20 Aug 2018
A major study released last month found that non-retired UK investors are saving a higher proportion of their income for retirement than many parts of Europe. Before we start celebrating, there are two important points to consider.
First, estimates are that the UK still has a significant pension savings gap (the retirement gap is the difference between actual retirement savings and the amount thought to be needed to retire comfortably).
Second, and much more importantly, it is how this money is invested pre and post retirement that will make a real difference to how comfortable that retirement will be. Financing a retirement that is long and healthy requires attention to be paid to consistent and sustainable income generation; not just in the short-term, but over a period of years. Seeking income from too few sources puts both aspirations at greater risk.
This is where home bias can represent a problem. Many have discussed how this product of familiarity and availability biases can result in suboptimal investment returns, but the risks to UK savers of this particular bias could be significant in the period ahead. Importantly, these risks are not all about Brexit, but are a result of the current structure and valuations of the UK bond and equity markets.
In the last 5 years, Gilts have become a more unappealing option for investors seeking income or simply wanting to rely on the safety characteristics of this asset for portfolio construction. Gilts are not only trading at significantly lower yields to their American equivalent, but they also bear the risk of substantial capital loss should a normalisation of UK rates occur.
A move in UK yields to merely close the gap with US Treasuries (a far from unusual phenomenon) would bring about a 12% loss in capital for holders of the 10-year gilt.
…and equity income comes with some hazards
By contrast, the UK equity market might look like a good place to invest if you are seeking income: large familiar names are paying generous dividends that have become even more attractive (in yield terms) following Brexit related uncertainty.
However, the income sources of the UK equity market are highly concentrated, with close to half of the dividends paid being generated by just 10 stocks.
Those high dividend yields also come with risks in their own right; currency being one of them. A significant portion of FTSE 350 dividends are declared from non-Sterling accounts so the actual payment in GBP could fluctuate significantly, especially in an environment where Brexit uncertainty might cause more currency volatility.
Another variable to have a strong impact on UK equity income is commodity prices. About 25% of UK dividends come from energy or materials companies (including large players like Royal Dutch and BP). Back in 2016, with low oil price affecting companies’ revenues, the pay-out ratio of UK energy companies spiked, threatening the sustainability of their dividends.
These characteristics of the UK equity market aren’t new, but with the extreme low levels of Gilt yields prompting savers to look elsewhere, they are becoming increasingly important considerations for many.
It has been argued for some time that investors everywhere can benefit from diversifying beyond domestic markets. There have been many studies showing evidence of home country bias, and not just among ‘unsophisticated’ investors: multi asset funds in the 20-60% IMA sector still show a significant reliance on domestic markets with 18% average exposure to UK equities and 14% average exposure to UK fixed income.
However, today it seems that it is retirement savers in particular who need to pay close attention to the potential threat of this bias. This has little to do with widespread forecasts that Sterling will inevitably decline, or that bearishness is required in response to Brexit. Rather it reflects the specific income characteristics of UK assets today. Savers should be prepared to seek out attractive investments elsewhere across countries, sector and asset classes. This flexibility will enable them to capture investment opportunities and provide for their retirement in a highly changeable world, of which Brexit is only a small part.
Stephen Andrew manages the M&G Episode Income Fund.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.