At the turn of the century (well nearly 20 years ago) cash was a usable asset class. For those wanting to “safeguard” capital and receive an income it seemed the perfect choice; £100,000 could provide an “income” of around £5,000 per annum.
In 2008/2009 this all changed as globally, interest rates dropped to near zero; income effectively dropped by 80% overnight. Inflation also meant that cash had become a negative yielding asset class.
Over the last ten years we have heard many people say that interest rates will go up, or they will return to normal. But the reality is, that the ‘new’ normality is likely to be 2% to 3% at best, over the next 10 years or more. Even if we get to that point, we could be looking at a 40% to 60% decline from previous levels. Inflation can no longer be excluded from the equation; so, what can investors do?
For those who have read our blogs, we are not ‘anti-cash’, it is integral to financial planning. Everyone should have some cash. However, the level of cash required depends on personal needs. But we must accept that the level of “return” on that will be almost nothing, which is why such levels are kept low (approx. 3 – 6 months of salary).
For those who have no other savings, then cash will likely be the only real option.
If we consider the primary purpose of saving and investing now is to provide an income in retirement, then perhaps we need to consider a different route. To get an income we must consider taking on some risk. A risk-free return does not exist.
The first step on the journey is understanding risk, which is the potential for the permanent loss of capital. Someone will only lose capital if they invest in something that reduces to zero, or they sell at a point when the value is negative. The movement in the value of assets from day to day is not risk, it is volatility. There is a big difference.
If we take this journey one step further and look at an investment of £250,000 to provide both an income and some growth, what could we expect?
This is a simplistic view, but the figures below show projected rates of return on different asset classes over a 10-year period. It is important to stress that these rates are not guaranteed, and returns could be higher or lower.
|Projected Annual Returns over 10 years plus|
|Developed Market Equity||7.00%|
|Developing Market Equity||7.50%|
To build a portfolio, we always recommend diversification across different asset classes. If we take an example of a how a cautious and adventurous portfolio might look, we can then see how the two differ in terms of returns.
|Allocation||Projected Annual Return||Allocation||Projected Annual Return|
|Developed Market Equity||38%||2.66%||64%||4.48%|
|Developing Market Equity||8%||0.60%||23%||1.73%|
|6.36% p.a.||7.19% p.a.|
In terms of pure returns and £250,000 invested over 20 years, the cautious portfolio would potentially be worth £750,465, and the adventurous portfolio £864,515. This means that the adventurous portfolio returns about 0.75% p.a. more (or £114,050) over the 20-year period.
In terms of volatility the cautious portfolio would be less volatile at 5.03% against the adventurous at 8.87%. In plain English, this means that the cautious portfolio would fluctuate by a lower rate and has the ability to cushion the downside when markets are falling.
What does this all mean for those wanting income?
Income is often seen as interest from cash, or dividends from shares or funds but with lower interest and falling dividends there is and has always been a different option. This is a withdrawal from capital.
In this era of low interest rates, coupled with longevity, investing money to provide income through a withdrawal of capital is an alternative option. Although the capital is not guaranteed, not only can it provide tax-efficient withdrawals to provide funds to live on, but also the chance for the capital to grow.
For a cautious investor wanting 5% a year, with a projected growth rate of 6.36% p.a. (as shown above) they will have a small amount of growth but also an ‘income’ through capital withdrawals. If they are prepared to take on additional volatility, then the potential for growth is that bit greater over the longer term.
(Please note these are estimated returns and not guaranteed. Investments can fall as well as rise.)
What about tax
We can’t avoid tax! But there are options. Taking withdrawals to provide an income from an ISA is tax-free and withdrawals from non-ISA investments are only taxed once gains exceed the annual allowance.
Is buy-to-let an option?
The maths for buy-to-let looks attractive. Buy a 3-bedroom house for £300,000 cash. Rent the property for £12,000 p.a. This is a return of about 4% p.a. (Obviously this depends on location, and figures will vary from place to place).
But there are number of factors to consider. Firstly, the rental market is changing and rental income in some areas is starting to fall. Additionally, we are starting to see a small downward movement in property prices.
There are upfront costs when buying the property, including an extra 3% Stamp Duty for 2nd or 3rd properties. Rental income is taxed at the higher rate, and from 2020 tax relief for finance costs will be restricted. Other costs include insurance, maintenance and property management. There is also the potential for periods when the property is empty meaning no rent is received. And of course, when the property is sold there is the potential for capital gains (also at the higher rate of 28%).
This means that anyone choosing this route needs to understand that the 4% top line figure could be much lower after tax and costs, that the investment could return no profit, that there could be significant time and costs involved in owning and running the property and that if capital is needed then it is not a liquid asset.
On the flip side if someone is prepared to accept this, they may like the idea. It is a tangible asset; they may be happy to tie up their money in an illiquid asset and they are prepared to take the risk on potential returns.
It is an option, but careful thought needs to go into it.
A new norm, different thinking
If we hold a lot of cash, then we need to understand that effectively there is no means of getting a good “return”. If something looks too good to be true, it often is!
The new norm means that interest rates are likely to only get to around 2% or 3% (if at all). But the journey to this could be five years plus away. If this is the case, those holding large sums of cash hoping to get “income” would have waited 15 years for nothing.
In that time, investing in a diversified group of assets would have delivered not only an ‘income’ via withdrawal of capital but also the potential for growth. Using both the ISA and capital gains allowances would have mitigated some of the tax.
Property is an option, but the question remains whether it provides the same level of flexibility and tax benefits as investing in a diversified basket of assets.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.