The present recession has brought about a recurring set of problems that people tend to forget in good times. Yes, I said recurring. Most recessions see certain patterns happening and those who learn from past lessons thrive while those who fail to pick up the lessons run into repeated concerns.
What lessons does a recession teach us?
Investment Opportunities
For starters, it's a known fact that big market downward movements are closely associated with recessions. However, knowing that falling markets presents discounted valuations is only meaningful to people with excess funds to take action. For the ones who don't, they can only salivate on the sidelines.
Interest Rate Reductions
Another thing that recessions are closely related to are reduction in interest rates. In recent years, governments have found qualitative easing (printing money) measures to be their preferred way to support the economy. Essentially, this means that they would be pumping a lot of money into the economy through buying up securities. As part of the QE program, the Federal Reserve also cut interest rates. The purpose of these actions is to encourage lending and investments to stimulate the economy.
What this means to businesses is a lower interest rate environment where loans are cheaper. On the consumer end of things, you have lower mortgage rates. However, if you are saving money in the bank, you will also experience lower yields on your deposit accounts. While it may not be a concern to many who invests their funds, hardcore savers who have funds in high yield savings accounts, fixed deposits, structured deposits and Singapore Savings Bond will feel the pinch.
How Much Has Yields Drop?
These are the present fixed deposit promotions as of May 2020. For people who hardly place money in fixed deposits, the interest may seem normal as we tend to associate FD rates with being low. However, to provide some context, FD rates in 2019 could be as high as 1.8% to even 2%.
Likewise, the 10 year rate for the Singapore Savings Bond (SSB) has dropped below 2%. I recalled the time when SSB first came into the market, it was deemed as a better alternative to fixed deposits because of its highly liquid nature and attractive 10 year yields.
If you need more convincing, check out the revision of higher yield saving account rates of our three local banks.
What's the moral of the story here? High interest rates are never permanent. When interest rates are high, people tend to forget this, thus I've met many dismayed people during this period who are suddenly thrown into a low yield environment again. While this may appear like a normal market cycle behavior, it creates a cause for concern among savers because of inflation. If you do marketing regularly at NTUC, you will probably make the same observations that my mom felt, that most grocery prices have increased.
Reinvestment risk & it's implications to you
Reinvestment risk basically means being unable to reinvest your funds at the comparable rate of return which you previously were enjoying. So a lot of times, people like short duration instruments like fixed deposits and SSB because of its liquid nature. However, for a significant number of these savers, the preference is psychological. They just want to have their money easily accessible but not because they really need the funds in the short term. These instruments change their rates every year and the real risk is the inability to grow their savings at rates that is comparable to inflation when interest rates fall. Typically, a low interest rate environment can drag on for a good number of years.
While I can relate to people preferring instruments that gives a good return with little lock-in, there're practical concerns that we need to face up to. For starters, we may not feel the effects of inflation now because we still have an active income. Also, inflation effects is typically felt over the years as it is increasing gradually, so it is subtle. Ask yourself this question, do you know how much a Happy Meal at McDonald's has increased in price from 2018-2020? Frankly, I don't know nor bother. I just know there was an increase and I am still currently able to comfortably pay for it, hence I don't seriously care at the moment.
The subtle inflation effects will continue for years and one day, if your savings rate is not robust enough, you'll be concerned. That's partially the reason why I get cases every now and then from prospects seeking help with their finances in their late 40s to 50s. Many times if the resources aren't sufficient, it's a little too late to help them attain their ideal retirement at 65 with limited risk exposure. Yup, you read correctly, 10-15 years is too short to save up for a good retirement if the resources available is too little.
How can we be better prepared for the next crisis?
It is a little late to deal with issues currently face in the present crisis if you haven't prepared before hand. However, for the rest of us, we can learn from this COVID-19 crisis and be well positioned when the next crisis comes.
Avoid unnecessary reinvestment risk
Given my previous experience as a banker, I know that the typical consumer of Fixed Deposit, SSB and Structured Deposit does not need the funds in the short term. In fact, many times, the funds are kept there for mid to long term savings. This means that we are talking about a 15 - 30 years saving period. Most of the time, this profile of consumers will hunt around banks for the best rates every time the deposits are due and move the funds around like musical chairs. Frankly, if not because most banks only give promotional rates to fresh funds, many would have just left the money at the bank to auto-renew. In my opinion, unless the funds are meant for a short-term function or part of your emergency funds, this method of savings is less than ideal.
The returns you are getting doesn't even beat inflation
The returns promised to you are on a yearly basis. After each recession, the rates promised to you has proven to remain low for 3 to 4 years
Even when you get higher rates, the rates still rarely beat inflation
A better way to save might be through annuities. An annuity has some similar benefits to the spirit of the deposit structure. Most people who put their funds into these instruments will be planning to compound the interest or in the case of retirees, use it to fund certain expenses during retirement. An annuity plan typically starts giving a pay-out after a minimum of 5 years that can also either be compounded or used as an income stream. Of course, for most of these FD, SSB-like instruments, the funds are liquid after year 1 or at worse, forfeited without affecting the principal. For annuities, the lock-in period prior to the principal being guaranteed is 5 years or longer. However, the yield of such policies tend to be between 3-4% which might be a fair trade off for the lock-in duration. Naturally another key concern of endowments is the guaranteed and non-guaranteed portion of the plan. For such annuities, the guaranteed portion of the plans already is pretty much on par with fixed deposits & SSB yearly returns. The non-guaranteed portion would thus be an added bonus on top of the guaranteed returns. Looking at it from this perspective, consumers are not really short-changed. Above all, remember I mentioned that most of the FD and SSB profile types tend to keep their funds for mid to long term savings? In this case, by having a baseline fixed by the guaranteed returns of an annuity plan, you avoid reinvestment risk that short term instruments expose you to.
Prepare a warchest to take advantage of market crashes
So another benefit annuities may serve to the profile types that can take risk would be to act as a saving instrument that can accumulate your funds for the next crisis. As mentioned earlier, market crashes are only meaningful to people with excess money. Regardless you wish to get significant gains in the stock market or down-pay a property, you need a sizable lump sum. Annuities with short break-even points can serve as a better saving instrument to store funds waiting to be deployed during market opportunities. Most market crashes happen during a 10 year cycle. Assuming we want to save up for such events, annuities serve as a better mouse trap compared to your lower yield FD, Structured Deposits and SSB.
Even if you didn't deploy the funds for any specific purpose, these funds might come in handy supposing you prepare early because it might save you if you are suddenly made redundant during a market crisis.
Summary
In short, recessions teach us repeated lessons that some of us conveniently forget when life becomes comfortable. Those who remember and take measures to get prepared will probably emerge richer while those who lag behind might find their financial positions much worse off post crisis.
If you would like to understand more about how to mitigate reinvestment risk and save up for new market opportunities, please speak with a trusted advisor. Alternatively, you can drop me a message if you want me to help you with it.
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Disclaimer: The content created are based on my personal opinions and may not be representative to everyone or any organisation. If you have any doubts or queries pertaining to insurance or investment, please seek professional advice from a trusted adviser in an official setting. You may also reach out to me if you do not have a present adviser using the message box under 'Let's Talk'.
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