The rather dramatic increase in local interest rates has been well documented and, with other topical issues like petrol prices, inflation, load-shedding and crime, has comfortably taken its place in day-to-day conversations among South Africans.
Interest rates have gone up and may remain higher for longer as inflation remains well above the inflation target range.
The base lending repo rate has been increased by 450 basis points from 7% in mid-2004 to the current level of 11,5%. The prime lending rate has consequently been increased by the same margin over the same timeline and borrowers face the reality of a prime lending rate of 15% (up from 10,5% in mid-June 2006).
Rates are at levels last seen during the interest rate downtrend in 2003.
A benefit of a higher, and potentially rising, interest rate environment is that investors are able to invest in cash deposits or money-market funds and take advantage of a higher, near risk-free returns in low, double-digit territory.
This is especially important for new and existing investors that face the onerous task of balancing the need for income in the short term with the need for growth in real or nominal terms over the medium to long term.
A trend has consequently developed among investors. Income requirements from a living annuity for the next 12 months or even two years are now being housed in a money-market fund to benefit from a higher interest rate environment.
This is to meet the income requirement of investors in the short term.
The balance of the investment is invested in a range of cautious to moderate multi-asset-class funds to provide for medium to long-term growth within the portfolio.
But these funds are at least afforded the headstart of not being drawn against in the first year or two, which is especially important if this is at a time when investment markets are flat, or worse, falling.
Funds earmarked for growth purposes typically invest in broader asset classes that include equity, property, bonds and international assets and these asset classes generally require a longer investment term to extract the possible returns, especially real returns, associated with each asset class over time.
This approach and adjustment to investment strategy is possible within a living annuity as a result of the flexibility of the product. Investors are taxed on the income stream from the living annuity.
The overweight cash position within a living annuity portfolio is therefore not tax onerous.
Larger discretionary portfolios exposed to a relatively high cash component are often tax inefficient and individuals under the age of 65 may only earn up to R19 000 a year in the form of the annual interest exemption.
In the long term, however, the use of cash within an investment portfolio needs to be considered carefully, as the real return from cash is in the region of 1%. Equities reward investors with a 7% real return in the long term, but need this time in the market to act as a beneficial inflation hedge.
By way of example, assume an investor invests R2-million in a living annuity and requires an income of R5 000 a month — R60 000 a year; R120 000 is invested in a money-market fund to be drawn down over two years to meet the required income objective.
The balance of the portfolio (R1,88-million) is invested in multi-asset-class funds that include exposure to equity, bonds, property, cash and international assets.
No income drawdown against these funds for at least two years means that at the end of the first two-year term, proceeds from these funds can be used to provide for the investor’s income requirements in the next two years and so the process goes on.
This adjustment to investment strategy provides the necessary “time in the market” to particular asset classes that require a longer-term consideration and also means that short-term income drawdowns are not levied against these funds earmarked for medium- to long-term growth, that could also face challenging conditions in the short term.
The implication for portfolios that have the income requirement drawn routinely from a range of underlying funds (often proportionately) is that income is drawn against a portfolio where the fund value is flat or falling when investment markets deliver below-average or negative returns.
There is a health warning, as with any investment or retirement decisions: get professional advice and speak to a financial intermediary who understands what your needs are.