For savers, the combination of lower investment returns and rising longevity is a toxic combination. In days gone by one may have only needed to make a savings pot last 10 years and could have expected real returns from a typical balanced fund in the order of 5% per annum. This would have equated to an annual withdrawal of £12,950 (rising with inflation over the 10 years) on a pot of £100,000.
"Equity markets often have a remarkable predisposition to recover from sharp falls"
If returns fall to 2% and you need your pot to last 30 years, this figure falls to £4,465. (These numbers assume the said investment return is achieved each and every year. That they will vary from year to year just complicates things further).
There are two ways to deal with this problem. Either you reduce your spending in retirement or you try to increase your investment returns. If you opt for the latter, you’ll have to take some investment decisions that you may not be comfortable with.
The low or negative long term real interest rates that prevail across the developed world currently mean two things.
First, they mean that real returns from long-dated developed market government bonds will almost certainly be low or negative. For them to produce decent real returns, inflation would have to be substantially negative, and for many years. This is unlikely given that central banks can always prevent such through use of their printing presses.
Second, they reflect the fact that economic growth going forward is likely to be lower than in the past, perhaps considerably so (lower economic growth means a lower return on capital and thus a lower cost of capital i.e. lower interest rates). If economic growth is going to be lower, real returns from equities will also very likely to be lower. Lower lower lower.
So, it is not out of the question that the expected real return on a 50/50 bond/equity balanced fund will be much lower going forward.
What could you do to improve your investment returns?
First, do not hold any developed market government bonds. This will make you feel very uncomfortable, as government bonds are generally considered the bedrock of any in-retirement savings pot. The way to overcome this discomfort is to change the way you think about risk. Government bonds – at least those in the developed world - are considered low risk because their returns are generally very stable. But if real yields are low or negative, your real capital will likely be permanently eroded over time as mentioned above.
My suggestion would be to think of risk in terms of the scope to lose real capital rather than in terms of short-term price volatility. You will then be able to think of developed market government bonds as being high risk not low risk.
Second, with respect to equities, go active. There has been a huge move into passive funds in recent years but all this does is lock in returns from equities generally, which as mentioned previously are likely to be lower. Going active does not mean lots of activity. Quite the contrary in fact. Going active means targeting subsets of equity markets such as smaller companies or higher yielding stocks that have demonstrated in the past a propensity to perform well. It can also mean being selective - with some fairly rudimentary analysis one can construct a portfolio that consists of a small number of companies that can be held for the long term. There is no right number – holding too many companies means little scope to produce excess returns, too few means too much risk. It is about balance.
Again, you may not be comfortable with this approach. My suggestion would be as it was for bonds – change your definition of risk. Yes, smaller companies exhibit higher short term price volatility than bigger companies, but over the longer term they have in most if not all countries performed better. As for holding a smaller number of companies in your portfolio, understand that holding a large number of companies is only going to generate mediocre returns – that is effectively what passive funds do and thus what you should be seeking to avoid.
One can argue that in retirement one does not have the luxury of exposing oneself to high short term volatility. This is wrong, in my humble opinion. In the event that there is a sharp fall in equity markets in the early years, one should increase one’s equity exposure. This again would make you feel uncomfortable but the reality is that equity markets often have a remarkable predisposition to recover from sharp falls. You can then return the equity exposure to its previous level.
You’ll have noticed that there are lots of uncomfortable feelings attached to the recommended approach, but this I’m afraid may be the cost of a more comfortable retirement.
Of course, there are other things that can help improve investment returns, such as investing in REITs, other specialist investment trusts, or indeed other parts of the fixed income spectrum. But I believe the above two are the main ones.
If you don’t want to do this yourself, you needn’t fret – we have three funds that could do it for you. But then that’s what you expected me to say, isn’t it?
Published in Fidelity Funds Network
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.