How to weigh up your income options when savings rates drop

With the Reserve Bank of Australia lowering interest rates again in July, most experts agree that we are likely to remain in a ‘lower for longer’ period.

That’s great for people with a large mortgage, but where does that leave savers, or people in the pension phase of retirement? What are the options for people like you?

When we look back to 2011, when the RBA cash rate was 4.75 percent, you could get close to a risk-free return of around 5 percent or even more. Fast-forward to 2019 and the cash rate is down to 1 percent, with most of the major banks already pricing in another drop by November to 0.75 percent. Savings rates like 5 percent just don’t exist anymore.

As interest rates fall it’s understandably changing the attractiveness for retirees and savers of parking cash in a savings account year after year and watching inflation immediately eat away at any return.

Many Australian investors have traditionally had what’s called a barbell approach to their investment portfolios. At one end of the barbell is a heavy cash reserve (their low-risk investment option) and at the other end is a heavy allocation to equities (their high-risk investment option). Because they’ve had a heavy weight at either end of their investment ‘barbell’, they view their overall risk profile as relatively balanced. Perhaps this is similar to your current strategy if you have an SMSF?

The issue with the barbell approach, when savings rates are low, is that many investors may start moving funds directly from their low-risk investment (cash) to their high-risk investment (shares). If the barbell was once balanced, it certainly isn’t anymore – it’s taking on a significantly increased level of risk as the portfolio chases a higher return.

Yes, blue-chip shares may pay an attractive dividend and a place to get a decent yield when it’s increasingly hard to find.

However, as I’ve written in a previous post about the risks of investing in blue-chip shares, don’t confuse investing for yield in a savings account with investing for yield in a stock because there’s a big difference in risk level. Depending on what happens in the market, the consequences to your portfolio could be catastrophic.

So, what are your options in a low-rate environment?

Investors who use the barbell approach are only utilising two asset classes. To be fair, they’re not putting all their eggs in one basket, but they’re putting their eggs in just two baskets (and apologies for the mixed metaphor there!).

Another strategy to consider is to introduce exposure to more baskets (more asset classes) to further diversify your overall portfolio. What about bonds and fixed income? What about infrastructure? What about global property?

These asset classes sit in between cash and equities in the risk spectrum. That is, they typically don’t have the same high level of risk as equities, but they can provide a higher return than cash right now.

Not only this, diversifying across a variety of asset classes can reduce the overall level of risk of your portfolio because when one asset drops in value, another may increase. Shares and bonds typically have this kind of relationship, which is known as inverse correlation.

In the past it’s been expensive to diversify over so many asset classes, but exchange-traded funds (ETFs) now provide investors exposure to these asset classes in a simple and accessible way. They can help you add new investments to your portfolio so you’re no longer invested in just two ‘baskets’. ETFs now represent more than $50 billion of Australian investments, so it’s clear that investors are recognising the important role they can play in simplifying the process of diversification.

So if you’re concerned about the level of rates you’re getting from your cash in savings and thinking about transferring money out of cash and into the sharemarket, make sure you’re aware of the potential pitfalls of this strategy. There can be lower-risk ways of managing your portfolio that don’t involve relying on the barbell strategy.

Has falling interest rates hurt your retirement income? Have you considered investing in other assets to potentially offset the impact of low rates?