In an era of low returns, many retirees are questioning the value of cash investments. Jon Kalkman of the Australian Investors Association (AIA) considers the options.
Retirees are traditionally very attached to holding their retirement savings in cash. The reasons are simple. The value of a cash holding does not fluctuate with market prices, it is government guaranteed up to $250,000 per account * and there is no risk of loss.
Bonds are similarly attractive for retires because they have a guaranteed income payment like interest, called a coupon. If held to maturity, the risk of the bond not returning your capital depends on the creditworthiness of the issuer. With government bonds there is low risk because governments can always levy more taxes to repay bondholders, but government bonds also have the lowest yield.
This demonstrates that risk and return are directly linked; it is difficult to achieve high returns with low risk. If sold before maturity, the bond price is set by the market and depends on many variables.
Accordingly, the change in market price provides scope for capital gains and losses. Traditionally, many retirees have been encouraged to invest their savings conservatively in cash and bonds to ensure they do not risk their capital. People who invest aggressively in growth assets, such as shares or property, must accept the risk of volatile market prices and the risk that the asset’s sale price will be lower than its purchase price. In accepting this risk, these investors have been rewarded, at least in the long term, with higher returns.
The problem for today’s retirees is that we no longer live in a traditional world. Central banks have pushed interest rates very low to zero or below, in an attempt to stimulate economies smashed by the GFC. In the process savers including retirees have been squeezed. In 2007, a term deposit of $800,000 would have generated about $64,000 per year in interest, or eight per cent. Today that same term deposit will generate about $24,000, or three per cent.
At the same time, the Australian Government has made it more difficult for retirees. Rather than using actual income to determine eligibility for the Age Pension it uses “deemed” income. Any investment, including superannuation, is deemed to be earning a level of income whether it does so or not. Income in excess of the deeming rate it is not counted and that is a bonus to you. If your investment earns less, your pension is calculated as earning the deeming rate even though you don’t receive it. Using the present deeming rate, a term deposit of $800,000 is deemed to earn $24,791, which is higher than the $24,000 from our term deposit above.
It gets worse. Assume a retired couple own their family home and hold $800,000 in a term deposit – their only other asset. At present they receive a part Age Pension of $567.15 per fortnight, or $14,750 per annum, in addition to the interest on their term deposit, which at three per cent is $24,000. This gives them a modest retirement income of $38,750 pa. Changes to the Age Pension assets test that take effect from 1 January 2017, mean that this couple will have their Age Pension reduced to $47.40 per fortnight, or $1,234.40 pa. From this date the couple will see their income fall by more than $13,500 pa. Compare their situation with the couple whose assets are below the test threshold.
From 1 January 2017 they can hold $375,000 and still receive the full Age Pension, plus whatever income their assets can earn. The search for yield is now a global phenomenon. This has led many to consider shares as a source of income. This is not a recommendation, but consider Telstra shares. At present they cost about $5.10 each (depending on the day of purchase).
The dividend in 2015-16, which is the shareholder’s share of the profits, was 31 cents per share. That is a yield of six per cent. Under Australia’s unique imputation system, Australian dividends have a tax credit for the company tax already paid. That tax credit can be used to pay other income tax and any unused credits are refunded as cash. Many retirees pay little or no tax because they hold their investments inside a superannuation fund or they benefit from the Senior Australian and Pensioners Tax Offset (SAPTO). That means they can benefit from the cash refund of these tax credits. In that case, the Telstra dividend represents a yield of about 8.6 per cent. This compares very favourably with both a term deposit rate and the deeming rate.
The global search for yield has driven some share prices to unsustainable heights and when interest rates return to normal, the attractiveness of these shares and their market prices will likely fall. Considerable care and advice is needed in selecting suitable shares for income.
Retiree’s discomfort with shares stems from market volatility. The media’s hysterical fascination with falling prices doesn’t help. Remember market volatility relates to an uncertain sale price. If you are prepared to hold a share for the long-term for income, as you would a bond, the sale price may be less relevant.
Low interest rates mean that retirees need to accept more risk. How much, depends on your individual appetite for such risk. One thing is certain; dependence upon income from cash will erode your capital very quickly, because the income will not even keep pace with inflation.
In summary, retirees may find it helpful to remember:
- Depending on term deposits for income in retirement is very expensive. With a return of three per cent, your capital needs to be 33 times your annual income if you want to live on the income and not eat your capital – and that ignores tax and inflation.
- Bonds are similarly expensive but they have the added risk that their market prices are likely to fall if interest rates rise.
- Some shares provide a viable alternative for income but you must be prepared to tolerate the market volatility of prices. The unsavoury choice is between accepting some market risk or longevity risk – the risk that you outlive your money.
* per person per Authorised Deposit-taking Institution
Jon Kalkman trained as a teacher before qualifying as a psychologist. He has held various positions in schools, including spending 10 years as principal of special schools, and has also worked within the Department of Education. Jon joined the Australian Investors Association (AIA) in 2005. He is currently Vice President of the AIA and Chair of the Brisbane Committee. This is not investment advice. The views of the author may not represent the views of the AIA Board or members.