This has been written with pension funds in mind but you will find the concept applies just as well to larger sums of money sitting in building society or bank accounts.
Whilst ‘cash’ is useful because it can protect against steep declines in capital the problem we are currently faced with is that the interest rates are very poor. The biggest challenge that a cash investment is faced with is that the underlying Bank of England Base Rate has been 0.5% and inflation has been 2.7% (change over the year to Dec 2012).
This has been disastrous for savers because the value of a cash investment is being gradually eroded over time. Although the actual amount of capital has not decreased, it cannot buy the same goods that it could last year, because they have become more expensive. When an investment grows and keeps pace with inflation, this is known as ‘real’ growth.
Cash and Gilts, often thought of ‘risk free’ assets, are currently yielding less than inflation and so delivering a negative ‘real’ yield. Savers can get a positive ‘real’ yield only by taking risk.
The return needed to match inflation was 2.7%. (Figures to Nov 2012)
Cash provided 0.5% and Gilts offered a yield of 1.8%, with a Notice Account offering 2.1%. Interestingly, the FTSE 100 dividend yield was 3.7% along with UK Corporate Bonds.
Dividends have generated consistent income through the decades for investors.
So the question you must ask yourself, is can you afford not to take any risk with your capital. Investors are forced to take greater risk if they want to outperform inflation and protect the real value of their capital.
This leads us nicely into the topic of how to manage your funds just before your retirement.
‘Life styling’, where you start to put more of your funds into secure, less volatile assets in the countdown to retirement to avoid a sudden market drop affecting your fund and therefore your expected retirement income, is a sensible strategy if the timing is right. However, there would seem little point in holding a cash investment for too long and this money would be better served providing you with an annuity income sooner rather than later. The argument here is that it would be better to receive the extra annuity payments available from buying the annuity now, instead of letting your fund be eroded by inflation. We refer to this as the ‘cost of delay’ and would be happy to provide you with more specific guidance if you think this is relevant to your circumstances.
Essentially, the risk you are taking by holding onto your fund, in cash, is that you are gambling with inflation and future annuity rates. A further, more technical issue also comes into play. This is referred to as mortality drag and it means that as you get older your fund must produce an extra return, just to match the diminishing cross subsidy that is lost by delaying annuity purchase. The younger you are when you buy an annuity provides you with a greater mortality cross subsidy. This reduces with age and can be measured as additional growth required in your investment to replace this lost benefit.
If you would like any further assistance or guidance in these matters, please contact Simply Retirement (01622 664440).