Are you living off a fixed income? Or are you about to become someone who will live off a fixed income? If you fit either category, this column is directed at you.
A quick definition of a fixed income: normally, a fixed income comes from sources that cannot be altered. In other words, you could receive a pension with no opportunity to increase the amount. People on a fixed income predominantly receive a pension or an income from interest-earning investments.
Interest rates are important for two categories of people: those with debt and those on a fixed income. People with debt want interest rates to fall as low as possible, whereas those on a fixed income would like rates to rise as high as possible.
The same conflict exists with inflation. Inflation eats away at debt (reduces its value in real terms), but it also eats away at the spending power of people on fixed incomes. That is why, over time, they need more rands to buy the same groceries.
So people with debt want high inflation and low interest rates, giving a low real (after-inflation) rate of interest, whereas those on a fixed income want low inflation and high interest rates, providing a high real rate of interest.
Locking in
One way to achieve and maintain high real rates of interest against the trend is, for as long as possible, to lock into interest rates when they are at a peak.
The reason is that interest rates and inflation tend to move in tandem. So, if inflation drops, interest rates will follow suit, but if you have locked into a higher interest rate, you improve your chances of receiving a much higher return.
Robert Keip, the head of investments at First National Bank (FNB), pointed out in a media release this week that the Reserve Bank has already cut interest rates twice since December, and further cuts are anticipated over the next few months.
He says: "With the lower-than-expected growth figures released this week, some economists are predicting that the Monetary Policy Committee may convene an urgent meeting to further reduce interest rates."
Leading central banks around the world are lowering interest rates as inflation dwindles and economic growth spirals downwards, Keip says.
International lending rates are at all-time lows, with the Bank of England's lending rate at 1.5 percent, the European Central Bank at two percent, the US Federal Reserve at 0.25 percent, Sweden at 1.75 percent and Australia at 2.75 percent.
Keip's statement is a timely call to action for people on fixed incomes to lock into higher interest rates - particularly the elderly, who find it difficult to supplement their incomes.
What you can do
Some of the ways you can lock into higher interest rates are:
- A guaranteed annuity (pension) from a life assurance company.
The underlying investments of a guaranteed annuity are mainly interest-earning instruments, such as money market funds and bonds (loans to big institutions). So when you buy a pension with a lump sum, the prevailing interest rates, particularly what are called long-term interest rates that apply in the bond market, are locked in for the life of the annuity.
A guaranteed annuity can be bought for life or a fixed period (term). If you buy a term annuity, make sure you understand the guarantees. The guarantee may be on your income only and not on your capital, so at the end of the period you may receive only part or none of your capital.
- RSA Retail Bonds issued by the government.
These instruments, which are linked to the bond market, come in various guises over investment periods up to five years.
You have a choice between inflation-linked bonds, where the rate rises and falls in line with inflation, or fixed-interest bonds, which pay the same interest rate over the term of the investment.
The fixed-interest RSA Retail Bonds are currently paying 10.75 percent over five years.
- Bank term fixed deposits.
You can invest in bank term deposits over different periods. When interest rates are on a downward trend, the banks' shorter-term interest rates tend to be higher than their longer-term rates, and the opposite tends to be true when interest rates are on an upward trend.
Currently, the best rates are available from money market investments, but the rates can be reduced without notice.
You need to balance the term with the rate. If you refer to our data tables on page 2, you will get an idea of how interest rates vary over time periods, as well as between institutions.
Choose carefully
Always compare the interest rates of the different institutions to get the best deal.
Some banks, such as FNB, offer senior citizens an incentive to invest with them, such as a further 0.5 percentage points on interest on fixed deposits.
And make sure you compare rates on the same basis. Interest rates can be quoted in two forms: effective or nominal. An effective rate is where interest is paid on interest because you do not withdraw the interest you earn.
Making a comparison on a correct basis is particularly important if you are drawing interest monthly as an income. If you are quoted an effective rate, you will be disappointed when you receive your first interest payment.
There is an extra bonus for people who earn interest. Finance Minister Trevor Manuel announced in the Budget that the first R30 000 earned in interest is tax-free for people aged 65 and older; for people under the age of 65, the tax-free amount is R21 000.
Keip says these exemptions mean that, at current interest rates, people over the age of 65 can invest up to R1 427 500 tax-free. (For a couple, that translates into R2 855 000 tax-free). If you are under the age of 65, you can invest up to R940 000 tax-free.
(These amounts are based on the 2009/10 tax exemptions on interest earned and the assumption that interest earnings are your only source of income.)
Speed is of the essence, as Reserve Bank governor Tito Mboweni could well soon take action on interest rates.
- Cameron is the author of Retire Right (Zebra Press), which is now in its second edition.