PLAN AHEAD AS THE GOLDEN YEARS DRAW NEAR
▶ Older investors must ensure they continue to generate an income when they stop working, reports Harvey Jones
Inflation scares everybody, but it is particularly menacing if you are reaching the end of your working life or have actually retired. Young investors can sit back and hope it passes while trying to outpace today’s rampant consumer price growth by investing in riskier assets such as commodities and cryptocurrencies.
They are lucky, time is on their side.
For older investors, volatility can be unnerving as they have less time to recover from any stock market setback, which forces them to play it relatively safe with their money.
Their investment goals have also changed. While the young are looking to build their wealth, older investors want to protect what they have and generate income from it.
This is always a challenge but gets even harder when inflation is working flat out to erode everybody’s incomes. US consumer price growth hit 6.2 per cent in October and the cost of living in the UK accelerating to 4.2 per cent.
The lower risk asset classes that older investors favour, such as cash and bonds, tend to perform badly when inflation is on the march.
“Low interest rates and high inflation make generating income in retirement tough but not impossible,” says Vijay Valecha, chief investment officer at Century Financial.
So which asset classes can you protect from inflation?
Cash
The old phrase “cash is king” makes absolutely no sense these days.
Cash was dethroned more than 12 years ago, when central bankers cut interest rates almost to zero after the global financial crisis in 2008, then again last year to counter the pandemic.
Now, inflation will compound their woes. Central bankers are reluctant to raise interest rates to curb inflation, fearing it will crush the postCovid-19 recovery and continue to claim it is “transitory”.
They have good reasons to be cautious. In the UK, a 1 per cent rise in interest rates would add more than £20 billion ($27bn) to debt interest payments.
The average US savings account pays only 0.06 per cent, according to Bankrate, and today’s 6.2 per cent inflation rate will shrink $10,000 to $9,386 in real terms after one year, destroying its spending power.
Cash doesn’t cut it, either for young or old, says Rachel Winter, associate investment director at Killik & Co. “Those who have left their savings in cash over the past year will have seen their money eroded by inflation, while at the same time, the MSCI World index has gained over 20 per cent.”
While everybody needs a pot of cash they can access for emergencies, if you leave your money in the bank, it will only shrink and shrink. Some risk is required.
Bonds
Government and corporate bonds are another retirement income standby that now offer more risk than reward.
Bonds pay a fixed rate of income, but that is much less attractive as inflation rises because its value will be eroded in real terms, says Ed Monk, associate director at Fidelity International, says.
As a result, bond investors are now demanding higher yields before parting with their money. But there’s another catch: when bond yields rise, bond prices fall, hitting existing investors. Nobody wants to be at the sharp end of a bond market crash just now.
Inflation-linked bonds offer some protection, says Rob Morgan, chief analyst at Charles Stanley Direct. “The downside is that they can become expensive when lots of investors are looking to protect themselves from this risk and drive up prices, so they don’t always work as a hedge.”
Investors can invest in inflation-linked bonds via an exchange-traded fund. Popular options include Vanguard Short-Term Inflation-Protected Securities ETF, which currently yields 3.4 per cent, iShares 5 Year TIP Bond ETF, which yields 3.88 per cent, and SPDR Portfolio TIPS ETF, which yields 4.18 per cent.
TIPS stand for Treasury Inflation-Protected Securities, which are linked to US government bonds.
Annuities
The safest way to generate a steady income in retirement is to buy an annuity, which will pay a fixed and guaranteed income for life, no matter how long you live. Once again, low interest rates have wreaked havoc. Demand for annuities has collapsed because few want to lock up their wealth at today’s record-low interest rates.
Someone aged 65 with £375,000 in their pension could pay a single level income worth £14,518 a year, says Daniel Hough, financial planner at wealth manager Brewin Dolphin. That is a poor return for a lifetime of saving and there is another issue. Level annuities play a flat rate of income, which makes them a machine of wealth destruction when inflation takes off.
After 20 years, that income would be worth £7,895 a year in real terms if inflation averaged 3 per cent a year. If it averaged 5 per cent, its value would fall to only £5,204. “Inflation steadily erodes your purchasing power,” Mr Hough says.
You can get annuities with inflation protection, but they pay a lower initial income, especially if you take out a joint annuity that pays your spouse or partner 50 per cent of the income if you die before them.
In that case, £375,000 would buy you £5,800 in income in the first year of an index-linked or “escalating” annuity. “That will rise over time, but is not a great deal to live on,” Mr Hough says.
He now recommends only annuities in particular circumstances, typically when people have a specific need for a secure income and their costs are unlikely to change much. “They may also suit single people with no dependents as their annuity payments will cease when they pass away and cannot be passed on.”
Some annuities do allow you to pass on some unused wealth, but this further reduces the starting income, Mr Hough says.
It may be worth investing a small portion of your portfolio in annuities to give you a basic retirement income that will never run dry, Mr Valecha says.
Stay invested
The traditional methods of generating income in retirement have been destroyed by low interest rates and rising inflation. The best way to fight back is to leave your retirement funds invested in a diversified portfolio of inflation-hedging assets such as stocks, real estate and inflation-protected bonds, Mr Valecha says.
There is scope for some gold even though it doesn’t generate income. This is to hedge your exposure to stock market volatility, while cryptocurrencies do not pay income.
Equity income funds are possibly the best way of generating both dividends and capital growth in retirement, says Mr Valecha. He recommends so-called “dividend aristocrat” companies that have a track record of increasing their payments for decades.
You can access this type of stock through the SPDR range of ETFs by State Street Global Advisers. SPDR S&P US Dividend Aristocrats UCITS ETF currently yields 2.2 per cent, SPDR S&P UK Dividend Aristocrats 4.72 per cent, and SPDR S&P Euro Dividend Aristocrats 3.43 per cent.
SPDR S&P Pan Asia Dividend Aristocrats UCITS ETF, which tracks companies in the Asia Pacific, yields 3 per cent.
“Dividends give you a recurring stream of quarterly or monthly payouts providing a reliable source of income in retirement, and reducing the risk of outliving your assets,” says Mr Valecha.
Mr Hough also backs having a diversified portfolio of investments with equity exposure. “A cautious £375,000 portfolio could realistically generate a rising income of around £15,000 a year,” he says. “This would give you both capital growth and deliver a consistent level of income, with smoother returns overall.”
He suggests spreading funds across different geographies, sectors and asset classes, so that not all of your eggs are in one basket. “This might include a range of equities, as well as property, gold and commodities, and a mix of government and corporate bond funds.”
Combining annuities and drawdown in a blended way would give you the best of both worlds, says Canada Life technical director Andrew Tully. “Managed effectively, this approach should ensure you don’t run out of money too soon, while avoiding being so conservative that your money does not grow.”
However, there is no onesize-fits-all approach and your plans will need to evolve as you move through retirement, says Mr Tully. “As inflation climbs, taking independent financial advice is more important than ever.”