In the last year or two, cash and mainstream shares have produced better returns than other asset classes, and this has led many investors to ask “should I just give up on investments and stick my money in cash deposits?”. It’s a perfectly understandable reaction to recent market returns, and we think it’s worth examining.
For the figures used in this post, we’ve worked on the basis that no other investments would be available, so that we don’t get tempted into imagining that we have worked out how to time our entry into and exit from the investment markets. Many investment alchemists have tried to do this; they have all failed, and they always will (the reasons for this will make a good subject for another post, but let’s not get distracted).
The benefit of cash is its certainty of capital – you can, pretty much, always be certain that you will get your original capital back (Yes, it’s possible that a bank could fail and you could lose your money in exceptional circumstances, but let’s discount that possibility for the purposes of this post!). However, the amount of interest you receive will vary over time, and there won’t be any capital growth, unless you reinvest the interest.
The amount of interest you receive from cash has been correlated, in the longer term, to the rate of inflation in the UK. For the last 15 years, since the Global Financial Crisis, the rate has been a bit lower than the measures of inflation (Consumer Price Index and Retail Price Index), but prior to that, there was a significant period of more than ten years when it was higher than inflation. We can’t predict the future, so it seems reasonable to assume that the rate of interest payable on cash will continue to be a bit lower than inflation. This is an important assumption for retirement, as it means that, all else being equal, your outgoings will increase more quickly than your investment returns.
Most retirement plans, which rely upon mainstream investments, like shares, fixed interest stock and property, assume that investment returns will be higher than inflation, over the long run; this is a reasonable assumption, based on past experience.
So, our first conclusion would be that, if cash were the only investment allowed for retirement, you should expect to need more of it at the point of retirement, in order to fund your expenditure for the rest of your life, than you would need in a conventional portfolio. This means that you would either have to accept a later retirement or save more during your working life (which would mean that your standard of living, pre-retirement, would be lower, as you would be able to spend less of your income).
Having said this, the cost of managing a portfolio of cash should be lower than the cost of managing a portfolio of investments. For example, you don’t pay charges for a cash ISA, whereas you do pay charges for an investment ISA (usually, a platform/administration charge, fund management charges, and advice charges). If you were to invest in a pension which was simply made up of cash deposits (yes, this is allowed!), you would still have to pay a platform/administration charge for the pension. It is unlikely that you would be able to advise yourself throughout retirement, partly because decisions about investments are only one of the many, complicated decisions you will need to make when planning your retirement (you will still need to make assumptions about how your expenditure will change throughout retirement, how long you and your partner expect to live, to what extent you are happy to “front load” your spending, how tax rates and allowances will change, legacy goals, amongst others), and you’ll need a plan for your own cognitive decline. So, you should expect to pay some charges for advice throughout your retirement. It’s fair to conclude that you might reduce charges by investing solely in cash deposits, but it’s very unlikely that you will pay no charges at all.
We have stress-tested a cash based retirement plan (using the Timeline software, which is designed for this and which uses data for investments and inflation going back to 1915), and compared it to a more conventional approach, taking account of past returns and inflation rates, and the potential reduction in charges. Our conclusion is that a typical client of Sussex Retirement Planning (1) might need to have saved twice the amount, by the time they retire if they only hold cash on deposit, as opposed to holding a conventional investment portfolio (2).
One of the issues we would need to consider with a cash based approach is the lack of diversification. This lack of diversification increases the risks associated with any portfolio. Putting all your eggs in one basket is not the received wisdom! There really is nothing to prevent interest rates from going back to the levels we saw just a few years ago, and staying there. More importantly, there’s nothing to stop the difference between the inflation that retirees experience, and interest rates, widening. Faced with this, a retiree who held only cash would have to accept a lower standard of living in retirement.
These aren’t the only pitfalls of a retirement plan based on cash deposits only; we can add a lack of flexibility, and administrative complexity (you’d need money with a lot of different banks if you wanted to keep the FSCS protection for your portfolio) to the disadvantages pointed out above.
The cash based approach may appear superficially appealing, particularly at the moment, when expected returns from deposits are higher than the returns experienced by most investment portfolios over the last couple of years. But a cash based approach doesn’t add up – unless you are prepared to accept that you will need more money to retire in the first place, so you will have to retire later or have a lower standard of living during your working life, you are prepared to accept the extra risks that a lack of diversification brings, and to accept the lack of flexibility and administrative complexity.
As you might have gathered, we don’t think that it’s a good idea to rely on cash deposits solely in your retirement portfolio. However, unlike many other advisers, we do recommend that most people hold some cash in their retirement portfolios. Cash helps to reduce many key retirement risks, and the amount of cash you hold in your retirement portfolio should continue to depend on factors like your priorities and objectives, your financial personality, and your ability to cope with financial losses. Our approach will continue to make use of a combination of the mainstream asset classes of shares, fixed interest stock, property and…cash deposits.
(1) We have assumed that this client would be aged 67, married to a 67 year old, needing an income of £25,000 per year, after tax, which would increase in line with inflation. This income would be in addition to their other income from state and company pensions. They would pay tax at 20% on any income that was taxable. 60% of their retirement savings will be in pensions, with the remainder in ISAs. The client would stop work at age 67.
(2) The conventional investment portfolio would be made up of shares (50%), fixed interest stock (35%), cash (10%), property (5%), at outset, and annual charges would be 1.75% per year of the value of the investments. The cash portfolio would have annual charges of 0.5% per year of its value for the ISA and 1% per year for the pension.
Philip Wise | philip@sussexretirement.co.uk
Managing Director and Chartered Financial Planner
