Safe deposit?

It seems almost a lifetime ago, but in the summer of 2008 savers could enjoy interest rates of over 7 per cent. Today, they’re lucky to get 2 per cent. The situation is made even worse by inflation – the cost of living has gone up by about 15 per cent in the past five years.

There appears to be no end in sight for one group in particular: the pensioners who avoided investment risk and relied on savings stored safely in the bank.

Those people might feel that although they have been very prudent, they are unlucky in seeing their returns decimated. But perhaps that’s not true at all. Were they always, without knowing it, taking a huge risk?

First, spending the interest means the capital will never increase and (if rates stay the same) the same income will be generated year in, year out. With inevitable inflation, they must either cut back on their spending or start dipping into capital – ultimately running out of money.

Second, many people believe that bank interest will give a ‘real return’ – that is, it will beat inflation and gradually increase its buying power. However, the ‘noughties’ were the exception rather than the rule. ?In reality, money held in the bank normally loses its buying power over the long term.

But we’re advisers, not statisticians. How do we explain this to clients? We use buying cars as an analogy.

Hidden risks

Suppose that three couples in their early 60s retired in 1982, with a 30-year retirement ahead. Each couple has £100,000 in savings and want only one thing: to buy a new car every year (a proxy for living costs and, for this story, having no trade-in value).

The Andersons take the ‘safe’ route: their money is kept on deposit. To begin with, the yearly interest (ignoring tax) is more than enough to buy a new Ford Escort (an XR3i, no less) – and all with no apparent risk. But inflation creeps up. Within a few years, the interest is no longer enough on its own to buy their yearly car. They start to dip into their savings each year; a little at first, but then more and more each year. About 25 years later, in their mid-80s, the money runs out. They then rely on their children.

The Burns also take the ‘safe’ deposit route and again within a few years their interest is not quite enough. Rather than dip into their savings, they choose to buy cheaper models. Eventually, they can’t afford their yearly car, but at least their £100,000 is safe (even if inflation has made it worth much less in real terms).

Devastating consequences

So, what did the Andersons and Burns do wrong? Focusing on capital security meant they were looking in the wrong direction and forgot about inflation. It’s gradual, so it’s easy to miss. But the consequences can be devastating over the years.

Enter the Clarkes. Their adviser (the ‘hero’ of ?the story) advised them to invest in the UK stock ?market. Their income remained fairly stable and grew steadily along with the profits of the underlying companies. Unlike the other couples, their capital fluctuated over the years. They were told so by their adviser, who then held their hands a little through the stock market crash in 1987 through to the current European financial problems.

The Clarkes didn’t panic, however, and although share prices rose and fell, they didn’t lose anything because they never sold out. Today, their yearly income would be in the region of £29,000 a year (before tax), which is more than enough to buy a new Ford Focus Oh, and their capital would be around £866,000.

Although the Andersons, Burns and Clarkes are imaginary, the outcomes are all based on real figures. As ever, past performance doesn’t equal future performance. ‘Cash equals safety’ and ‘shares equals risk’ aren’t always true preconceptions. In fact, long timescales can turn these on their head.

Scott Gallacher is a director at Rowley Turton