Cameron McCallum of Netto Invest explains to YEI readers how the recent interest rate hike will affect retirees/seniors/pensioners
With the Reserve Bank raising the repo rate by 0.5% earlier this month, investors may start looking to cash to provide investment returns.
Given the volatility that we have seen recently, keeping money in the bank may sound like a compelling option.
However, there are a few other factors to be considered as retirees could be tempted to invest too conservatively too early.
Firstly, the reason for the rate hike (the second consecutive one we have seen) must be remembered – it was done primarily to manage inflation and the depreciation of the Rand.
What investors must remember is that investment returns must be measured after taking inflation and tax into account. As an illustration, if the bank pays you 7% interest and you are in the 26% tax bracket, you are earning 5.2% after tax. This 5.2% return must then be compared to inflation (currently around 6%, but expected to rise). It then becomes clear that even though it may feel good to get a stable 7% growth on your investment, you have in fact lost capital in real terms. Obviously if your interest rate is lower, an inflation beating return is possible (albeit a small one).
That said, there is always a place in an investment portfolio for some cash holdings, whether this is to provide certainty of short term cash needs, an emergency fund, or for rebalancing when investment opportunities present themselves. As SARS gives individuals an interest exemption every year, some cash can be held without paying any tax on the interest – and this is quite compelling as rates rise. Let’s see what our new finance minister has to say next month in the budget speech about the 2018 interest exemption!
So while Money market or cash yields may give returns which are only close to inflation matching, better yields (in excess of inflation) should certainly be available to bond holders subsequent to the rate hike, although investors should tread carefully as long term bond yields are driven by investor expectations and further interest rate hikes may negatively impact capital value.
So what is the solution?
Firstly, retirees should not see themselves necessarily as short term investors. With more and more people living into their 90’s and beyond, inflation brings the very real risk that income may not keep up with living costs.
Your financial plan should start by determining how hard your investments need to work (i.e. how much investment return you need on your capital to sustain your required level of income) and your overall investment strategy should be driven by that. There are a number of asset classes in which you can invest – shares, bonds, property and cash – and of course the balance of local versus offshore is also an important decision as a depreciating currency will impact our inflation rate (and your overseas holidays!). Each asset class has different risk and return parameters and an investment portfolio should be well diversified and include a mixture of these. The allocation between these asset classes should be managed in line with a financial plan tailored to your specific circumstances and goals. The risk, volatility and the investment timeframes must also be carefully assessed and considered.
The interest rate hike has potentially given you the ability to earn the same type of investment return at a slightly reduced level of portfolio risk. In other words, depending on your required rate of investment return, you may be able to allocate slightly more of the portfolio towards cash and bonds, and slightly less to risky assets.
With a higher interest rate, it is important also to shield your interest earning investments from tax by holding the more conservative portion of your portfolio in retirement vehicles (e.g. Living Annuities or Retirement Annuities) where there is no tax levied on the interest.
And what about other investment options?
For those investors intending to purchase a guaranteed life-long pension (life annuity) in future, the income offered by the life annuity will be greater when interest rates are higher and as such would benefit from the recent hike. However, as there may be further hikes, yields may be better in future. Whether the life annuity option is the right option for you depends on many factors which should be carefully considered, as once you have elected the life annuity option, your pension income is set for life and you cannot revisit your decision.
In conclusion, while we should take advantage of being able to earn a better return on cash and bonds, the risk we must continue to manage is inflation and future pension increases. One should be cautious of being too conservative too early on, and must remember that over time, an appropriately diversified investment portfolio and ongoing financial planning will provide the greatest certainty of achieving one’s financial goals. Interest rates will go up and down in future and as always, we recommend working with a qualified financial planner to assist you in making these difficult decisions.
Author: Cameron McCallum I CA(SA) CFP®
Cameron is a Chartered Accountant, CFP® professional and Wealth Manager who joined Netto Invest in 2007. Since moving to Netto Invest Cameron has enjoyed building personal relationships with clients as he helps them achieve their financial and lifestyle goals. His belief in the need to provide retirees, investors and business owners with well-researched, comprehensive and independent advice prompted him to become a shareholder in 2013.
Cameron is a keen cyclist and mountain biker, and has completed more than 23 Argus Cycle Tours. He is married to Wendy and they have a daughter, Mila, with their second baby on the way.