Should I switch some of my pension fund to cash as I approach retirement?

[Duke of Marmalade]

Dividends are an important source of return but they are not magical. Failing to reinvest dividends is precisely the same thing economically as selling shares that produced those dividends.

I am not sure I follow this point.
Let us assume the pension fund is invested in a widget maker. The current share price is 1000 and over the next 6 months it accumulates 10 in cash from the profits on widgets to pay out a dividend. This 10 is just sufficient to meet the pensioners consumption needs. The share price doesn't matter unless you have to sell. So it doesn't matter if the share price jumps 20% today and falls back 20% in 15 years time or vice versa. So I think Colm is right that dividends are a means to dampen the sequence risk of share price movements.
Now if the dividends get reinvested automatically as they would in a fund then any withdrawal at all involves substantial share sales and is, I agree, exposed to sequence risk.

@Marc Interesting paper by Dimitri Mindlin but what are the learning points for the current debate?

Boss I agree with Marc that Cash has an inflation protection dimension - inflation is quickly followed by an increase in the interest rate on cash - and has beaten inflation over the longer term (for pension funds not subject to tax on interest). But I certainly can't understand why anybody invests in long term bonds at these yields, unless you are a financial institution seeking to match liabilities.

 

[Sarenco]

I am not sure I follow this point.

All else being equal, when a stock goes ex-dividend its price will fall by an amount equal to the declared dividend, because new shareholders will not be entitled to the dividend payment.

So, failing to reinvest the dividend is basically the economic equivalent of selling shares to the value of the dividend.

 

[Brendan Burgess]

Boss I agree with Marc that Cash has an inflation protection dimension - inflation is quickly followed by an increase in the interest rate on cash - and has beaten inflation over the longer term (for pension funds not subject to tax on interest). But I certainly can't understand why anybody invests in long term bonds at these yields, unless you are a financial institution seeking to match liabilities.

Hi Duke

That surprises me. But I stand corrected.

Just to be absolutely sure I understand you. Someone who has put their money in a deposit account over the last 30 years and reinvested the interest received would have retained the real value of their money? Or would have done so, if the returns were not subjected to DIRT?

So if I am retired today aged 65 and have €1m in my ARF after I have taken out the tax-free lump sum. I can leave that money safely in a deposit account and expect that it will keep pace with inflation?

Brendan

 

[Marc]

Hi Duke

That surprises me. But I stand corrected.

Just to be absolutely sure I understand you. Someone who has put their money in a deposit account over the last 30 years and reinvested the interest received would have retained the real value of their money? Or would have done so, if the returns were not subjected to DIRT?

So if I am retired today aged 65 and have €1m in my ARF after I have taken out the tax-free lump sum. I can leave that money safely in a deposit account and expect that it will keep pace with inflation?

Brendan

No, the economic conditions that have been historically poor for equities have been fine for short term cash, or more specifically short term fixed interest and therefore provides a valuable diversification benefit for periods when equities perform poorly.

As I have already said, it’s perfectly possibly that the next 20 years will be a terrible time to be an equity investor and cash/bonds could provide the highest returns.

if you were retiring at the start of any of the following graphs with a 100% equity portfolio you would have had a better investment experience with all your money in the bond market.

for the avoidance of doubt I’m not suggesting putting all of an ARF portfolio into bonds. I am saying it’s reckless to put ALL of an ARF into equities

And in the US 5 Year treasury notes provide an even better result

Another period in history when you would have been better off in bonds

Also putting the 70s and early 80s into perspective

Including inflation data over the same period

 

[Duke of Marmalade]

So if I am retired today aged 65 and have €1m in my ARF after I have taken out the tax-free lump sum. I can leave that money safely in a deposit account and expect that it will keep pace with inflation?

Now, now Boss don't be naughty. Nothing is that certain an inflation hedge, not even equities.
This Cash Returns Calculator is for the US market and for 30 years there has been a .24% real return on 3 month T-bills. This is 1.04% since 1980 and 0.35% since 1928.
The same link does say that equities have been the best long term hedge, 10 year bonds second and cash third. Now obviously 10 year bonds provide no hedge over 10 years but over the long term, if the government wants to borrow it will have to compensate for expected inflation.
So let's say someone is looking ahead to a 20 year retirement, 20 year bonds would seem to be useless in the face of possible inflation. Yes there are economic arguments that equities will be a good hedge though in the short term they tend to react negatively against inflation upticks.
Cash on notice deposit will be unlikely to match inflation but term deposits do have some historic inflation protection.

 

[Brendan Burgess]

No, the economic conditions that have been historically poor for equities have been fine for short term cash, and therefore provides a valuable diversification benefit for periods when equities perform poorly.

Hi Marc and Duke

I am trying to translate this into what the OP or anyone else should do today in today's conditions.

He has €1m in an ARF.

He can buy 30% bonds, but that looks crazy today.

(But maybe it won't look crazy in two years, when we look back at a 50% fall in the stock market.)

Or would you say put the 30% in a deposit account/current account earning nothing?

It just seems wrong.

Brendan

 

[Sarenco]

Currently banks are charging institutional depositors (including pension funds) around 60bps on their cash deposits.

The yield to maturity of Eurozone government bonds (EGBI) is currently around 5bps.

And obviously management fees also apply to cash held within a pension.

So, where possible, it probably makes sense for a retail investor to hold cash deposits outside their pension vehicle and maintain a higher allocation to equities within their pension/ARF.

 

[Duke of Marmalade]

Hi Marc and Duke

I am trying to translate this into what the OP or anyone else should do today in today's conditions.

He has €1m in an ARF.

He can buy 30% bonds, but that looks crazy today.

(But maybe it won't look crazy in two years, when we look back at a 50% fall in the stock market.)

Or would you say put the 30% in a deposit account/current account earning nothing?

It just seems wrong.

Brendan

Difficult one to answer. Though I was discussing the inflation hedge aspect and with negative inflation cash under the mattress is such a hedge.
@Sarenco has made the important point that pension funds are earning negative interest rates.
Who would be a financial advisor in these conditions?

 

[Marc]

Earlier post updated to include some graphs of periods in history where bonds won hands down for over a decade

it doesn’t matter what starting interest rates are for the bond market when you are rolling over short-term fixed interest positions.

lets say you are running a short bond fund with terms up to 5 years.

right now you hold a portfolio of bonds with zero or negative yields so the logical assessment is that you can’t possibly make any money so why bother.

wind the clock on a year and lets say that inflation assumptions have changed and interest rates have gone up.

some of your bonds with terms of a year or less have now matured and you have a pile of cash to reinvest.

you get to roll over that cash back into the bond market which now has higher yields due to the rise in interest rates

as you keep repeating this process you get to constantly reassess inflation and interest rate conditions in the market.

think of it like a conveyor belt in a supermarket.

your purchases keep getting put back at the top and run through the til at constantly rising prices fall off the front and get put back at the top again.

Traditional retail bank deposits with DIRT paid are completely irrelevant in this analysis since in a pension fund you would use a global euro hedged short bond fund and there is no tax on the interest.

We can see that over the very long term short-term bonds have been a consistently good hedge against inflation. This is data for the USA from 1926

One of the benefits of this approach is that it doesn’t rely on having to forecast the future rate of inflation or interest rates. The market is doing this for you.

You simply need to be confident that the relationship between inflation and short term fixed interest is reasonably stable over time.

And you can ignore every post that had phrases like “I think” in them

What Drives Bond Yields?

In this overview of the various factors that influence government bond yields, we show that both in theory and in the data, non-monetary policy factors drive significant variation in yields, particularly at longer maturities. Despite the exceptionally low yield environments we have witnessed...

www.aqr.com

Some takeaways
- bond risk remains two-sided
- bonds still provide diversification
- a fundamental approach to investing in bonds still makes sense


The bottom line: Building a prudent portfolio requires careful consideration of the unique characteristics of both equities and fixed income and what each can add to the portfolio

 

[NoRegretsCoyote]

I agree with Marc that Cash has an inflation protection dimension - inflation is quickly followed by an increase in the interest rate on cash - and has beaten inflation over the longer term (for pension funds not subject to tax on interest)

Show me a time series where after-DIRT retail rates have beaten inflation over a sustained period over the last 40 years. You'll find it about 2009-2013 where banks were fighting for deposits and inflation was very low (negative in one year) but I can't think of any other.

As I have already said, it’s perfectly possibly that the next 20 years will be a terrible time to be an equity investor and cash/bonds will provide the highest returns.

But the risk is just not symmetric for bonds and equities right now. There is a lower limit to interest rates which we are at or very close to. Interest rates could fall from 5% to 1% but they can't fall from 1% to -3%. There is very little upside for bonds.

Equities can and do fall in value but there is effectively unlimited upside to equities the way there just is not for bonds.

But with annuity rates so low at the moment it just seems very wrong to buy an annuity.

You may well have an income 30 years, but it might be worthless due to inflation.

Inflation can erode equity values too though. A small annuity (say 10% of fund on retirement) makes sense as it provides insurance against heavy equity losses. Central banks have struggled to generate much inflation and may continue to to do and inflation may not be a big risk.

 

[Brendan Burgess]

Who would be a financial advisor in these conditions?

This is their problem.

But the OP's problem which a lot of us face, is how we should invest on retirement for the rest of our lives.

Every option is risky. Which results in some people with all their money in cash and others with all their money in equities.

Brendan

 

[Duke of Marmalade]

All else being equal, when a stock goes ex-dividend its price will fall by an amount equal to the declared dividend, because new shareholders will not be entitled to the dividend payment.

So, failing to reinvest the dividend is basically the economic equivalent of selling shares to the value of the dividend.

Taking a dividend does not impact future dividend pay-outs. Selling shares does reduce future dividend pay-outs. So there is an economic difference.
The counter example to sequence risk is someone who lives off the dividends alone and never has to sell shares - the ups and downs of market movements and their timing are of no consequence. It is an extreme example of course but suggests that Colm has a point that using dividends to fund withdrawals mitigates against sequence risk.
This assumes that market prices move simply because of market sentiment and are not tied to the real dividend prospects of the shares. Your example of a 30% fall in share values at the beginning followed by regular encashments assumes in effect that the market was right and subsequent dividends are 30% lower. Clearly if dividends are to be 30% lower it is better that happens later than earlier but this is not so much sequence risk as economic risk.
I was wrong though in saying that Colm's approach cannot be applied to a fund. If one encashes fund units at the average internal dividend rate it is true that at the point of encashment one is selling shares but internally at the point of dividend receipt the fund reinvests thus cancelling out that selling.

 

[Duke of Marmalade]

This is their problem.

But the OP's problem which a lot of us face, is how we should invest on retirement for the rest of our lives.

Every option is risky. Which results in some people with all their money in cash and others with all their money in equities.

Brendan

Yes and I wouldn't dare to advise. However, reading these pages OP can get a flavour of all the "on the one hand, on the other hand"s but ultimately it is their call.

 

[Gordon Gekko]

In my view, cash would be a ‘riskier’ asset than equities taking a 30 year view from here.

After WWII, when there was a large amount of public debt in the world, the powers that be kept interest rates behind inflation with a view to inflating away the debt. My understanding is that the average ‘real’ (i.e. after inflation) interest rate was around -1.5% per annum for the period 1945 to 1980. So wealthy people who thought that they were being sensible bought things like ‘War Bonds’ and saw their wealth destroyed by inflation.

The playbook this time seems exactly the same, and there’s even more debt out there, both public and private.

I would really worry for anyone who plans to sit in cash for a prolonged period of time.

Bank of Ireland now was -0.6% for some cash deposits; imagine the effect of that over 30 years with inflation at 1.5-2.5%?

That could be going from being rich to struggling to afford to heat your home.

The financial industry and the regulators define ‘risk’ as volatility, i.e. the amount that something goes up and down in value. But that’s horse manure. Risk is actually permanent loss of capital and permanent loss of purchasing power.

Taking a 20-30 year view, I would classify €1m in cash as far riskier than a €1m diversified portfolio of global equities.

 

[Brendan Burgess]

Bank of Ireland now was -0.6% for some cash deposits; imagine the effect of that over 30 years with inflation at 1.5-2.5%?

Hi Gordon,

I agree with your conclusion, but I don't think that this point is valid.

Charging 0.6% for deposits is unlikely to continue for very long and certainly won't continue if inflation returns.

Brendan

 

[Sarenco]

Taking a dividend does not impact future dividend pay-outs. Selling shares does reduce future dividend pay-outs. So there is an economic difference.

Failing to reinvest dividends will reduce the number of shares that would otherwise be held by an investor.

Holding less shares obviously reduces the quantum of any future dividend payments and potential capital gains.

Exactly the same thing that happens when you sell shares.

 

[Duke of Marmalade]

That could be going from being rich to struggling to afford to heat your home.

We're told that won't be an issue

 

[Duke of Marmalade]

Failing to reinvest dividends will reduce the number of shares that would otherwise be held by an investor.

Holding less shares obviously reduces the quantum of any future dividend payments and potential capital gains.

Exactly the same thing that happens when you sell shares.

My main point is that if the 30% fall is just due to an increase in dividend yields with no change in dividends then to the extent that withdrawals are covered by dividends the fall is of no relevance. So Colm's dividend point against sequence risk has some validity.

 

[Gordon Gekko]

Hi Gordon,

I agree with your conclusion, but I don't think that this point is valid.

Charging 0.6% for deposits is unlikely to continue for very long and certainly won't continue if inflation returns.

Brendan

Hi Brendan,

The nominal rate isn’t really relevant though.

If Bank of Ireland stop charging -0.6% for deposits, inflation will probably still be 1.5-2.5% higher and purchasing power will be steadily eroded over time.

Real after-inflation rates are probably -2.5% right now. Imagine the negative compounding effect of that over time, especially in a pension or ARF with fees as well.

People talk about equities being risky but cash strategies seem like a sure fire route to the poorhouse.

 

[NoRegretsCoyote]

Taking a 20-30 year view, I would classify €1m in cash as far riskier than a €1m diversified portfolio of global equities.

That's a bit of a straw man.

Keeping a million in a retail bank account for decades would not be wise advice in any time or place.