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What will zero interest rates do to the ‘lucky generation’?

By Gofran Chowdhury

Interest rates are going towards zero and leaving people with a massive gap in the income they expected from their savings to live.

 

Interest rates are going towards zero and what worries me is the impact it will have on those in retirement or approaching it.

Most of these people are ‘baby boomers’ and often labelled the ‘lucky generation’, as for most of their careers as wage earners they had solid economic and wage growth and relatively high interest rates to help generate wealth in a steadily climbing share market . They range in age from 55 to 73 years of age.

There were blips along the way like the 1989 ‘Black Monday’ share market crash and the recession it precipitated in the early 1990’s, when unemployment went to 10.3 per cent. And certainly those holding a mortgage in 1989 and paying 17 per cent on their mortgage repayments would have felt hard done by.

But they have also enjoyed unparalleled periods of sustained growth in two key investment classes, property and shares.

The global financial crisis of 2007-08 changed everything. It precipitated the end of ‘easy money’, led to massive intervention by governments in markets and regulation and a sustained period of weak economic growth that subdued wage rises, inflation and share and property markets and put us on the path to zero interest rates.

 

Of course not everyone suffers from low interest rates, at least on the surface. Those with mortgages are the obvious beneficiaries as their payments reduce, as are those able to use debt efficiently like leveraged investors, as long as they make smart investments.

From the Reserve Bank of Australia’s viewpoint lower interest rates help stimulate the economy by encouraging businesses to use cheap debt to expand, which in turn increases employment. Workers also are under less pressure to meet debt repayments and have more cash in hand to spend and simulate the economy.

Unfortunately its not working as well as we could expect due to the current environment where people are still concerned about job security and remain focused on reducing household debt, so they are not spending. Businesses are also not taking advantage of low cost debt to expand as business confidence remains low.

Savers also suffer and in particular those in or near retirement.

If they aspired to be self-funded they likely made decisions about the wealth they needed to acquire some years back when the investment environment was more conducive to accumulation. About three quarters of self funded retirees own their home, so that helps.

However, there is a good chance they are going to live longer than what they might have considered likely a couple of decades ago. So their investments probably have to stretch out longer then expected and that reduces the desire to draw down on principal savings to meet any shortfalls or take advantage of additional lifestyle opportunities.

 

Their children and grandchildren are also now in an environment where growing their savings is difficult, so there may be a greater desire to help but less capacity.

Any decisions they make will likely be taken knowing there will be no government assistance available if they have to lower their lifestyle expectations.

The hurdle for receiving even a part pension is quite high. Following Government changes to pension entitlements in 2017 benefits like the Age Pension caps out at $860,000 for couples that own a home. The cap is only slightly higher if you don’t own a home.

Ensuring people in or heading into retirement have every opportunity to be self-funded is an important element in ensuring an undue burden isn’t placed on the government’s coffers. If interest rates, as expected, stay lower for longer, its also important the government’s financial strength remains robust to allow it to provide stimulus where needed to encourage growth.

Currently 3.7million Australians are above the age of 65, according to stats from the Australian Institute of Health and Welfare. This number is forecast to grow to 8.7 million by 2056.

As people grow older conventional wisdom dictates an increased holding in ‘defensive assets’, as people’s ability to come back from a significant fall in an asset class is reduced. Financial planners typically suggest holding 20-30 per cent in cash. Australian Tax Office statistics show that around 25 per cent of all self-managed-super-funds (SMSF) are in cash and term deposit.

Source: Australian Taxation Office

If people stick to that historical advice it will be a significant drag on people’s income capability if term deposit rates stay at current levels or fall further.

What is worrying is in every jurisdiction where interest rates have gone below 1 per cent, it remains there for an extended period. We have already seen this in countries with demographics similar to Australia, including Japan, Switzerland, Europe and the US.

The European Union has had zero interest rates since 2011, in Switzerland zero interest rates have been a norm since 2008 while Japan has been close to zero rates for two decades. In the US interest rates have remained close to zero for almost a decade.

The lesson we have learnt from historically low rates is it’s hard to raise again as it means a central bank wants to slow down an economy following a period of hardship. This is hard work as one wrong move can mean a spike in unemployment. It’s usually an unpopular decision allowing for political grandstanding and consumers tend to spend less as they have to put aside more to service debt.

Imagine the impact on retirees if interest rates remain close to zero per cent for decades! In Japan we saw retirees working longer to supplement their retirement or defer retirement. In the US and Europe we saw major banks struggling to achieve growth. Our “lucky generation” holds a big part of their wealth in Australia’s ‘big 4 banks’ for dividend yield. A recent SMSF study released by COMMSEC shows most SMSFs hold a big chunk of their wealth in the ‘big 4 banks’.

Source: Switzer Daily

The question arises, will they will remain “lucky” if banks struggle to maintain growth in a low interest rate environment like their American and European cousins?

In Australia, we have recently heard horror stories of investors trying to make money by day trading! What worries us also is the rise of subprime mortgage funds paying guaranteed returns of 6-plus per cent. If the RBA chooses to cut rates to zero or keeps rate low it’s a sign that the economy is not doing well and potentially we are in recession. In that environment subprime mortgage funds are high risk.

So what can you do? Well for starters, seek investments that perform well when interest rates go down. The longer you wait to act the harder it will be to find decent returns if rates go lower.

Bonds and property tend to perform well in this environment as you lock in your income yield based on current market conditions. At Citi, we have also seen investors move into non-directional investment. In these types of structured solutions you do not hold a view on the direction of the market but focus on managing risk.

These investments tend to perform even if the market goes up or down within a 20 per cent range. With the ASX around record highs it may be a good time to look at investments which are resilient in a potential downturn.

Holding a number of uncorrelated assets remains a priority for client portfolios as this reduces overall portfolio volatility as well as improving long term returns when compared to holding a single asset class.

This includes holding equity linked investments, bonds and US dollar assets.

Failure to act may mean the only alternative is to go back to work or defer retirement.

Gofran is Citi's Head of Investment Specialists

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