Investing for inflation: Part One
Smart Money investigates inflation-beating investments. This week, we look at income funds.
It’s no secret that inflation is set to rise. This is bad news for everyone, but especially for pensioners, who need their retirement savings to generate an adequate real return while preserving capital, or at least minimising the risk of loss. Over time, it’s been proved that cash is a no-no, as savings definitely won’t beat inflation.
What are the alternatives to cash or the money market and how will they assist pensioners?
Two financial vehicles are currently being touted as significant, with potentially great benefits for pensioners: income funds and with-profit annuities. Are they everything they’re cracked up to be?
Our low-interest-rate environment has seen low returns on money market funds and investors have been looking for higher yields from their investments so they can achieve a higher level of income at low risk to their capital.
According to Nico Coetzee, Head of Sales at PPS Investments, fixed-interest securities just became a lot more attractive thanks to the implementation of amendments to Regulation 28 of the Pension Funds Act. This is because investors typically think of allocating their capital to money-market funds to get fixed-interest exposure, without thinking about income funds.
No longer investing solely in cash and bonds, managed income funds now have wider mandates to invest in securities like preference shares, property, even offshore (though it must be noted that the new offshore limit of 25% has just come into effect, as of 1 April; there’s also a 25% limit with respect to property, and 75% with respect to equities).
What investors need to understand, though, is that the mandates of income funds vary to a great degree, so some are low risk and some are slightly more risky (those with equity allocation, for example). This may appeal to you if you’re seeking a higher yield. If you’re considering an income fund, bear in mind that they’re varied and you need to ask:
- What is the mandate of the fund? What assets is the fund invested in?
- How risky is the fund?
Coetzee argues that these risks can be minimised as income funds can now move actively up and down the yield curve, so the fund will look quite different in different interest-rate cycles.
“When the fund manager expects interest rates to increase, the fund will resemble a money market whereas with an expected decrease in the interest rate these funds will look more like bond funds,” he says.
“The fund can be positioned to get additional yield, yes,” Veldtman agrees.
As a result, Coetzee suggests that income funds might be a better choice than money-market funds, or cash. There may be slightly higher risk, but the funds are still conservative.
“An income fund is for the investor who doesn’t want exposure to volatile asset classes such as equities. It is most commonly used in post-retirement, specifically living annuity investors who require an income,” he argues.
Independent financial adviser Stuart Kantor says if we look at performance compared to the CPI, money-market funds typically yield 0% to 1% above inflation and income funds 2% to 3%.
According to Anthony Katakuzinos, retail chief operating officer at Stanlib, income funds can invest in short-dated bonds that can mature anything between one day and three years or more, with average duration of instruments in the fund of not more than two years. By contrast, money-market funds invest mainly in bank paper, with instruments with a duration of between a day and 12 months (with maximum average duration of 90 days).
An income fund obviously allows managers to invest in slightly longer-dated instruments to try to lock in higher yields when the time’s right.
“In the current low interest-rate environment, when we suspect that rates have bottomed, income funds can lock into one-year- and two-year-dated instruments to try to capture a higher yield than, say, a money-market fund, which can only access shorter-dated instruments,” says Katakuzinos.
Obviously, buying longer dated instruments means facing a bit more capital risk, as the capital value fluctuates depending on short-term interest rates and demand for these instruments.
“In the short term you could see the capital value of the fund fluctuating by 1% to 5%, up or down,” he says.
If you invest for longer, there’s less chance of that loss—but in return for the short-term volatility, the income fund could give you between 1% to 2% increase in yield as against a money-market fund.
“There’s a little more risk involved, but returns are likely to be better. The higher the allocation to longer-term bonds, the more risky the portfolio will be,” Coetzee agrees.
In terms of costs, an actively managed income fund is certainly pricier than a money-market fund, but there are advantages. You don’t have to select your own fund, for one thing.
“The difference between an investment generating a return of 6% or a return of 9% over a 20-year period is significant and this often balances out the risk that one takes on by investing in an income fund,” Coetzee says.
Kantor says that quibbling over whether there’s negative monthly performance or not is somewhat beside the point, because this is not really “risk”. What pensioners really have to guard against is watching their savings decline as their capital fails to keep pace with inflation over the period of their retirement, which can last for perhaps up to 30 years, thanks to modern medicine.
He advises pensioners to consider the “big picture” that is retirement and assess whether or not their investments are likely to beat inflation over time. That is the crux of the matter.
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