Third, unlike stocks and shares, which are valued every minute of every day, you don’t know what it’s worth until you sell it.” Then there is tax: residential property can’t go into an Isa or a pension, while capital gains and income tax chew through returns.

A big reason why property remains the go-to for many lump-sum investors is that for a long time it was a smart call. Until relatively recently, low interest rates, supportive legislation and rising prices allowed hundreds of thousands of private landlords to parlay small cash deposits into growing income streams and asset piles. The ubiquity of this playbook has both entrenched biases and turned property portfolios into the established currency of security, wealth and status.

 

Taking the plunge

Fortunately, the hammer that is property is not the only investment tool available to the cash-rich individual. But this doesn’t mean the alternatives will be obvious, and there are still a few factors to consider before deciding what to do.

The first is your risk tolerance. To Swarup, this is both an individual’s “capacity to take risk, and their attitude to risk”, two things which aren’t always aligned. You might, for example, be able to stomach the volatility that comes with sink-or-swim small cap stocks, and yet need a stable asset base from which to generate a consistent monthly income.

Familiarising yourself with the risks that characterise different types of assets, and how these interplay with your long-term or ongoing needs, is a useful first step. In very broad terms, shares tend to offer better long-term returns than bonds and cash but are riskier in the short term and can often sharply re-price both up and down.

“We need to lean on evidence: most of the time you’re better off in equities than cash,” says Schwarz. “But it’s also important to understand your relationship to money, which is why it can help to get professional investment advice to understand the purposes and characteristics of an investment, and to know that it is normal for markets to regularly move 10 to 15 per cent.”

Even if you feel you have a handle on the risks, taking the plunge can be hard. After all, isn’t timing everything? What if that YouTube video saying the stock market will crash this month is right?

The truth is that for all the historic evidence, you can’t know how an investment will perform any more than you can know the future. But for those seeking peace of mind, there are always fail-safes.

“I generally say take the plunge or don’t, though one option is to invest half while you think about the rest,” says Hanley. “We emphasise that it’s impossible to get the timing right, aside from drip-feeding into an Isa or pension.”

Drip-feeding – the process of regularly investing small portions of a lump sum into a portfolio over time, in order to smooth average buy-in prices – has an intuitive attraction for those who cannot bear the idea of a big immediate loss. But history suggests the practice, also known as pound-cost averaging, is less effective than going all in, given that asset prices tend to rise over time.

Swarup agrees. “Both statistically speaking, and in my experience, it’s about time in the market, rather than trying to time the market,” he says. “[But] psychology is always a factor, so the right answer when it comes to drip-feeding is what you are most comfortable with. If you put everything in, and you have three months of sleepless rights, then that’s not the right call. If there are nerves or hesitancy, I might suggest putting 25 per cent in upfront, and then the rest in stages.”

Still, as Hanley notes, gradual investments can also be a smart call for the purposes of tax efficiency. A couple with two children and starting from a blank investing slate, for example, could completely deploy a £275,000 lump sum via tax wrappers over the next six weeks, if they used their full self-invested personal pension (Sipp), individual savings account (Isa) and junior Isa allowances for the current and next fiscal years.

As to how you might start to fill those tax wrappers and turn that lump sum into a bigger lump sum, a source of passive income (or both), many financial advisers recommend low-cost, well-diversified tracker funds. For more targeted ideas, there’s always a certain weekly investing magazine.