Emma Ann Hughes explains why income seekers must adjust their expectations
Double-digit returns have become stuck in our memories but as the 2020s get underway, it is important to remember that this rate of income is the exception, not the rule.
Across a broader sweep of history, base rates have stayed far closer to where we are today.
The years since the 2008 to 2009 global financial crisis have been difficult for income seekers and investment experts expect this is unlikely to change in 2020, so it is vital for financial advisers to adjust their clients’ expectations.
This is because low interest rates are likely to persist, limiting the income on offer from so-called safe assets and meaning cash and government bonds may no longer compensate for inflation.
Rupert Rucker, head of income solutions at Schroders, says: “We live in a world where record low interest rates and years of asset purchases by central banks have led to ultra-low bond yields.
“This means that the lower-risk investments and savings accounts that helped produce an income for previous generations simply do not offer high enough returns to grow our money.
“In developed markets in particular, rates of inflation are higher than deposit rates, meaning the value of cash savings is actually being eroded.”
In 2019, many central banks, such as the US Federal Reserve (Fed), cut interest rates rather than raised them.
This low interest-rate environment looks set to persist in 2020.
As a result, Mr Rucker points out that income seekers will not be able to rely on cash savings or low-risk government bonds to provide the income they have come to expect.
In fact, investors want higher levels of income than any asset class can provide.
A poll of investors by Schroders found that the average expectation of annual investment returns for the next five years now stands at 10.7%, yet the investment house’s multi-asset team’s latest forecasts for the next 10 years show emerging market equities are likely to provide the highest return but even these are only likely to deliver 9%.
Sheridan Admans, investment manager of The Share Centre, agrees that advisers should prepare their clients to expect lower returns from some regional or sector equities ahead.
Mr Admans says: “Equities generally in the last 10 years have delivered a Sharpe of about one; the long-run average is 0.6.
“Reverting back to the long-run average, it is likely equity returns will be nearer to about 5% returned during the next 10 years against a higher volatility backdrop, which equals a lower Sharpe.”
But Schroders’ Mr Rucker says it is important that investors do not despair.
He says: “It may be unrealistic to expect returns of 10.7% per annum but it’s still possible to achieve higher returns than those offered by savings accounts or government bonds. However, you and your money will have to work for them.
“Higher returns are available but they are likely to carry higher levels of risk. It is important for income seekers to be aware that they are risking capital when investing in asset classes like corporate bonds or shares. Investors need to understand the risks and how comfortable they are with taking those risks.
“Investing for a short time period is unlikely to bring the best returns. A timeframe of at least five years is likely to be needed, particularly when investing in higher-risk assets such as shares.”
In developed markets in particular, rates of inflation are higher than deposit rates, meaning the value of cash savings is actually being eroded
Educating the client
Emma Wall, head of investment analysis for Hargreaves Lansdown, says what is key in 2020 is that advisers need to spend a lot of time on financial education – explaining the eroding impact of inflation, what market volatility is and how different assets such as stocks, bonds and cash have performed in the long term.
She says advisers should also take time to explain the importance of diversification and how different asset classes contribute to a portfolio and complement each other.
Ms Wall says: “It is also very important to establish the individual’s capacity for loss, their investment time horizon and their existing wealth and savings.
“One of the most effective tools for ensuring an individual really understands what they are investing in – and that it well matches their risk appetite – is to actually avoid risk profiling and categorisation of low/medium/high risk.
“Our advisers use a lot of open questions and aim to agree on a ‘tolerance’ that the client can afford and understand, then ask them to explain back to us why that is the case.
“We use situational questioning and stress testing based on different asset allocations to establish this, for example: what it would mean if the stocks in your portfolio dropped 50% versus what it would mean if equities dropped 50% in a mixed-asset portfolio?”
As a number of metrics suggest the next 10 years in markets will not be as rewarding as the last decade, what is clearly very important is for advisers to ensure they have established a rapport with a client so they can adjust income expectations.
Emma Ann Hughes is communications director of the PFS