Following my last two articles on the importance of compounding in driving long-term returns and helping us to save the considerable sums of money we will need to fund our retirement, I will finish with the third and final insight in this series.
We are going to fast forward to our retirement and the delightful prospect of being able to relax, finally have time to work in the garden, spend time on all those hobbies and travel the world after what looks set—for most of us—to be a relatively long working life. But have you really considered what your expectations and funding requirements will be for your retirement?
So just a few ground rules to begin with:
If you have been a non-smoker and were born in the 1960s, for example, then you should be planning on living another 30 years, which means living well into your 90s!
The average pension pot for a US citizen is circa USD 100,000¹; the average UK citizen has circa GBP 150,000; and in Germany it is all based on state-dominated pay-as-you-go systems with defined-benefit schemes from employers.
In the UK, a pensioner has to acquire an annuity (despite the recent UK budget changes) or is given a fixed return by the government in question, which of course shows the extent of pension financing, which is currently unfunded.
As you can see, not only will we be around for quite a while in retirement, but also most of us will have not secured sufficient pension savings, although many also own houses, which they may have to consider selling to meet their retirement needs—disappointing their children's inheritance hopes in the process!
But when it comes to planning an annuity and understanding the critical importance of choosing the correct asset class to invest in to provide sufficient capital and income in retirement, it is key for investors and those planning for retirement to understand the returns and risks or drawdowns which various asset classes can experience so that an appropriate allocation can be made.
Sovereign fixed income
Sovereign fixed income is often very advantageous in terms of taxation, as governments need to encourage holders of their bonds, either through regulation like Solvency II or through lower income or capital gains taxes. However, returns on many sovereigns are now so repressed that their income returns are very low; even holding 10-year bonds yields less than the prevailing rates of inflation, meaning that your wealth and purchasing power is falling in reality. Moreover, after a 30-year bull market and the closing of the aggressive QE² policies, sovereigns could see a further drawdown of another 15-25 per cent of capital if interest rates were to normalise 3 per cent higher.
Sounds like a place to park money for the short term, rather than a vehicle to use for meeting investment return goals during your retirement.
Credit and high-yield bonds
Credit and high-yield bonds offer more attractive spreads than sovereigns in many cases, and are often backed by stronger corporate balance sheets than those of their governments, but they too are higher risk, especially in the case of high yield. While offering investors an attractive higher return, they are vulnerable to the same rising interest rate risks and drawdown losses as sovereigns, mentioned above.
Sounds like a better place to invest during the financial repression days ahead.
Property may well look attractive as it can offer good rental and capital-gains opportunities, both of which can be beneficial to taxpayers, but it suffers from both void periods of rental as well as being immoveable, or illiquid with high transaction costs! Also property is quite lumpy as an investment, so that not all pensioners will have the wealth to diversify into this asset class in addition to owning their own home. But property has, in the UK and US, been a good inflation hedge over the longer-term. Whilst drawdowns have been rare in property, we obviously have seen serious losses in various real estate crises from the US, Ireland and Spain in the last five years.
Sounds like a good investment to live in, but not for one's retirement savings.
Equities, on the face of it, look attractive as they are liquid, capable of generating a good income and offer both inflation protection as well as the potential for continued capital growth. However, equities have seen up to 50 per cent drawdowns in the first 14 years of this millennium, which would clearly affect the perception of safety for those investing for their pensions. Yet, that is if they crystallise their losses. European markets lost 60 per cent in 2008-2009 and have so far regained 75 per cent of this loss in the last five years, but this is still a loss! They lost 55 per cent in 2000-03 but regained it all in the next four years—and US equities have exceeded their prior highs. Thus, whilst the drawdown risks remain severe, equities have the scope to regain and recuperate all these losses over time and offer real-world exposure to the growth and dynamism that is the world economy and its people.
Sounds like it might still fit the investment needs of a pensioner with a long time to garden, hobby and travel.
At the end of this three-part series on the importance of compounding, we can draw the following conclusions on saving, compounding and the importance of choosing the right asset class to help us achieve our long-term savings goals.
Financial repression, inflation and the erosion of investment returns
In the face of what remain very high levels of public and private debt in the Western world, Western governments will continue to practice financial repression, whereby interest rates are held below real inflation rates for years and effectively erode real rates of return on savings – "an invisible assassin" on long-term saving and returns.
Compounding is critical
As we illustrated in a real-life example, compounding, plus the selection of the most appropriate asset class, plays an absolutely critical part in helping people achieve their long-term savings goals to help fund their retirement. This occurs at a time when publicly funded pension schemes are under severe strain and individuals must increasingly take responsibility for funding their own retirement as opposed to relying on the state.
Take smart risk and think long term
Plan carefully; consider your long-term goals and funding needs and taking the appropriate level of risk by investing smartly in order to achieve inflation-beating long-term investment returns, making use of the various asset classes available and their ability to deliver both income and capital growth.