Bank of England base rate has been kept at its historic low level of 0.5 per cent for more than four years. But with inflation a persistent issue, more and more savers are being forced to move away from keeping their cash on deposit to try and avoid the value of their savings being eroded.
The impact of inflation on cash savings has been dramatic. BlackRock recently calculated that when measured against the Consumer Prices Index, £1,000 five years ago is worth £846 today while £50,000 five years ago is today worth only £42,320.
Figures from Moneycomms.co.uk show that basic-rate taxpayers would need a deposit account paying 3.375 per cent just to keep up with inflation. For 40 per cent taxpayers, the hurdle is even higher at 4.5 per cent. At 15 October this year, Skipton’s seven-year fixed-rate bond paying 3.5 per cent interest is the only deposit account that could help basic-rate taxpayers’ savings stay above inflation – and their money will be tied up until October 2020. There are currently no accounts that produce inflation-beating returns for cash deposits.
There are alternatives to deposit accounts that provide better returns but these will push savers up the risk ladder. Some people can tolerate the move up a few rungs and others may find one step up a bit too much – but staying in cash is not risk-free.
Capital Trust Financial Management partner Bruce MacFarlane points out that many elderly people have a high proportion of their assets in deposit accounts to provide an income.
He says: “There is a problem in that those investing in cash are generally low-risk investors. But they have had to confront the reality of the risk they are taking by investing in cash because they are losing 3 to 4 per cent a year in real terms as their money is eroded by inflation. Risk is about what the client is willing to accept and there is trade-off between the income they need and the risk they need to take to achieve it.”
For clients who are able to accept volatility, many advisers highlight equity income funds as the option which best rewards investors for the extra risk they are taking relative to cash.
Chapters Financial director Keith Churchouse says: “Each client is different but if they are prepared to accept risk, many equity income funds can offer significant and competitive returns as an alternative to deposits.”
MacFarlane says: “Why get 0.5 per cent interest from cash when you can get a 5 per cent yield, taxed at 10 per cent, with equity income? Investors are well rewarded by dividends for the risk of taking their money out of cash. If you invest in equity income you’re being paid to wait because if the stockmarket doesn’t do anything for a year, you are still getting dividends.”
Royal London Asset Manage-ment equity income manager Martin Cholwell’s fund is the only UK equity income fund to have outperformed the sector average in each of the last six calendar years.
He points out that equities can deliver a decent yield over the long term and, although they can be volatile, they can also provide a natural inflation hedge against inflation.
He says advisers should look at whether managers have performed better than the sector average, the consistency of their performance and how risky the funds are.
Cholwell says: “One factor behind the performance of my fund is the sustainability of dividends and the ability to grow dividends over time. I look for cashflow backing of the dividend because good cashflow indicates a company should deliver growing dividends.”
Some advisers may feel that full exposure to equities is unsuitable for their clients. With-profits, the traditional halfway house between cash and equities offered by life companies and friendly societies, has fallen out of favour but could offer an alternative to just investing in equities. With-profits funds aim to deliver higher returns than cash with less volatility than equities by smoothing out the peaks and troughs in the stockmarket by investing in mix of equities, bonds and UK commercial property and holding back some of the returns from good years to top up returns, which are paid as bonuses, in years when performance is poor.
With-profits funds have been criticised in recent years due to falling bonus rates, a lack of transparency and the application of market value reductions if investors exit before maturity.
Foresters Friendly Society marketing director Neil Armitage says: “Much of the criticism of with-profits funds has been borne from a failure to live up to the forecasts used to sell the product. However, it seems senseless to tar the whole industry with the
However, Armitage points out that although smoothing protects with-profits investors from short-term fluctuations, it does not protect from long- term and sustained falls in asset values.
Investment bonds provided by life companies can be a tax-efficient source of income as tax can be deferred on withdrawals of up to 5 per cent of the original investment each year. These bonds provide a range of funds, including with-profits in some cases. But withdrawing more than 5 per cent up to the 7.5 per cent maximum may create a tax liability for higher-rate and additional-rate taxpayers. Withdrawals are not natural income so capital will be reduced as more withdrawals are made, which can constrain potential growth in the future.
Distribution funds investing in bonds, equities and cash are designed to provide a natural income for cautious investors who are taking a step up from cash but do not want too much exposure to volatile equity markets. As they invest in equities, capital growth is also possible.
Axa Investment Managers portfolio manager Richard Marwood runs two of the funds in Axa’s distribution range. He says: “Our distribution funds invest in two main asset classes – UK equities and UK index-linked gilts. Index-linked gilts are the lowest risk asset you can have. You are lending money to the Government which guarantees to adjust the value of the investment by the Retail Price Index so it keeps its real value. It takes the strain on the equity side as gilts hold up well and may even rise in value when there is real stress in financial markets. So you get a bit of an offset with the long-term benefits of equities.”
Fixed income used to be seen as a lower risk asset class but has become more volatile since the financial crisis. UK gilts are still expensive for the yields they provide so investing in them on a standalone basis could lead to negative real returns.
Across the bond market, concerns about quantitative easing winding down in the US and signs of a global economic recovery have brought about the risk of interest rates rates. This would be bad for bonds because they would lose value. Strategic bond funds that invest wherever the best
value lies have become popular but that may mean investing in higher risk areas of the bond market.
MacFarlane says: “We are not fond of bonds. The timing is stacked against this asset class now and we feel bond investors are likely to lose money in the long term.”
Instead, he says, there are some commercial property funds that are worth looking at.
Bricks and mortar funds are less affected by market sentiment than funds investing in property shares, which makes them less volatile than real estate investment trusts. Although volatility is greater for funds investing in property shares, they have better liquidity. Some funds will invest in bricks and mortar and property shares to capture the benefits of both but advisers may do this by building a portfolio of funds with different risk profiles.
“There are some half- decent ungeared commercial property funds which yield between 3.5 and 4.5 per cent,” says MacFarlane. “Property shares in Reits are more volatile but tend to have performed better for people who are willing to take the risk.”
Another option for investing in property is residential property. Buying a rental property is expensive and time-consuming but investors can access this market through funds like the TM Hearthstone UK Residential Property Fund.
“In our residential fund, the income yield after all fund costs is expected to be around 3.5 per cent.
Even if we assume house price growth only matches inflation for the foreseeable future at, say, 3 per cent, the combined return at 6.5 per cent plus is significantly higher than is currently available in any savings account,” says Hearthstone Investments chief executive Christopher Down.
But advisers may be reluctant to recommend residential property to people who already have exposure to it by owning their own home. Property may also be seen as too difficult or costly to be an alternative to cash, so could structured deposits fit the bill?
These are cash-based structured products that link returns to the perfor-mance of an underlying index such as the FTSE 100 while returning capital in full at the end of the specified term, regardless of the performance of the under-lying index.
Investec structured products head of intermediary sales Gary Dale says rates on structured deposits are double that of fixed-rate deposit accounts but there are few providers left due to the difficult pricing environment.
Dale says: “It is important to recognise that we’re talking about structured deposits, not structured investments, which are not an alternative to cash. Structured deposits have market risk but that is the only risk they have. Structured investments not only have market risk, they have counterparty risk and the industry has to be careful with these things.”
Structured deposits can provide growth or regular income. Investec Structured Products FTSE 100 Target Income Deposit Plan 7 provides income of 5.15 per cent a year over a six-year term if the FTSE 100 is higher than 90 per cent of its starting level on each anniversary.
Although the capital will not be affected by index performance, if the index does not hit the required target at any anniversary, no income will be paid for that year.
The merits of a diverse portfolio are well known and an income-focused multi-asset fund that provides a one stop shop for asset classes may appeal to investors.
Premier Asset Management’s multi-asset funds allocate across bonds, UK and global equities, property and alternative investments.
These funds are run on a multi-manager basis so diversification is also achieved among fund management groups.
Premier multi-asset funds director David Hambidge says cash is probably the worst asset class to deliver an income and that diversification makes sense in providing a better and more reliable income.
“I think people focus far too much on short-term capital values and not enough on the reliability and robustness of an income stream,” he says.
Premier’s multi-asset monthly income fund provides a net of tax yield of 4.5 per cent which is paid monthly and Hambridge says its volatility has been half that of the UK stockmarket.
The firm also has a multi-asset distribution fund that aims to combat the effects of inflation by delivering a growing level of income over time.
“Our multi-asset funds are a good halfway house for investors and we say we are asset class agnostic. Our equity holdings provide capital growth but also a smooth and reliable income stream.
“Bonds aren’t a good asset class at the moment, they are nothing like as attractive as they were. Some parts of the corporate bond market are good and most parts of the government bond market are not.”
Premier’s multi-asset team is moving into commercial property because it provides a decent income stream and potential capital growth. “Commercial property is annualising into low double digit total returns,” says Hambidge.
Generating returns from a multi-asset portfolio solves the problem of relying on a single asset class to produce inflation-beating returns. It also frees investors and their advisers from having to make asset allocation decisions, choose funds and constantly monitor the markets.
However, filling a portfolio with different assets does not necessarily translate into strong performance and good active management needs to be paid for.
Costs are slightly higher for multi-manager funds because they have to absorb the charges of their underlying funds, so the returns net of charges need to be worthwhile for the investor.