How to survive an ultra-low interest rate environment
Just six days after the referendum result was announced, Bank of England governor Mark Carney suggested Brexit would force an interest rate cut this summer. The warning immediately scared investors into seeking a more secure home for their money than shares.
Cash poured into gilts – bonds issued by the UK government, which are considered a safe haven in times of trouble – pushing up their prices so that the yields on some actually became negative. Anyone who bought the March 2018 gilt the day after Mr Carney’s interest rate warning will actually lose money on their purchase if they keep the investment until it matures in 20 months’ time.
The Bank of England Monetary Policy Committee in July voted to leave the base rate - which is used by banks and building societies as a guide for settingtheir own savings and mortgage interest rates - unchanged. But economists expect a cut in August and for the base rate to stay low for several years.
Howard Archer, chief European and UK economist for IHS Economics, expects the base rate to stay at this incredibly low level until 2020.
He says: “This reflects the fact that I think the UK economy is likely headed for stagnation and very possibly mild recession in the near term followed by very gradual recovery amid prolonged uncertainty.”
This is the last thing that most savers will want to hear. People who have been relying on savings interest to boost their income are currently earning a pitiful average of 1.02%, according to independent savings adviser Savingschampion.co.uk. That means someone with £100,000 saved in the bank or building society is doing well to be getting more than £1,000 annual savings income.
Savings rates are now likely to fall even lower. Sue Hannums, director of the website, says: “The past seven years have been horrendous for savers. The Bank of England base rate fell to record low levels and government schemes were launched to boast lending, both of which sent savings rates on a downward spiral that they have never recovered from.”
In the eight months before the launch of the government’s Funding for Lending scheme in August 2012, there were 22 cuts to the interest rates paid by savings accounts, according to figures collected by Savings Champion. Since then there have been a staggering 4,682 cuts (see Savings Champion chart, below).
Ms Hannums says: “Providers no longer need a reduction in the base rate to cut savings rates, as they did in the past, although any downward movement in the base rate is unlikely to pass by without a reaction from most, if not all, the banks and building societies,” she says.
Savings accounts – keep switching
The recent stock market turmoil means that for many people, despite the low interest rates on offer, cash remains king because of the security it appears to offer.
Rachel Springall of financial product comparison service Moneyfacts says speedy action could be vital to secure the best rates: “If providers are swamped with new money too quickly then the best buy deals could well be withdrawn from the market. Therefore, anyone looking to save may be wise to consider doing so while there are still some decent deals left to choose from.”
Ms Hannums says savers should also keep their money on the move to improve returns: “Switching if your rate becomes uncompetitive or when your bond matures is vital to stay in the very best rates possible. With rates at their current level, it’s never been more important to switch, as every little helps.”
One thing that should cause savers less trouble is finding an account that outstrips inflation, as the Consumer Prices Index (CPI) rate of inflation measured a very modest 0.3% rise in May (the latest figure available at the time of writing).
Starting with cash individual savings accounts (Isas), for those looking for a long-term deal to see them through the next five years, United Trust Bank pays 2.05% gross on sums from a minimum of £5,000, while Nationwide pays 2% gross on deposits from £1. Saga pays 1.8% gross on £1or more for three years for those aged 50 or more, while Shawbrook Bank pays 1.7% gross from a minimum of £5,000 regardless of the saver’s age.
Leeds Building Society meanwhile, pays 1.4% from a minimum of £100 for two years. All of these Isa accounts either refuse access or will deduct interest if savers need to withdraw money before the end of the fixed rate term.
If you have already used your cash Isa allowance, Raphaels Bank offers the highest paying five-year fixed-rate bond set at 2.35% with a minimum investment of £5,000. Vanquish Bank pays 2.16% gross for four years, while Chartered Savings Bank pays 1.91% gross and 1.79% gross for two years and one year, respectively. None of the fixed-rate bonds allow savers to access their capital during the fixed- rate period.
These rates were correct on 8 July, but remember with the base-rate being cut, bank and building society savings rates are likely to change rapidly. Visit our best cash Isa rates page for the latest rates.
Retirement income worries
Prospects for those who are approaching retirement and intend to buy an annuity to provide pension income are also now very worrying.
Annuity rates, which are based on gilt yields at the point of purchase of the annuity contract, are set for the entire remaining life of the purchaser. So someone who has to buy their annuity in the next few months or even years, will being buying into an unescapably low income that will not improve even if the economy picks up.
Annuity rates have already fallen, with retirees aged 65 now being offered worse levels of pension income than those aged 60 just six months ago.
Tom McPhail, pension expert at investment broker Hargreaves Lansdown, says: “We’re into uncharted territory now, so it is hard to predict whether annuity rates have further to fall or how much lower they might go.”
As we seem to be saddled with ultra-low savings rates for the foreseeable future, cautious savers and investors may have to manage their money with extra care and even take on extra risk to keep returns at a survivable level.
(Click on the graph below to enlarge)
Pensioners should consider drawdown
A ‘comfortable’ retirement for the average person in the UK requires an annual income of £27,000, according to insurer MGM Advantage.
To generate that kind of income from an annuity, eight years ago a 65-year-old would have needed a pension fund of £343,949. But now, they would need £552,373, and the amount being quoted by annuity companies is increasing daily. Hargreaves Lansdown’s Tom McPhail says: “Annuity quotes are typically guaranteed for two to four weeks, so investors who [already have an annuity quote and] are worried about a further drop in rates should get their skates on.”
You should, as always, shop around different annuity providers to make sure you get the best deal – do not just accept the quote supplied by your pension provider. If you suffer from any medical condition that could have an impact on how long you expect to live, check whether you are eligible for the higher income paid by an ‘enhanced’ annuity.
Even then, the low amounts of income on offer may encourage some investors who are risk averse to consider putting their pension into ‘drawdown’, leaving the pension money invested and drawing an income directly from the pension pot, rather than buying a guaranteed annuity.
Martin Bamford, a chartered financial planner with independent financial adviser Informed Choice, says: “Low interest rates have a big impact on retirement planning, as they mean lower yields across all types of investments. If you are tempted away from the security of an annuity income to the flexibility of income drawdown, making your pension pot last for the rest of your life is an important consideration. Cautious investors using income drawdown should consider keeping a healthy cash reserve, so they are not forced to sell investment units when markets have fallen.”
He suggests that investors keep enough of their fund invested in cash to cover three years’ worth of planned withdrawals. “This is usually long enough to avoid being forced into selling investment units when the markets have dipped, but not so much that it acts as a significant drag on long-term returns,” he says.
Mr Bamford says the rest of the pension pot can then be invested in a diversified portfolio of equities, bonds and property with the aim of capital growth over the longer term. “It is important to review income levels and investment performance at least annually, adjusting the portfolio composition and withdrawal rates accordingly,” he adds. “A realistic withdrawal rate is probably 2.5% to 3%, if you want to reduce the risk of your pension pot running out before the end of your life.”
Mr McPhail points out that eight years ago people also felt that annuities offered poor value of money: “Who’s to say that in five years’ time, today’s rates won’t look like a bargain?” He suggests that investors hedge their bets by splitting their pension fund, allocating some of it to an annuity and keeping some in drawdown.
He adds that it is imperative for investors to build inflation-proofing into their pension arrangements: “Given the fall in sterling in the past couple of weeks, it may not be possible to avoid inflation creeping back into the economy over the months and years ahead. If you invest in a portfolio of funds or shares with prospects of dividend growth and only draw the natural yield on your investments, then you should enjoy income growth over time.” [Drawing the natural yield means taking the annual dividend payouts in the case of shares, or the coupon payments from bonds, but leaving the capital untouched.]
Investing for a higher income
Maike Currie, investment director for personal investing at Fidelity International, says savers may have to move out of their comfort zone to generate the income they need. “To stand a chance of generating a real return, you may need to move money further up the risk spectrum, investing in slightly riskier bonds issued by companies rather than governments, or consider moving into equities,” she says.
Cautious investors who previously would not have considered investing in stock market-based funds may find that they no longer have any choice, adds Mark Dampier, investment expert with Hargreaves Lansdown. He cites his 91-year-old mother, Christine, as an example of why cash savings will no longer provide the income necessary for many people to survive, let alone have a good standard of living.
“My mum is about to sell her home to buy and move to a bungalow in a sheltered accommodation development much closer to me and my brother,” he says. “This will leave her with about £400,000 to invest, but she will need additional services, which I think will cost between £500 and £1,000 a month. There is no way we can generate the money needed if we put the proceeds from her home into savings, so I am thinking of an income and capital fund which is generating about 4%. That will produce £16,000 a year – enough to meet her needs, plus some.”
But Mr Dampier is upbeat about the prospects for shares over the next four to five years. “I don’t know where else people will get their income from,” he says.
He recommends reducing risk by investing in a wide spread of shares through unit trusts, open ended investment companies (OEICs) and investment trusts, rather than trying to select individual shares. “Dividends can be cut on individual shares, but I’ve never known a fund go from offering a 5% yield to nothing,” he says.
Income investment suggestions
Mr Dampier says the Marlborough Multi Cap Income and JO Hambro Equity Income funds both yield more than 5%, and the JO Hambro fund has grown dividends by around 10% a year over the last few years. He suggests dovetailing these funds with the CF Woodford Income and Artemis Income funds.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).