Jonathan Howard discusses the role cash can play in retirement planning
The author and analyst Robert Prechter once wrote "There's nothing wrong with cash. It gives you time to think." Those who have been 'thinking' over the past twelve months are surely delighted they chose to do so, but is there more to investing in cash than just biding your time, and what role does cash play in retirement planning?
First things first, it is important to set the question into context. When discussing retirement planning, it is easy to assume we are thinking solely about investments within pension plans, but increasingly people are looking to alternatives such as ISAs or property to supplement their state pension. Regardless of the method used, we must assume that since we are considering retirement planning, the timeframe is consistent.
In the UK the average age at which a person joins their first pension scheme is 28. Given that the normal retirement date for most schemes/employers is 65, the typical investment window is some 37 years. The fundamental risk of investing in cash over a long period is inflation and as a result most pension investments are heavily weighted towards equities to maximise returns over the working life of the investor, and rightly so.
To illustrate the point, had you invested £100 back in 1900, by 2007 the 'real' annualised returns from an equity portfolio would have been 5.26%. The equivalent return from a gilt portfolio would have been 1.1% and from cash just 0.99%.
While we live in fairly benign inflationary times we also live in a period of unprecedentedly low interest rates, meaning that cash investments are being eroded proportionately as fast as they ever have been. In addition, low interest rates and increasing longevity have contrived to force annuity rates down, resulting in an increased dependence on 'real' returns from pension investments.
Few advisers, of course, would recommend a client invest solely in cash throughout their working life, but given current market volatility, what about temporary switches to cash? As I mentioned at the start of the article, some people will have been fortunate enough to switch to cash in the final months of 2007, and will be untroubled by the fact that more than £150bn has been wiped from the value of UK personal pension funds in the past year. The difficulty with this approach is deciding when to make the jump back to equities.
Successful market timing is notoriously difficult and relies on the investor's luck as much as skill. The months of October and November 2008 saw four of the 10 biggest one-day falls on the FTSE 100 index ever, while September, October and November saw six of the 10 biggest one-day rises. With that kind of volatility how could you accurately advise a client when to get back into the equity market? Plenty will say they are prepared to miss the first stages of the recovery to avoid the pain of a prolonged downturn, but it must be remembered that by the time it is evident that a downturn is under way significant losses will already have been suffered. Furthermore, most clients will not thank you for missing out on even a small part of the recovery, particularly if it is swift and pronounced.
Investing in cash does have its advantages though. As part of a well diversified portfolio, a holding in cash is a useful hedge against riskier investments, and the typical insured balanced managed UK pension fund has seen a three or four fold increase in the cash levels in the past 12 months.
It is also advantageous to invest larger proportions of retirement funds into cash in the run up to retirement when the investor loses the luxury of time. With automatic lifestyling now an integral part of the majority of pension schemes, most people will find themselves holding a quarter of their fund in cash by the time they vest their pensions, whether they are aware of it or not. For those retiring today, the lifestyling gamble will have paid off as equity investments gave way to bond/cash holdings over the past few years.
A recent article in one of the Sunday papers criticised the concept of lifestyling, stating that for people retiring five years hence, the process will automatically crystallise equity losses and give the investor limited opportunities to rebuild their funds. While this is no doubt true, lifestyling is not intended to be a solution for every investment scenario, but simply a sensible risk-reduction strategy for the apathetic majority.
Those retiring five years from now do face a difficult choice as to whether to stick with equities for another few years, or just allow the lifestyling strategy to kick in. The reward for the former could be significant, but so too will be the risk.
Defined benefit schemes generally have a different mandate to individual pension plans in that they don't have a single retirement date to plan towards and as a result can afford to maintain a higher equity content throughout the lifetime of the scheme. Their requirement for cash is therefore driven more by liquidity requirements, and I doubt there have been significant increases in cash levels over the past 12 months, especially since declining equity prices have pushed many back into deficit.
Cash certainly has an important role to play in retirement planning. It is useful for hedging risk and providing stability for those nearing retirement. However, it is dangerous to use cash as a safe-haven in times of equity market volatility where investors still have a reasonable investment horizon. Investors need to appreciate that markets will recover and they shouldn't be left waiting in the wings when they do. If the investor's objectives can be met by investing solely in cash then they are lucky indeed, but most need to take a little risk while still young enough to weather the storms.
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