While cuts in interest rates are greeted with glee by homebuyers and other borrowers, for the millions of retirees and others who depend on interest payments for their income, falling interest rates can be a disaster. For them, a drop in interest rates from 4% to 3% equates to a 25% drop in income. If rates fall from 2% to 1%, income falls by a massive 50%. Add in even a modest level of inflation, and many retirees are going backwards financially. And while the RBA has indicated it doesn’t want to go down the strange path of negative interest rates, this has happened in several European countries and Japan. Imagine: depositors pay banks a fee to store their money, and borrowers receive interest payments rather than make them.
The idea behind negative interest rates is to encourage lending for productive purposes, and to head off deflation. If prices of goods start to fall, consumers delay spending in anticipation of lower prices in the future, further weakening economic activity. However, negative interest rates carry the risk that depositors will withdraw cash and hide it under the bed or in safes. Aside from the risks of fire and theft, which could lead to a total loss of funds, withdrawal of cash on a large scale could lead to liquidity issues for the banks and less economic stimulus.
What are the alternatives?
Aside from the term deposits favoured by many retirees, annuities are worth considering. An annuity effectively exchanges an up-front lump sum for regular income payments. They are generally considered to be low risk. However, as an interest-producing investment, returns are low when interest rates are down.
High dividend-yielding shares have also been a traditional source of income for retirees, offering not just income but also the prospect of capital growth. However, shares can also fall in value, and the economic uncertainty precipitated by COVID-19 saw many companies cut or cancel their dividends as their profits fell.
Hybrids such as converting shares, preference shares and capital notes have elements of debt and equity investments. Their pricing is usually more stable than ordinary shares, and they pay either a fixed or floating rate of interest, often as a fully-franked dividend, above a particular benchmark, usually the Bank Bill Swap Rate.
For retirees with a less hands-on approach to managing their portfolios, a vast range of managed funds are available that suit all risk tolerance levels, and that can provide regular income.
With interest rates at unprecedented lows, many retirees will have no choice but to dip into their capital to meet their cash flow needs. If the portfolio contains a reasonable allocation to growth assets and depending on market conditions, then capital growth may be sufficient to cover cash withdrawals.
A long-term perspective
In abnormal economic times it’s important to keep some perspective. Economic upheavals are often short term. Retirement, on the other hand, can last for decades.
To make sure your retirement portfolio is set to help you weather a cash flow drought, talk to your financial planner.
Sources:
How Negative Interest Rates Work
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