Investment strategy in a high interest rate environment

Interest rates have gone up and may remain higher for longer as inflation remains well above the inflation target range. A high interest rate environment may lead to the need to adjust an investment strategy – especially for living annuity clients.

A benefit of a higher, and potentially rising, interest rate environment is that investors are able to invest in cash deposits or money market funds and take advantage of a higher, near risk-free returns in low, double-digit territory.This is especially important for new and existing investors that face the onerous task of balancing the need for income in the short-term with the need for growth over the medium to long-term.

New trend emerging

A trend has consequently developed among investors. Income requirements from a living annuity for the next 12 months or even two years are now being housed in a money market fund in order to benefit from a higher interest rate environment, to meet the income requirement of investors in the short-term.

The balance of the investment is invested in a range of cautious to moderate multi-asset class funds to provide for medium to long-term growth within the portfolio – but these funds are at least afforded the head start of not being drawn against in the first year or two, especially important if this is at a time when investment markets are flat, or worse, falling. Funds earmarked for growth purposes typically invest in broader asset classes that include equity, property, bonds and international assets, and these asset classes generally require a longer investment term to extract the possible returns, especially real returns, associated with each asset class over time.

Flexible living annuities

This approach and adjustment to investment strategy is possible within a living annuity due to its flexibility. Investors are taxed on the income stream from the living annuity. The overweight cash position within a living annuity portfolio is therefore not tax onerous.

Over the long-term, the use of cash within an investment portfolio needs to be carefully considered as the real return from cash is in the region of 1%. Equities reward investors with a 7% real return over the long-term, but need this time in the market to act as a beneficial inflation hedge.

Example

By way of example, assume an investor invests R2 000 000 in a living annuity and requires an income of R5 000 per month (R60 000 per annum).R120 000 is invested in a money market fund to be drawn down over two years in order to meet the required income objective.

The balance of the portfolio (R1 880 000) is invested in multi-asset class funds. No income drawdown against these funds for at least two years means that at the end of the first two year term, proceeds from these funds can be used to provide for the investor's income requirements in the ensuing two years, and so the process goes on.

Time in the market

This adjustment to investment strategy provides the necessary 'time in the market' to particular asset classes that require a longer term consideration and also means that short term income draw downs are not levied against these funds earmarked for medium to long-term growth, that may face challenging conditions in the short-term.

The implication for portfolios that have the income requirement drawn routinely from a range of underlying funds (often proportionately), is that income is drawn against a portfolio where the fund value is flat or falling when investment markets deliver below average, or negative, returns.