Pension planning: Interest-bearing assets
There used to be a rule of thumb in pension planning, that the percentage of bonds or other income-bearing securities, in one’s pension portfolio should equal one’s age. Things are somewhat more complicated and that, hopefully, has been replaced by more grounded and detailed analyses.
It remains true, however, that income-bearing assets are the keystone of a pension portfolio, providing for a time of life when a secure income stream is vital. In simpler times, a pension portfolio would be divided between higher quality equities and bonds. We now have more choice, which is generally considered to be good. But with increased choice comes increased complexity, and this creates pitfalls for the unwary.
The income return on an asset is known as the yield. It is normally expressed as an annual percentage of an asset’s cost. In general, as the cost of an asset increases, its yield will decrease: if you pay more for the same income stream, the value of this income as a percentage of its cost will fall. Yields vary widely across different asset classes, determined by such factors as risk, liquidity and potential for capital growth as well.
Over the past decade we have seen two contradictory processes at work: the reduction of the yields available from traditional income-bearing assets, alongside an increase in the variety of income-bearing assets. The former has very much catalysed the latter, as investors have sought higher-yielding alternatives in a lower-yielding world.
This reduction in yields has been driven by quantitative easing and the maintenance of historically low real interest rates. Central banks (such as the Bank of England) have bought government bonds and other assets on a massive scale prompting large increases in the cost of these assets, and therefore corresponding reductions in their yields. This has been exacerbated by aging populations in the developed world, with a greater proportion of the population seeking secure incomes in their retirement, which has further enlarged the market for interest bearing assets.
So it is useful to know what is on offer. Below, we list the main options, with a short description:
Cash: There’s a story that when Alec Guinness got his surprisingly large check for playing Obi Wan Kenobi in Star Wars, he popped down to his local Post Office and put it into his PO savings account. Sir Alec lived very happily on the return. That, the capital and all the other films he’d done, we suppose. You won’t be able to do that now. The UK base rate is 0.25%. Savings accounts pay, at best, a nudge above 1%.
Money market funds: These invest in cash and near-cash equivalents, and pay a little more than savings accounts. They are generally held to be as safe as cash, but this is not necessarily the case, as some funds lost money during the global financial crisis.
Government bonds: While you can buy these directly, you’ll more than likely hold them in some form of collective investment fund. UK pension funds have to hold a certain proportion by law, which also acts as an artificial support for the price. At the start of the 1980s, the yield on a 10-year UK government bond (gilt) was about 15%. Now it’s little more than 1%. On the positive side, government bonds are highly liquid, or easy to trade in and out of. The UK government also issues a minority of its bonds linked to the Retail Price Index, giving their owners some inflation protection.
Investment grade bonds: This is debt issued by high-quality companies as you might find in the FTSE 100. The highest graded are rated AAA, down to BBB- by specialist rating agencies indicating their relative risk. Again, while you can buy an individual bond, this is uncommon in the UK, where your holding is most likely to be through a fund. These are generally thought to be relatively secure (depending on the rating), if riskier than government debt: companies, even big ones, are more likely to default than governments. UK investment grade indices are currently yielding less than 3%, before you consider the cost of the fund managing your bond holding for you.
High-yield bonds: Again these are bonds issued by companies, and are rated as riskier than investment grade bonds. They used to be referred to as ‘junk bonds’, but familiarity and perhaps clever PR has seen a rebrand. As a riskier investment, high yield pays more than investment grade (hence ‘high yield’). However, investors need to be aware that the value of these bonds is much more volatile and can more in step with equity issued by the same company, so it might not be advisable to hold too high a proportion of these in your portfolio. The weighted average yield for European high yield last year was 5.3%1, although top-performing funds have beaten 15% on a total-return basis over the past year through security selection and actively timing the market.
For any of these bonds, you are only certain to receive your money back if the borrower does not default and you hold the bond until it matures as opposed to selling it to someone else beforehand. However, you are likely to hold these bonds in a fund where repayments are constantly reinvested, so your value is dependent on the market, and the riskier the bond, the more volatile this will be.
Property: There are many ways to invest in property, from your own buy-to-let to retail commercial property funds. Outlining each one could easily be an article in its own right. Here, though, suffice it to say, that this is a more illiquid asset than the ones above – meaning you may not be able to get out of it when you need to. On the positive side, unlike fixed-income assets, there is the opportunity to make capital gains as the value of the property increases. The capital value can also, of course, depreciate. The government has made strenuous efforts to make buy to let investing less attractive for private individuals to reduce the chances of a housing market bubble. Famously, retail property funds were obliged to refuse investors withdrawals immediately after the Brexit vote as their cash holdings ran dangerously low. UK commercial property yields currently run between 2 and 6%, depending on the sector. With capital appreciation, the average return for the Investment Association’s Property sector was 7.9%, although this is not solely UK-based. And, while five-year returns have been nearly 47%, the 10-year returns are just shy of 10%, denoting heavy losses during the financial crisis.
Equity income: In short, shares that pay a dividend – generally taken to be at least 10% above that of the FTSE100 index, which is currently yielding about 3.7%. Investors can build their own portfolios, although over the past couple of decades investing via funds has become the main route for individuals. Indeed, the Equity Income fund sector is seldom out of the top three selling sectors. It’s worth noting that while five-year returns in the IA Equity Income sector have been a very healthy 69.9%, 10-year returns are lower, at 65%2, again indicating heavy losses during the financial crisis that have taken a long time to recoup. So equities do come with both the potential for capital growth in addition to their income yield, but with the potential for substantial volatility.
Alternative lending: Yields tend to be higher, with data provider AltFi recording 4.85%3 for its UK index over one year and ThinCats returning between 7 and 8.5%* AER. Comparing different platforms is very difficult as there are not the equivalent of public rating agencies as there are for bonds. Though secondary markets for many of these (like ThinCats loans) do exist, loans are generally held to maturity, so volatility is less of an issue than bonds, although the flipside of this is that selling a loan when you want to will be more difficult. On the other hand, many loans repay the capital borrowed regularly rather than in a lump sum like a bond maturity. Even so, care needs to be taken not to invest money that might be needed unexpected.
In the next article in the series, we will drill down into alternative lending, and look at how one avoids capital erosion.
 Investment Association data to 30 April 2017
 http://www.altfidata.com/marketdata, retrieved 07/07/2017
*Estimated weighted average annual interest after all costs and provisions for losses of actual defaulted loans after forecasted recovery of security but before income tax (2012 to date). Past performance is not indicative of future results. Capital is at risk.
The views and opinions are provided for information purposes only. It has been prepared without taking into account your objectives, financial situations and needs. It is not intended to be and does not constitute financial advice or any other advice, is general in nature and not specific to you. None of the information on our website is intended as an advice or recommendation to invest in ThinCats platform. You are responsible for your own research and investment decisions.