Some of us get a thrill out of taking a risk, perhaps enjoying occasional gambling. But still, most of us would rather reduce risk around the important things in our lives.
It’s somewhat of a truism that there’s no reward without risk. However most of us don’t find it natural to embrace this concept, especially when it comes to our retirement plans. With the gradual demise of gold-plated final-salary pensions, most of us have will need to live off our accumulated savings, using a drawdown strategy. There are a number of popular ideas for getting around the risk/reward problems of drawdown.
Avoiding risk by living off ‘natural’ income
Why not invest our savings into high-income blue-chip shares? We’d only ever touch the dividend income, and let the capital grow. This way, don’t we get the best of both worlds? Even if the share price tanks, couldn’t we still live off the income? And if the share price rises, which is hopefully more likely, we can pass it on to our heirs. Haven’t we reduced risk?
The main flaw in this reasoning is that one of the main causes of a company’s share price fall is often that its earnings prospects have reduced. So in a share price crash, we’d probably see our dividend income drop too. If a company were to keep its dividends artificially high when profits were falling, it could eventually hit severe cash flow problems. So it seems we haven’t eliminated the risk.
Another possible flaw is that the income-only return from a share portfolio is likely to be quite low. This means you’d need a lot of savings to generate quite modest income.
Then there are tax considerations. By only living off income, you’ll be liable to income tax. On the other hand, if you invest in growth shares, and sell part of your portfolio to live off, then you’ll be liable to capital gains tax, which may well work out considerably less.
Finally, some of the most innovative and disruptive companies will have very low income in their growth phases. By restricting investment exclusively to blue chips, you’ll never ride the next great wave.
So ‘natural’ income from shares is not a panacea.
Safety in bricks and mortar
Most of us want to own our home. But many see property as a better investment than the stockmarket. Property prices have risen dramatically over the last few decades. Even if property prices were to crash, we’d still have our bricks and mortar; with shares in a company, you can lose everything if the company goes bust.
When you own property, you have legal responsibility for it. With shares, you have so-called ‘limited liability’, and you delegate nearly all responsibilities to the directors. Property investment is only for people who are willing to invest time as well as money.
Property is not immune to risk. Like all investments, prices (and rental income) can fall as well as rise. Also, unlike shares, property has low liquidity, meaning that you can’t sell it quickly.
If you have enough savings, property may well be attractive as part of a balanced portfolio, as long as you’re willing to invest your time too.
Bonds with guaranteed income
Bonds are traditionally seen as a half-way risk between shares and cash. The idea of a bond is really simple. You lend a lump sum to an organisation, which agrees to pay you regular fixed interest, and to repay the original loan after a stated number of years. If you need your money back early, you can sell the bond to a third party; they then receive the interest payments and the loan repayment.
Where’s the risk? The risk is that market interest rates may rise while you hold the bond. That would mean that you could have invested for higher interest, if only you still had the cash. That might not matter so much, as you still receive your interest income. However if you need your money back early, the sale price for your bond would be less than the original investment. This compensates the buyer for receiving an interest rate that’s lower than market rates.
On the other hand, if interest rates were to fall, you’d be able to sell your bond for a higher price than your original investment. However in the current economy, very few people expect interest rates to fall further.
Bonds face an additional risk. What if the organisation that issued the bond can’t afford to pay either the interest or the principal? If the lender is the UK government, there’s very little chance of that. For bonds issued by companies, the risk will be higher, but so will the return.
It makes sense to view bonds as a means to generate reliable intermediate-term income, rather than as a long term solution with no risk.
Eliminating drawdown risk with annuities
Actually, there’s a way of getting the same type of income as someone with a gold-plated pension. Such a pension is really nothing more than an annuity. You can buy an annuity with your own savings.
A final salary pension typically rises each year in line with inflation. To buy an index-linked annuity with your own savings works out very expensive. You can get a much higher income if your annuity doesn’t keep pace with inflation. But then you run the risk of not being able to afford your spending in the future as prices rise. You can also buy an annuity that rises buy a fixed amount each year. Provided you guess average inflation correctly, then this can be the most cost-effective type of annuity.
Apart from a few limited safeguards, once you’ve bought your annuity, your savings are gone, and can’t be inherited.
Annuities also have a similar risk to bonds in that they depends on the provider, typically an insurance company, remaining solvent. Insurance company failures are rare, but not unheard of.
Over-caution is a risk
When faced with all these risks, many people are tempted just to hold cash. By spreading your cash among multiple financial institutions, you can benefit from the government guarantee. This mitigates against the risk of a bank defaulting. But interest rates are pitifully low at the moment. Even under more normal conditions, savings rates don’t keep pace with inflation, on average. This means that the value of cash declines over time. You’ll also need to make regular withdrawals to cover ever-increasing expenditure. It’s easy to see that you’d need a vast amount of cash to be safe from running out of money.
Combining cash with government bonds may generate slightly better returns. However a policy of eliminating all short-term risk from a portfolio will damage its prospects for long-term returns. In other words, to reduce long-term risk, it’s sometimes necessary to increase short-term risk.
This can be a tough fact to swallow for the risk-averse. There are only two possible remedies if you’re one of these:
- Increase your risk tolerance by learning about how risk impacts financial markets.
- Limit your expenditure in line with your risk aversion.
If you’re more risk-tolerant, then you still need to understand how your level of risk-tolerance impacts your ability to spend.
The EvolveMyRetirement® intelligent financial calculator is designed to help you discover how much investment risk you should be taking, whether annuities are right for you, and how much you can afford to spend sustainably.