Retirees face a fixed income nightmare
The life stages investment methodology requires that you structure client portfolios more conservatively as they near retirement age. The old wisdom was to move clients almost entirely into cash and fixed income products at retirement. But professional financial planners soon cottoned on that these clients were too conservatively invested given life expectancy at retirement. The solution was to push the life stages ‘boundary’ back a few years and maintain higher levels of equity exposure through the first five or ten years of retirement.
Pensioners suffer more than most through economic recession. As equity markets collapse retirees are forced to accept significant cuts in monthly pension income. An individual drawing 5% per annum from a living annuity would suffer a ‘pay cut’ in line with the capital depreciation on the annual annuity value. When you consider the JSE All Share index shed 25% through 2008 you appreciate how severe this cut might be. Retirees take a second hit when monetary policy interventions aimed at kick-starting the economy are introduced. The Reserve Bank cut interest rates aggressively through the downturn with the result real cash returns are now close to zero, and in some cases negative.
The hunt for fixed income
For how long will these poor cash yields persist? To find out we attended an Old Mutual Investment Group SA (Omigsa) quarterly press conference held in Johannesburg on 20 October 2009. Johann Els, senior economist at Omigsa, identified a number of factors affecting the domestic investment environment.
His first observation – supported by steep declines in motor vehicle sales and retail sales growth – is that private sector demand remains weak. Flagging private sector consumption is partly offset by government expenditure, exports and an improving inventory cycle. Although Omigsa expects a return to positive economic growth in the third quarter of 2009 the prospects for medium-term growth aren’t exciting. Other positives include a better than expected current account deficit and a strong rand. Overall, concludes Els, South Africa has performed reasonably against a cross section of emerging market peers.
The short-term inflation outlook is flat too. But that’s not good news for savers. As long as inflation remains in check we’re unlikely to see an increase in interest rates. In other words – cash returns will remain in the doldrums for some time. Omigsa makes a number of assumptions when forecasting inflation rates. These assumptions for 2009 and 2010 are:
- R7.65/$ and R8.25/$ for the rand dollar exchange rate;
- $75/barrel and $85/barrel for oil;
- 5.5% and 7% for food price inflation; and
- 35% and 35% for Eskom price increases
Given this data Omigsa expects inflation to dip into the Reserve Bank’s 3% to 6% target range in the first quarter of 2010 and remain below 6% for the entire year. If this prediction holds there won’t be any argument for further interest rate cuts, but hikes aren’t likely either. We will see a rate cut “only if inflation drivers improve substantially AND the real economy does not improve substantially,” says Omigsa. They conclude rates will remain at current levels (prime lending rate of 10.5%) for the next 18 months.
When will interest rates move higher?
Omigsa says the prime lending rate will be 11% by the end of next year, suggesting a 50 basis point hike in the last quarter. Savers relying on returns on cash and near cash investments will have to wait until the end of 2011 for any notable improvement – the group expects a further 250 basis point increase in the prime rate over that year. Unfortunately higher interest rates don’t guarantee better real returns.
The Omigsa Macro Strategy Investments (MSI) team view on cash is negative over the next five years. They expect low real returns of around 2% per annum over that period, warning of negative after-tax real returns from this asset class. They remain neutral on bonds due to longer-term concerns over inflation. Local bonds will only provide 3% annual real returns over the next five years. Savers might take some solace from the situation their offshore peers find themselves in. Omigsa MSI I negative on offshore bonds and cash, with the latter expected to yield 0% per annum over five years!
Editor’s thoughts: How do you invest in low interest and low inflation conditions? Omigsa MSI is reducing cash holdings and investing close to the 20% regulatory limit in offshore asset classes. Do you advocate taking more risk when cash returns are low? Add your comments below, or send them to [email protected]
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