'A Saver's Guide to Surviving Record-Low Interest Rates'
If you’re either contemplating retirement or are a self funded retiree and worried that with record-low interest rates it will be difficult to survive on only cash and term deposits what other options do you have?
With cash and term deposits currently hovering around the 2-3% level, depending on which bank or what maturity you choose, double-digit returns are a thing of the past. In coming to terms with this an important first step is to acknowledge that it is not possible to significantly increase the return you get from your savings without taking on some increased risks; there are no short-cuts and the old adage that ‘if it sounds too good to be true it probably is too good to be true’ applies.
It helps if you have a good understanding of what sort of income you want - or need - from your savings and can get comfortable with the increased risk that you may need to take on in order to achieve that. You may be pleasantly surprised and find that in fact you are able to achieve your goals by only taking on a modest amount of additional risk.
What are the risks?
It can be human nature to focus on the downside of investment risk, for example the market risk that an investment achieves a negative return over time or the volatility risk where you fear you won’t be able to cope with the week-to-week or even day-to-day movements in the value of an investment.
However you shouldn’t forget other risks that may arise if you accept lower returns, for example the risk that the return on your retirement savings are lower than inflation, so the real value of your investment goes backwards. This in turn may lead to so-called longevity risk, or the risk that your retirement funds might run out earlier than you need them, that is you might outlive your savings.
Cash and term deposits score very well in terms of investment risk, there is no day-to-day volatility, the return on investment - or interest rate - is known in advance and the return of capital is guaranteed by the government on bank investments of less than $250,000. However they fare less well in their ability to keep pace with inflation, which in a world where we are all living longer can be the number one enemy of retirement savings.
How long will your savings last?
Currently a 65-year old retiree would have a life expectancy of around age 85, or will spend 20 years in retirement. However life expectancy is simply an average and the same government statistics tell us that 40% of females and 25% of males will live to age 90 and beyond1.
Imagine you are a couple both age 65 on the full pension with estimated living needs of $50,000 then you will need an additional $15,000 a year in today's dollars to achieve your goal. lf you have $300,000 in retirement savings with a long-term investment return of 0.5% your savings will be exhausted after 22 years at age 87, assuming you withdraw the required $15,000 each year. However if you can achieve a long-term return of say 3% over inflation, then your savings would last an additional 9 years to age 96.
Looking at it another way if we assume that the annual long-term rate of inflation is 2.5% the amount of income you would require at age 95 to have the same buying power as $15,000 in today’s dollars is approximately double, or a little over $30,000 - with inflation at 4% the income required would be almost $50,000!
The above example demonstrates a very important concept. Rather than focussing on the absolute returns that can be achieved from your investments, it makes sense instead to think about the return over and above inflation that can be achieved. We mentioned that double digit investment returns are a thing of the past, but so is double digit inflation. Cash and term deposits at 2-3% are still achieving a modest return over inflation, which is currently around 2.0% per annum.
What alternatives are available?
So what alternative investments - or asset classes - are available to cash and term deposits and how do they stack up in terms of the return over inflation that can be achieved and the risks involved?
An asset class is a specific category of assets or investments, such as cash, fixed interest, property or shares. In turn these specific asset classes are split into two broad categories - growth assets and defensive assets.
Growth assets such as shares and property generally experience higher volatility, while they offer greater potential returns over time they are prone to short term market fluctuations. A high proportion of the returns from growth assets are likely to come from an increase in the capital value of the investment rather than from just income. Growth assets include:
- Australian Shares
- Global Shares (hedged and unhedged)
- Residential Investment Property
- Listed Property
Defensive assets include investments such as cash and fixed income, typically carry a much lower level of volatility and risk and offer stable more predictable returns delivered in the form of interest income. As a result they are more likely to generate lower levels of return over time.
Defensive assets include:
- Cash
- Term Deposits
- Australian Fixed Income Securities (Including Government Bonds, Corporate Bonds and Hybrid Securities)
- Global Fixed Income Securities (hedged)
Diversification is key
If your retirement savings consist entirely of cash and term deposits the capital value of those savings will be safe the historical returns have been between zero to 1.0 % over inflation. One of the golden rules of investment is diversification - or not having all your eggs in one basket - and this applies just as much to safe & secure investments as it does to more volatile ones. If cash and term deposits underperform their historical long-term returns and interest rates fail to match or exceed inflation then your savings could run out much quicker than you anticipate. Investing across a variety of asset types helps increase your chances that parts of your portfolio will be performing well, even if other parts aren’t.
So how do you increase your returns without taking on more risk than you are comfortable with? One way is to invest a modest amount of your retirement savings into growth assets. This can be achieved by directly investing in shares or property, or more simply by changing the investment profile of your superannuation.
Most superannuation funds will offer pre-mixed diversified investment portfolios with a mix of growth and defensive assets. A ‘Capital Guaranteed’ investment option will be invested wholly in cash and term deposits whereas a typical ‘Balanced’ option might have around 70% exposure to growth assets spread across the different asset classes of Australian and International shares, and property. A ‘Conservative’ option will have a lower level of growth assets, perhaps 30%, and a ‘Growth’ option more, typically 85%.
Another approach is to stick completely to defensive assets but diversify by adding some fixed income exposure, such as Government or Corporate bonds or a diversified fixed income investment option, alongside your existing Cash and term deposits or your current ‘Capital Guaranteed’ investment option. While this will add some volatility to the value of your savings it will be relatively modest when compared to investing heavily in growth assets such as shares and listed property.
Asset Classes in detail - Risk versus Return
So let’s take a look at some of these assets classes in a little more detail, the risks involved and the long-term returns above inflation that they have achieved2.
|
Investment Options |
% Growth Assets |
Expected Long-term Return over Inflation |
10 year Historical Returns2 |
Expected Years of Negative Returns |
Recommended Holding Period |
|
Individual Asset Classes |
|||||
|
Cash & Term Deposits |
0% |
+0.0-1.0% |
+0.7% |
Negligible |
1 year |
|
Fixed Income |
0% |
+1.0-2.0% |
+3.8% |
2-3 in 20 |
3-5 years |
|
Australian Shares |
100% |
+4.0-5.0% |
+4.4% |
5-6 in 20 |
10-12 years |
|
Global Shares (50% hedged) |
100% |
+4.0-5.0% |
+3.9% |
5-6 in 20 |
10-12 years |
|
Listed Property |
100% |
+3.0-4.0% |
-1.1% |
3-4 in 20 |
5-7 years |
|
Residential Property |
100% |
+4.0-5.0% |
+4.3% |
2-3 in 20 |
7-10 years |
|
Diversified Investment Options |
|||||
|
Conservative |
20-40% |
+1.0-2.0% |
+3.3% |
1-2 in 20 |
3-5 years |
|
Balanced |
60-80% |
+3.0-4.0% |
+3.9% |
4-5 in 20 |
7-10 years |
|
Growth |
75-95% |
+4.0-5.0% |
+3.3% |
5-6 in 20 |
10-12 years |
Taking account of your investment timeframe
One way of getting comfortable with increasing the risk of your portfolio is to consider the timeframe of your investments by mentally breaking down your savings needs into separate ‘time buckets’. You may want to invest a modest amount into shares for example but be concerned that your timing is wrong and another GFC is just around the corner.
Let’s say your overall savings target is to fund 20 years of retirement living. You might want to keep the equivalent of five years of income - or say 25% of your savings - in cash or term deposits. The bulk of your savings - to fund the next five to fifteen years - might then be invested in a moderately conservative portfolio with say 20% of growth assets. You may then feel comfortable committing a modest proportion - say 20-25% - of your savings to a long-term investment in high growth assets such as shares or property, knowing that you won’t need to touch them for 10-15 years if things do go wrong in the short term.
Overall this will place around 35% or so of your portfolio in growth asserts but may be able to boost your returns to around 2-3% over inflation while being structured in such a way that allows you to sleep at night.
The value of financial advice
Any move to add to the risks of your savings should take place gradually over time with very much a ‘toe in the water’ approach. Whatever course of action you decide on it should be carefully considered and researched. A great resource in terms of information and education is the Australian Securities and Investments Commission’s (ASIC) MoneySmart website, https://www.moneysmart.gov.au
The information in this article should not be considered as personal advice in that it does not take into account your personal circumstances and needs.
While you may feel comfortable taking action on your own behalf it makes sense to speak with a financial adviser. You may have an adviser already or be able to find one through your superannuation fund. If not you could try the Financial Planning Association of Australia’s website at http://fpa.com.au/find-a-planner/ or alternatively a site such as Adviser Ratings at http://www.adviserratings.com.au
1 Australian Life Tables 2010-2012: Australian Government Actuary
2 10 year returns to December 2014, source Russell Investments/ASX Long-term Investing Report June 2015
Ian Town is a Certified Financial Planner® and an Authorised Representative of The FiftyUp Club and One Big Switch.
Information contained in this article is general advice only. It does not take account of your personal circumstances and needs. If in doubt about your personal situation or needs you should seek financial advice.
FiftyUp Club Pty Ltd (ACN 166 905 175) is a Corporate Authorised Representative (AR number 465649) of One Big Switch Pty Ltd (ACN 150 963 474) who holds its own Australian Financial Services License (AFSL 455982) and can provide you with factual information and general advice only
