You are not permitted to download, save or email this image. Visit image gallery to purchase the image.
A paradigm shift can be defined as a major change in the concepts and practices of how something works or is accomplished.
I think that it is no exaggeration to describe the prospect of negative interest rates in New Zealand as a paradigm shift.
For many it will require a rethink of their financial expectations and how they go about constructing a retirement portfolio.
In response to the economic turmoil caused by Covid-19, the Reserve Bank of New Zealand (RBNZ) reduced the official cash rate (OCR) to 0.25%.
At that time, the bank commented it would remain at this level for at least 12 months, suggesting a review in March 2021.
In what has been the natural scheme of things in the past, the expectation was that rates may start to rise from that point.
However, many commentators are now predicting the RBNZ will move the OCR to a negative figure in March of next year.
I could spend the rest of this column explaining how this mechanism could be implemented.
Although this might be technically interesting it would be a bit like explaining gravity; knowing how it works is less important than understanding its effects.
The simplest way to think about the OCR is that it sets the minimum rate at which the trading banks can source capital from the RBNZ. Because of this, the OCR influences the pricing of all financial assets.
As a rule of thumb, the 12-month term deposit rates generally sit around 1.5% above the OCR.
And in the case of mortgage rates, around 2.5% above the OCR (depending on the term).
The degree to which the OCR might go negative will ultimately dictate whether we will experience negative retail interest rates.
But if the relative margins are maintained, then an OCR of -1% would result in term deposit rates of about 0.5% and mortgage rates below 2%.
Whatever the outcome, it is likely to be a number of years before we will see term deposit rates restored to even modest returns of 2%-3%.
One of the risks in this environment is that investors will seek out higher-risk fixed-interest securities, in much the same way as occurred prior to the finance company collapses that occurred in the Global Financial Crisis.
These events were an important reminder that not all fixed-interest investments are created equally, and that statements such as first ranking security do not necessarily confer low risk.
At this point in the investment cycle we are also likely to see the emergence of a new range of property syndicates offering relatively attractive yields.
There may well be opportunities in this sector but competition for good properties with strong tenants will be high.
There will be properties on the margins that will be packaged up and promoted based on attractive yields but will involve a range of risks that might not be fully understood.
So what should investors do in this low-income-generating environment to maintain the return they need to meet their living costs?
The reality is that the old days, when the majority of portfolio withdrawals were funded from the fixed-interest part of a diversified portfolio, are in many cases a thing of the past.
Income will be generated from a range of sources within the portfolio, including rents, dividends and fixed interest.
In a recent article by Rebecca Thomas, of Mint Asset Management, she made the following observation: "It is likely that investors will need to treat their equities-based capital growth as a source of income. Over the long term roughly one-third of shares’ total return comes from dividends and two-thirds from capital growth. Investors can create their required return by crystallising some of this capital growth each year."
She goes on to say: "While some investors baulk at the prospect of spending capital, it is a far better solution than moving up the risk curve to maintain a higher-income payout".
In my view, the approach has real merit as it allows a client to meet their ongoing need for income supplementation without increasing the overall risk profile of their portfolio.
It also allows for regular withdrawals to be maintained at an agreed level without worrying about fluctuations in term deposit rates.
For many people this will represent a radical departure from how they have previously thought about managing their wealth in retirement — a classic paradigm shift.
- Peter Ashworth is a principal of New Zealand Funds Management Ltd and is an authorised financial adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily that of his employer. His disclosure statements are available on request and free of charge.