There are ways of getting a better return on your money whilst managing the various risks you face. However, in the first instance, it is important to acknowledge the very real, albeit somewhat misguided concerns many hold about taking risk with their money. We can then consider how we might better address the problems.
Many in retirement are reliant to various degrees upon the interest they receive on cash they hold on deposit to maintain their lifestyle. Although most express concern about the poor interest rates on their bank and building society deposits, as many see themselves as being risk averse, they avoid placing some of these monies in other investments with a view to securing a better return, as they fear losing some or all of their money.
Our experience strongly indicates, the most risk averse amongst us inadvertently often take greater risk than more risk accepting investors, in their quest to avoid risk. To better explain this point, here are two examples;
When the Northern Rock got into difficulty, account holders were concerned about the security of their money and started to queue to take their money out, despite the guarantees afforded by the Financial Services Compensation Scheme to protect them in just such an event. To quell the concerns and stem the panic, the Government of the day extended that guarantee to cover unlimited monies held at the Northern Rock ‘only’. Despite this, account holders still took their money out, only to place it in other banks and building societies where there was less protection for their money! It was an understandable but irrational action, driven by fear and being ill informed which led many into further problems, when other banks and building societies got into difficulty in the ensuing months.
The Halifax produced a research paper analysing 50 years of savings patterns and rates from 1959 to 2009. Over that period, the average gross interest rate on no notice accounts was 6.45%. Yet after deducting inflation, the real rate of annual return was 0.57%! If we assume a deduction of the current basic rate of 20% tax applied throughout, then we would need to deduct 1.29% from the gross interest rate, which means that after the effects of inflation and basic rate tax, the real net return over the 50 years would have been -0.72%. If we were to apply that principle looking forward for the next 30 years, then an initial deposit of £100,000 would be worth £80,568 in real terms and that is before you have drawn any income from it.
What of the current situation? The average Retail Prices Inflation from 2008 to the end of 2012 was 3.14% compound. Even if we extend the timeline to 10, 15 or even 20 years, it has been of the order of 3%. Currently, for larger deposits with long term fixed rates, you may secure circa 3.5% before tax or 2.8% net of basic rate tax. As for no notice accounts, you may be able to secure up to 2.25% before tax.
Sadly it is an inalienable fact it is not possible to avoid risk, the important issues are to manage what risks we expose ourselves to and how we mitigate all of those risks, including the following;
- losing some or all of your capital
- the effect of inflation progressively eroding the buying power of your money
- the additional strain your income requirements place upon the money
- how paying unwarranted tax reduces your money still further
- risks associated with trying to second guess an ever changing world
- holding more money with one banking institution than would be protected in the event of its failure
- the impact of fluctuating exchange rates on cash or investments you hold abroad
Given the above problems and their complex interaction, how do we effectively address these problems? Each individual’s circumstances is different and specific advice should be sought but in general terms, it is prudent to keep as cash deposits, those funds targeted to be spent on capital projects in the next 5 years, such as home improvements and new car purchases. In addition, it is also prudent to have as cash, an agreed sum as an emergency pot, in event of the unforeseen. Although it is likely this money is going to secure a net of tax interest rate of less than inflation, it does help ensure that you are not forced to sell other assets at a time when the market may be suppressed. Beyond that, the next step is to establish how much income, (if any), you need your capital to provide you with. Dial back in the allowance for inflation and we know what return we need to secure for you if you do not want your capital to reduce in value in real terms and thus the degree of ‘capital risk’ we need to take.
Having done all of the above, we manage the various risks, by ensuring you are not over exposed in any area, by spreading your money broadly across different asset classes, with different institutions in a low cost easy to manage and tax efficient manner. When your monies are spread correctly across cash, government and institutional bonds, commercial property, and shares, their behaviour tends to differ from one another at any given time and set of circumstances. Thus the extremes of highs and lows they may experience tend to cancel each other out and your money as a whole, gets a smoother return and has the opportunity to achieve the increased return you need over and above what you could secure in a bank or building society account.
Please remember, the value of your investment and the income from it can go down as well as up and isn’t guaranteed. You may get back less than the value of the money that you invest.