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Valuing Your Future
Ian McKeever & Co Consulting Actuaries
Market Views
Markets
Markets
Why should the government have to rescue banks?
The banking Crisis
The banking Crisis
Economic Views
The Economic Outlook
The Economic Outlook
Professional
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Issued by Ian McKeever & Co. Authorised and regulated by the Financial Services Authority in the conduct of investment business
What Government Borrowing means for you
What it means
What it means
Risk 2
Other Options and Risks
Clearly our theoretical pensioner had the opption of buying an annuity either level or with fixed escalation. He could have an index linked pension. This increases his income and may provide inflation protection. There is in some ways for him not capital risk because idf he does this he forfeits all right to his capital. In other words 100% capital loss is certain but he has income protection.
Clearly an annuity ids a bead investment if he killed the next day in an accident but this may be an acceptable. After all the fact that there is no money in his estate does not affect his standard of living because he is dead. Income risks have been eliminated apart from the risk that the insurer will fail and even then he is guaranteed to get 90% of the promised income.
Dependants also have certainty as to what the investment will provide them with and that what they get; nothing.
This is another aspect of risk that is worth pointing out and that is that a certainty of nothing is still a certainty and it can be planned for, at least in a portfolio. In the above example the grandchildren are not planning their lives on the basis that they will get some money when granddad dies.
In reality everyone takes some risk. This maybe to achieve a higher return. Even if they are not doing that, they are trading capital security for income risk or visa-versa. Either way it is worth identifying what your risks are and what your minimum risk investment is.
When looking at risk you should be aware that there is income risk and capital risk. Most importantly you need to know that you cannot protect against both.
Inflation is another risk. It may be high as in the 1970s, but it worth remembering that inflation can be negative and prices can fall. If prices actually fall that means that the real value of money itself rises. It happened between the two World Wars in the last century and it will happen again. Some leading economists fear that deflation (falling prices) is an immediate prospect. Although in my own view the risk resurgent inflation is the greater risk it is worth remembering that unlike death and taxes, inflation is not certain.
Real People
Most people think that they are most like the young man and are very concerned about capital security but regard the interest on their money as little more than the icing on the cake.
The reality is somewhat different. Most people spend the first half of their working life paying off student loans, saving for a house, paying off the mortgage and paying for the kids. Saving, in so far as it is done, is in order to provide some kind of security and keep the family afloat.
It is in the second half of someone’s working life that serious saving and investing becomes possible. By then they have reached the stage where they are saving for retirement. That needs to be rephrased; they are saving to provide themselves with an income in retirement. At retirement they will have to either buy an annuity or provide themselves with annuity like benefits. Roughly half of those annuity benefits will be dependent on income yields and half on capital value. Even though income generation is not critical until retirement actually happens, the ability of the fund to generate income at retirement is. This will be a function of both the capital value of the fund and interest rates at the time
Many comments on the pensions miss-selling scandal show this confusion about the nature of risk. Many people transferred their preserved benefits out of pension schemes and suffered a reduction in their pension as a result. Much of the blame is placed on equity investment returns. However, equity returns have until recently not been that bad. Not as good as was being projected, but not too bad. What has really caused most of the pain was the fall in Gilt yields. If Gilt yields had remained at 10%, most people would have suffered a small shortfall over what they could have expected from their old pension scheme but nothing major. Some would still have been better off, despite the slightly disappointing equity returns. What has really hit them however is that Gilt yields fell from around 10% to around 5% and annuity rates reflected this.
It is also the fall in Gilt yields that has put many final salary pension schemes in financial difficulties.
For most people saving for retirement both kinds of risk are equally important. In the end their target is their own zero risk investment which is a Gilt maturing about 20 years after they retire. If the amount of that Gilt that can be purchased by their pension fund falls they are losing pension and it is the loss of pension that matters. Whether the loss arises because the market value of their investments has fallen or because the price of the Gilt stock has risen makes little difference at the end of the day.
For someone who is wealthier the preservation of capital for the next generation becomes a more important consideration. They can continue to enjoy their current lifestyle whatever happens to interest rates because there is little risk of their expenditure depleting their capital to zero. In that case capital preservation becomes the primary goal, even in retirement.
Cash as an Investment
People are frequently trapped into the idea that the minimum risk investment is cash. In most cases it isn’t. It is not appreciated that if you are saving for a pension and interest rates fall cash will actually be quite a high risk investment. For people providing for their retirement government debt or corporate debt is the low risk investment.
The other risk affecting cash and bonds or Gilts is inflation. Although interest rates are generally higher than the rate of inflation, taking the long view, tax commonly reduces the interest rate on deposit account or bonds to below the rate of inflation. Clearly this is a bigger problem for high rate taxpayers. Once again index linked securities protect against this but at a cost.
If you have a short-term target such as a major purchase or you want a cash float to deal with emergencies then cash is the obvious investment.
If you think the equity market is likely to have a bad time and the fixed interest market is going to have bad time as well because of weakening Sterling and weakening government finances, invest in cash deposits. It’s a high-risk strategy but if you are right the rewards should be very good indeed.
Cash is another asset class and has important uses in tactical asset allocation. However in most situations it is not low risk.
Cash as an Investment
People are frequently trapped into the idea that the minimum risk investment is cash. In most cases it isn’t. It is not appreciated that if you are saving for a pension and interest rates fall cash will actually be quite a high risk investment. For people providing for their retirement government debt or corporate debt is the low risk investment.
The other risk affecting cash and bonds or Gilts is inflation. Although interest rates are generally higher than the rate of inflation, taking the long view, tax commonly reduces the interest rate on deposit account or bonds to below the rate of inflation. Clearly this is a bigger problem for high rate taxpayers. Once again index linked securities protect against this but at a cost.
If you have a short-term target such as a major purchase or you want a cash float to deal with emergencies then cash is the obvious investment.
Clearly our theoretical pensioner had the opption of buying an annuity either level or with fixed escalation. He could have an index linked pension. This increases his income and may provide inflation protection. There is in some ways for him not capital risk because idf he does this he forfeits all right to his capital. In other words 100% capital loss is certain but he has income protection.
Clearly an annuity ids a bead investment if he killed the next day in an accident but this may be an acceptable. After all the fact that there is no money in his estate does not affect his standard of living because he is dead. Income risks have been eliminated apart from the risk that the insurer will fail and even then he is guaranteed to get 90% of the promised income.
Dependants also have certainty as to what the investment will provide them with and that what they get; nothing.
This is another aspect of risk that is worth pointing out and that is that a certainty of nothing is still a certainty and it can be planned for, at least in a portfolio. In the above example the grandchildren are not planning their lives on the basis that they will get some money when granddad dies.
In reality everyone takes some risk. This maybe to achieve a higher return. Even if they are not doing that, they are trading capital security for income risk or visa-versa. Either way it is worth identifying what your risks are and what your minimum risk investment is.
When looking at risk you should be aware that there is income risk and capital risk. Most importantly you need to know that you cannot protect against both.
Inflation is another risk. It may be high as in the 1970s, but it worth remembering that inflation can be negative and prices can fall. If prices actually fall that means that the real value of money itself rises. It happened between the two World Wars in the last century and it will happen again. Some leading economists fear that deflation (falling prices) is an immediate prospect. Although in my own view the risk resurgent inflation is the greater risk it is worth remembering that unlike death and taxes, inflation is not certain.
Real People
Most people think that they are most like the young man and are very concerned about capital security but regard the interest on their money as little more than the icing on the cake.
The reality is somewhat different. Most people spend the first half of their working life paying off student loans, saving for a house, paying off the mortgage and paying for the kids. Saving, in so far as it is done, is in order to provide some kind of security and keep the family afloat.
It is in the second half of someone’s working life that serious saving and investing becomes possible. By then they have reached the stage where they are saving for retirement. That needs to be rephrased; they are saving to provide themselves with an income in retirement. At retirement they will have to either buy an annuity or provide themselves with annuity like benefits. Roughly half of those annuity benefits will be dependent on income yields and half on capital value. Even though income generation is not critical until retirement actually happens, the ability of the fund to generate income at retirement is. This will be a function of both the capital value of the fund and interest rates at the time
Many comments on the pensions miss-selling scandal show this confusion about the nature of risk. Many people transferred their preserved benefits out of pension schemes and suffered a reduction in their pension as a result. Much of the blame is placed on equity investment returns. However, equity returns have until recently not been that bad. Not as good as was being projected, but not too bad. What has really caused most of the pain was the fall in Gilt yields. If Gilt yields had remained at 10%, most people would have suffered a small shortfall over what they could have expected from their old pension scheme but nothing major. Some would still have been better off, despite the slightly disappointing equity returns. What has really hit them however is that Gilt yields fell from around 10% to around 5% and annuity rates reflected this.
It is also the fall in Gilt yields that has put many final salary pension schemes in financial difficulties.
For most people saving for retirement both kinds of risk are equally important. In the end their target is their own zero risk investment which is a Gilt maturing about 20 years after they retire. If the amount of that Gilt that can be purchased by their pension fund falls they are losing pension and it is the loss of pension that matters. Whether the loss arises because the market value of their investments has fallen or because the price of the Gilt stock has risen makes little difference at the end of the day.
For someone who is wealthier the preservation of capital for the next generation becomes a more important consideration. They can continue to enjoy their current lifestyle whatever happens to interest rates because there is little risk of their expenditure depleting their capital to zero. In that case capital preservation becomes the primary goal, even in retirement.
Cash as an Investment
People are frequently trapped into the idea that the minimum risk investment is cash. In most cases it isn’t. It is not appreciated that if you are saving for a pension and interest rates fall cash will actually be quite a high risk investment. For people providing for their retirement government debt or corporate debt is the low risk investment.
The other risk affecting cash and bonds or Gilts is inflation. Although interest rates are generally higher than the rate of inflation, taking the long view, tax commonly reduces the interest rate on deposit account or bonds to below the rate of inflation. Clearly this is a bigger problem for high rate taxpayers. Once again index linked securities protect against this but at a cost.
If you have a short-term target such as a major purchase or you want a cash float to deal with emergencies then cash is the obvious investment.
If you think the equity market is likely to have a bad time and the fixed interest market is going to have bad time as well because of weakening Sterling and weakening government finances, invest in cash deposits. It’s a high-risk strategy but if you are right the rewards should be very good indeed.
Cash is another asset class and has important uses in tactical asset allocation. However in most situations it is not low risk.
Cash as an Investment
People are frequently trapped into the idea that the minimum risk investment is cash. In most cases it isn’t. It is not appreciated that if you are saving for a pension and interest rates fall cash will actually be quite a high risk investment. For people providing for their retirement government debt or corporate debt is the low risk investment.
The other risk affecting cash and bonds or Gilts is inflation. Although interest rates are generally higher than the rate of inflation, taking the long view, tax commonly reduces the interest rate on deposit account or bonds to below the rate of inflation. Clearly this is a bigger problem for high rate taxpayers. Once again index linked securities protect against this but at a cost.
If you have a short-term target such as a major purchase or you want a cash float to deal with emergencies then cash is the obvious investment.
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