Interest rates come with dangers
Do you remember when a six-month term deposit might earn you 8%? I searched back in time to find myself in 2007. That was thirteen years ago. Since then rates have been on a steady decline to arrive at below 2% in May 2020 for a 5-year term deposit at one of the main banks.
And yet many investors live with the expectation that low rates are an anomaly and that 8% will return. And yes, during a business cycle interest rates will move higher and lower. But a realistic expectation for higher is now closer to 3% or 4%. Which is why investment markets have the current mantra of “lower for longer”.
While we hold on to the expectation of the past reoccurring there is the danger that we ignore the realities of the present. Lower rates can hurt us as investors whether we are accumulating or in retirement.
Those accumulating for retirement will want to ensure they are not over-weight to income investments. To be aged 35 and in a conservative or balanced fund has a cost attached to it – the longer term return advantage that won’t be earned by investing into a higher allocation of property and share investments.
Low interest rates expose retirees to twin risks – that inflation will eat away the value of their income and capital and that they might outlive their funds through lack of return.
Inflation doesn’t have to be at the high levels of the 1970’s to be a problem. Even 2% can cause significant damage. Imagine you have $100,000 in the bank and decide to only spend the income each year. At 2% inflation $100,000 will only buy $81,707 of goods and services in 10 years time, even though it will still say $100,000 on your bank statement. In 20 years purchasing power will have decreased to $66,760. The interest income will also buy less and the investor may have to spend a greater portion of their capital thus accelerating the decrease in value. Low interest rates only increase the risks.
Will there be higher inflation? Many governments around the world now have significantly higher borrowing and deficits as they inject funds into their economies to offset the impacts of Covid-19 and try to keep their economics turning over. Loosening the reins on inflation to reduce the real value of the debt they have to repay is one possibility.
Ultimately inflation is a risk to be managed like any other. And its antidote is the same as that for extending the life of your retirement funds – don’t rely on terms deposits alone. Each of us needs to consider where the balance sits between our funds in the bank and likely low interest rates for some time to come and a more diversified approach which includes growth investments such as shares.
And yet many investors live with the expectation that low rates are an anomaly and that 8% will return. And yes, during a business cycle interest rates will move higher and lower. But a realistic expectation for higher is now closer to 3% or 4%. Which is why investment markets have the current mantra of “lower for longer”.
While we hold on to the expectation of the past reoccurring there is the danger that we ignore the realities of the present. Lower rates can hurt us as investors whether we are accumulating or in retirement.
Those accumulating for retirement will want to ensure they are not over-weight to income investments. To be aged 35 and in a conservative or balanced fund has a cost attached to it – the longer term return advantage that won’t be earned by investing into a higher allocation of property and share investments.
Low interest rates expose retirees to twin risks – that inflation will eat away the value of their income and capital and that they might outlive their funds through lack of return.
Inflation doesn’t have to be at the high levels of the 1970’s to be a problem. Even 2% can cause significant damage. Imagine you have $100,000 in the bank and decide to only spend the income each year. At 2% inflation $100,000 will only buy $81,707 of goods and services in 10 years time, even though it will still say $100,000 on your bank statement. In 20 years purchasing power will have decreased to $66,760. The interest income will also buy less and the investor may have to spend a greater portion of their capital thus accelerating the decrease in value. Low interest rates only increase the risks.
Will there be higher inflation? Many governments around the world now have significantly higher borrowing and deficits as they inject funds into their economies to offset the impacts of Covid-19 and try to keep their economics turning over. Loosening the reins on inflation to reduce the real value of the debt they have to repay is one possibility.
Ultimately inflation is a risk to be managed like any other. And its antidote is the same as that for extending the life of your retirement funds – don’t rely on terms deposits alone. Each of us needs to consider where the balance sits between our funds in the bank and likely low interest rates for some time to come and a more diversified approach which includes growth investments such as shares.
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Stephen McFarlane is an adviser with NZ Funds Private Wealth in Timaru. The opinions expressed in this column are his own. A copy of Stephen’s Disclosure Statements are available on request, free of charge.
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First published in the Timaru Courier on 9 July 2020, as 'Interest rates come with dangers.'
