Hunt for income in a low-interest world

A decade of low interest rates and quantitative easing by central banks have reduced investors’ income from traditional assets of cash and government bonds significantly. For instance, the average rate for UK bank savings accounts was 5.09 per cent in 2008, falling to 1.18 per cent in 2018. With the inflation rate at 1.9 per cent, cash parked in these accounts is actually losing value.

Growth in most developed markets is faltering and inflation remains subdued, meaning interest rates are expected to remain lower for longer. Normalisation of rates is on hold for now. Indeed, the US Federal Reserve is now widely expected to cut rates by at least 0.25 per cent at its July meeting.

Hints by the European Central Bank that it may restart its quantitative easing programme has pushed the value of negative-yielding bonds to a new record of $12.8 trillion.[1] 

As the income on safe assets has fallen, investors have had to cast their net wider by moving further and further up the risk spectrum. 

Chart 1: Investors are being pushed up the risk spectrum in search of yield

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Source: Fidelity International, April 2019

There are other compelling reasons that are driving investors to consider income: slowing growth and an ageing economic cycle - with its potential for declines in equities and corporate bond prices. Investors will have to continue to balance higher risks in their search for higher returns. 

The demographics challenge

For the first time in history, there are now more people over the age of 65 than there are under the age of five. Globally, the number of people over the age of 60 years is expected to more than double to over 2 billion by 2050.[1] 

In the US alone, an estimated 10,000 baby boomers are expected to reach retirement age every day over the next decade.[2] These baby boomers are also the wealthiest generation with an estimated $20 trillion in assets.[3] In what has been called the great wealth transfer, an estimated $59 trillion is expected to be transferred to baby boomers and their heirs from 2007-2061 in the US alone.[4] To fund their retirement, this powerful cohort is expected to drive a sustained demand for investments paying regular income.

Demographic changes are also driving other shifts. Increased life expectancy is changing the way we live and work. Longer working lives in an increasingly knowledge-based global economy and less manual or factory-based work will keep a higher proportion of older people working and saving well in to what was traditionally considered to be retirement age. Working and saving for longer mean that this cohort is expected to continue to buy bonds for their predictive income streams, with global demographic demand for bonds expected to peak in 2025.[5]   

Regulatory change driving demand

In the aftermath of the global financial crisis, regulators pushed out a raft of tighter measures aimed at reducing risk, both idiosyncratic and systemic risk. For insurers, a combination of Solvency II requirements - an EU-wide regulatory framework introduced in 2016 - and lower interest rates have pushed them to re-assess their portfolios, driving up demand for income-related products.  The mark to market approach for both assets and liabilities required by Solvency II is creating more volatility in insurers’ assets and liabilities, forcing them into liability-matching solutions and strategies that offer secure income streams.

Changes to UK rules on pensions are also expected to accelerate demand for these solutions. In 2015, UK savers were granted full access to their pension funds, allowing them to withdraw cash either to spend or reinvest. This meant that people were no longer forced to use their pensions to buy an annuity - they could decide to take control of their pensions funds and opt for income generating funds to provide a steady source of income in retirement.

The choice between investment and annuitisation is not one or the other and many savers could opt for a ‘bit of both’ strategy, by splitting their pensions pot to create a combined retirement solution. For instance, an annuity can be used to cover regular, essential expenses while more diversified investments can provide inflation-protected income to cover additional expenses. A number of products such as target date funds and income drawdown solutions, are now being offered to savers in this decumulation phase. 

Pension scheme deficits

A combination of rising volatility, low returns and unpredictable market conditions have worsened funding levels in schemes[7], making it harder for them to meet their future cash flow obligations, and achieve sustainable returns on their funds. Schemes that are closed to new members, and not receiving any inflows through member contributions, have also struggled to manage their cash flow to meet their near-term commitments. 

For these schemes, investing in income products can allow them to make their investments work harder to deliver on their dual objective of generating income to meet cash requirements and growing capital over time.

Conclusion

In a world where the investment responsibility has shifted to the individual, with the move from state pension to private pension provision and from defined benefit to defined contribution pensions, investors will have to take on more risk to earn a higher income, especially in a lower-for-longer interest rate environment. This means looking beyond traditional asset classes for income. By investing across a range of asset classes, savers can earn a steady income for the long-term, as well as preserving capital in more volatile periods.

[1] *Barclays Global Aggregate Negative Yielding Debt Market Value

[2] www.un.org/en/sections/issues-depth/ageing/

[3] www.pewresearch.org/fact-tank/2010/12/29/baby-boomers-retire/

[4] www2.deloitte.com/insights/us/en/industry/investment-management/us-generational-wealth-trends.html

[5] www.bc.edu/content/dam/files/research_sites/cwp/pdf/Wealth%20Press%20Release%205.28-9.pdf

[6] www.pimco.co.uk/en-gb/insights/viewpoints/in-depth/70-is-the-new-65-demographics-still-support-lower-rates-for-longer

[7] www.bloomberg.com/opinion/articles/2019-01-13/pension-fund-crisis-has-a-start-date