Imagine retirement. All you have to live on is the money you have tied up in your retirement provisi...
Imagine retirement. All you have to live on is the money you have tied up in your retirement provision - your pension fund and some other 'top-up' investments you made along the way.
Unfortunately, you have to buy an income with the bulk of the money at some point before age 75, however poor a deal that might be. The day after you retire, any purchased pension is likely to be significantly less than last year's salary. The rest of your money, therefore, has to fill that shortfall but at the same time you want to keep it safe. It is all you have.
Retirement planning has always been something of a dilemma. Today it may be the single most important aspect of financial planning. People approaching retirement have had a lifetime in which to save, so they should have more capital available. Their problems are immediate and their time horizons shorter.
The problem is also going to get worse. According to the Office of National Statistics, the proportion of the population aged over 60 is projected to grow to 30% over the next 30 years, increasing from 12 million to over 18 million.
It is clear the strain on resources caused by this will be significant, and it is likely the social security system will act as a safety net only for the least well-off members of society. Advances in healthcare and general living standards also mean that our retiring client can expect to live at least 20 years.
Despite the fact that inflation rates are historically very low, even assuming the Government's inflation target of 2.5% is maintained throughout the next 20 years, a non-escalating pension of £25,000 would be worth only £15,250 in today's terms at the end of that period, a fall of nearly 40%.
Who would be willing to bet against inflation rates being any higher over that 20 years? The long run inflation rate during the last 100 years is 6%pa, and even discounting the hyper-inflation of the mid-1970s, the figure is closer to 4% pa. Self-reliance will be the philosophy of the new century.
Unfortunately, many retirees made woefully inadequate provision for retirement. Even the very few fortunate enough to benefit from revenue maxima will see their earnings fall by a third. To boost that 'retirement salary', an investor would have had to make additional arrangements.
Consider someone lucky enough to have been a member of a non-contributory, final salary scheme for the past 44 years. Retiring this year on a pension of £25,000, to restore their pre-retirement earnings level they probably need additional income of around £12,500. The capital sum required to fund this depends on the discount rate used and the need to preserve capital. They would need more than £330,000 in a deposit account to generate that £12,500 through interest payments. Very few clients can accumulate such an additional lump sum.
How might an investor have accumulated that £330,000? Assuming their investment kept pace with the market's total return (approximately 12%pa) our retiree would have invested just over £11 per month in 1956, and increased their contributions by the rate of inflation each year until their final year's contributions were £162 per month. Few investors have been as diligent and disciplined. Today's investors will have to be.
The higher the income yield the lower the sum needed to generate it. There has always been a diverse range of options available, and the popularity of each has depended on the relative sophistication of the advisory market and on economic conditions.
In the 1970s it is likely an investor would have deposited the proceeds in a building society account. This was perceived as the safe thing to do but there was no profit in 9% income when shop prices rose by an average of more than 13% a year.
The runaway inflation also decimated fixed interest investments and yields rose to compensate investors. Some gilts were trading at more than 80% discount to their par value. To maintain purchasing power, the income generated had to rise accordingly. Equities were the only investment likely to do this, because companies were able to increase prices without losing sales. This translated into higher profits and hence dividends.
In the recession of 1990, the UK equity market fell back by 10%, its first full year's fall since 1976. By 1992 a new phenomenon was taking shape in the form of significant falls in inflation and interest rates. Fixed interest securities did not need to compensate investors as much and so yields fell and prices rose from a low base. The building society appeared less than viable. Between 1990 and 1994, base rates fell from 15% to 5.25%. Investors needed a lifebelt. They were to get it in the budget.
Before 1995, corporate bonds were little utilised by both IFAs and investors but the attraction of yields in excess of 7.5%, tax-free within a Pep was clear. As long as capital was preserved, investors would be happy.
These were funds that, at least initially, had no pretensions regarding capital growth. Volatility attributable to credit risk was limited where investment grade securities were held; interest rates were low and stayed low. Inflation fell to levels not seen since the early 1960s. The Government handed over responsibility for the setting of interest rates to the Bank of England in 1997, thus removing political risk from the equation, further forcing down yields.
Another development concerned the abolition of advance corporation tax and the reduction of the tax credit on dividends. Interest-paying funds maintained their 20% tax-credit but dividend distributing funds had that credit cut to 10%.
There are of course many types of corporate bonds carrying different risks and IFAs and their clients have become familiar with debentures, convertibles, supranationals and FRNs. In 1998 it was recognised that many sub-investment grade bonds, less susceptible to interest rate risk than their investm
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