Adrian Vincent
Published Fri, Aug 25, 2023 · 12:00 pm
Source: Business Times Singapore 25 August 2023
Attributed to: Adrian Vincent, Chief Executive Officer of FWD Singapore
Market analysts often consider the current inverted yield curve, where short-term interest rates are higher than long-term rates, as a sign that an economic recession may be on the horizon.
Indeed, the last seven inverted yield curves have preceded recessions. The yield curve, a graphical representation of interest rates on bonds of different maturities, typically slopes upward, indicating that long-term investments yield higher returns compared to short-term investments. However, during periods of economic uncertainty, the yield curve may invert, signifying a pessimistic outlook. This inversion occurs when short-term interest rates surpass long-term rates, unsettling investors and often triggering a market downturn.
As short-term interest rates rise, money tends to move towards higher short-term fixed deposits or short-term treasuries. For example, we see banks competing for our deposits by offering attractive short-term fixed deposits or life insurance companies offering two or three-year high-guaranteed endowment policies.
With the flight of cash searching for high short-term yields, banks need liquidity. Unfortunately, some of those banks in other countries that failed recently have insufficient liquidity as their assets were invested in long-term fixed-income instruments to back their short-termliabilities, creating a mismatch. Coupled with the fact that fixed income prices fell with rising interest rates, these banks become technically insolvent.
On hindsight, it would have seemed pretty obvious that the mismatch created risks that could have been better managed. Can this learning be applied to one’s personal finance? Do you have a similar asset-liability mismatch for your retirement planning?
Applying lessons from bank failures and inverted yield curve to your retirement
It matters if you are mismatching your assets and liabilities. At a personal level, your liability is your retirement expenses. If you are in your 40s or 50s and assuming an average life expectancy of 80 years, you will likely stop working at the age of 65. This means you have another 15 to 25 years to save before relying on passive income for the next 25 years after retirement.
If you are chasing the high short-term rates today, you are exposing yourself to asset liability mismatching risk and this creates two potential problems.
Firstly, when you re-invest your short-term cash after your existing deposits mature, there is a risk that the interest rates would have fallen.
Secondly, considering the current core inflation rate in Singapore, projected to be between 3.5% to 4.5% today, it suggests that the short-term rates are likely just keeping up or just below the inflation rate. Consequently, this situation may result in negative or neutral real returns on your investments.
The short-term gains of an asset-liability mismatching strategy could be disastrous in the long term. Whilst the worst-case scenario for an individual might not be insolvency, it could mean working beyond your ideal retirement age or compromising on one’s quality of lifepost-retirement.
In situations like this, it is good to be prudent and work towards a more matched asset-liability strategy when building a retirement nest egg. Here are three strategies you could consider and as always please seek the advice of a qualified financial planner before making any decision.
Retirement planning in an inverted yield curve environment
1. Investment grade dividend-paying bond portfolio
There are many options out there with many assets manager shouting high dividend yields. At this point, there are a few first-quartile funds offering in excess of a 5% dividend yield.
There are a few ways to gain access to such instruments.
Firstly, one can consider buying the bond directly. However, this is typically not accessible for many retail investors due to the higher minimum entry requirement.
Alternatively, another option is to purchase a dividend fund directly online or via a financial planner. The latter comes with the advantage of receiving advice, which can be beneficial if you’re not familiar with selecting the right fund or if you lack the time to do so.
A third approach is buying an investment-linked policy (ILP) with access to these funds. ILPs can offer welcome and loyalty bonuses, which can enhance the overall yield of your investments.
The overall risk to this strategy is that the bond could default, or its value could fall below the principal amount.
2. Using the 4-5% rule
This is where you invest in a balanced fund comprising equities and bonds and withdraw 4-5% of the value each year for retirement. Some studies have shown that this strategy can potentially provide 30 years of retirement income.
Similar to the first strategy, your capital is not protected and that is a risk that you need to assess.
3. Participating plans
Singapore is one of the few markets in the world that has the concept of a participating fund which is regulated by the Monetary Authority of Singapore (MAS). This fund can only be accessed through a participating plan issued by a life insurance company and there are about 12 life insurance companies, including ourselves, that provide them through financial advisory firms, banks and tied agents.
Such funds are usually accessed through a participatingplan, which will provide policyholders with guaranteed benefits at a fixed schedule. Different companies offer different guaranteed benefits at different junctures, and you should do your homework to figure out which plan is right for you.
Such participating plans will provide policyholders with benefits comprising guaranteed and non-guaranteed components, where the latter depends on the performance of the participating fund. Given the nature of the plan, a long-term commitment will enable one to fully reap its benefits and optimise financial security during retirement years.
The current inverted yield curve and recent bank failures overseas serve as a reminder of the risks associated with asset-liability mismatching and the importance of prudent retirement planning. A good asset-liabilitymatching strategy for retirement income can help individuals build a retirement nest egg that matches their eventual liabilities. It is also important to note that risk and return are inherently linked, so the higher the risk, the higher the potential return.
By taking proactive steps towards sound retirement planning, individuals can mitigate risks and enjoy a fulfilling retirement without compromising their quality of life.
Disclaimer:
This article is for general information only and shall not be considered as financial advice.