By Mica Townsend
With so much news about cuts in the repo rate throughout 2020, South Africa has a ‘new normal’ - it’s one in which we have the lowest interest rates in many years. Driven by government’s concerns regarding the need to stimulate the economy, the cut in interest rates has been hugely positive for people wanting to borrow, such as those keen to get into the property market - in particular, first-time home buyers.
But, the other side of the coin is the impact that these cuts are having on savers, especially on the retired community, many of whom choose to keep large sums of retirement capital in interest-earning cash investments.
The main risk of funding your retirement with cash savings is not lower interest rates.
Most pensioners who live off interest from savings have had their incomes dramatically reduced by the interest rate cuts of the last few months, but this is not the only – or even the worst – risk they face.
When the investment market melted down in March, those invested mainly in the money markets might have felt relieved to see their capital remain intact. That relief would have been short-lived, though.
The Repo Rate, the rate at which the central bank lends money to commercial banks, has been cut by a total of 3% this year, which means that commercially available interest rates have almost halved since January.
Pensioners who are living off interest on their savings are now, like many other South Africans, feeling a lot poorer. They have seen their income shrink month on month without a likely commensurate decline in their living expenses.
They aren’t really poorer, though – at least not yet. These words may provide little comfort but, on the basis of the official inflation numbers, they are barely worse off than they were six months ago.
This is best illustrated by an example. Let’s assume a pensioner has cash savings of R1 million and that year-on-year CPI inflation is running at 4,6% (as it was at the end of February). They earn interest at 7% p.a., paid monthly into their current account, which they use to cover their living expenses. A year later, they would still have R1 million and perhaps imagine that their capital had been preserved. However, because of inflation, the purchasing power of that R1 million has diminished. The cost of living has risen and, with inflation at 4.5%, the R1 million is worth only R956 000 in terms of what it can buy.
In the current situation they would be earning, say, only 4% interest. If they spend the same as before, they would eat into their R1 million capital, leaving just R969 000 at the end of the year. With inflation running at 2,1%, the purchasing power of that money would have diminished to R950 000.
Therefore, practically, these pensioners are hardly worse off than before: a negligible 0,6% change, as the lower interest income is mostly offset by corresponding lower inflation.
Still, our example underlines the fallacy of this approach. Living off interest income may create the illusion that the underlying capital is being preserved but, in truth, the purchasing power of that money is being steadily eroded..
Cash is considered a low-risk investment because it provides an almost certain return over the contract period. However, that return is also typically quite low. Savers are usually only compensated for inflation, plus a little bit extra, say 1.5-2.5%.
The slight loss in wealth in our example above reflects the narrowing of that ‘little bit extra’, otherwise known as the real or after-inflation return. In our example, it has contracted from 2,4% to 1,9%. This presents the bigger risk in the long-term. Earning a lower real interest rate over a number of years without a cut in spending uses up savings quicker.
Additionally, pensioners may find that their expenses have a higher inflation rate, accelerating that depletion.
Indeed, the real issue facing these savers is not the current decline in interest rates, but the prospect that inflation starts to increase again, while the Reserve Bank is unable to raise interest rates because our economic circumstances don’t allow it. The real risk is that pensioners face the threat of outliving their savings.
Although every household should have an emergency cash reserve to see them through difficult periods like this one, cash is not the ‘safe’ option for investors with a long-term perspective. This includes retirees, who, depending on their age, might still have an investment time horizon of a couple of decades or more.
Cash leaves them fully exposed to the negative consequences of declining real interest rates. Diversifying into other asset classes would hedge them against this risk
Furthermore, cash typically delivers lower long-term returns than other asset classes. Relying on cash alone, therefore, increases the risk that retirees suffer a drop in lifestyle in the future.
Although it may make their portfolio’s performance more volatile over shorter periods, diversifying across asset classes should better protect them from inflation and concentration risk, ultimately making their savings last longer.
Such diversification is easily achieved by investing in a low-cost balanced multi-asset fund, which can also facilitate automatic monthly income pay-outs.
Even if they opted for a low equity fund, they would still have earned some 2% more p.a. than from the money markets over the last 10 years and would now have 24% more money. Not to mention the peace of mind, knowing that all their eggs were not in one basket.
Mica Townsend is Business Development Manager at 10X Investments
PERSONAL FINANCE