Diversification is important for income

Many retirees rely on investment returns to provide them with an income to meet their living expenses. Many invest in short-term ‘income’ assets for this reason, as they perceive them to be the safest form of investment.

Short-term ‘income’ assets like cash and term deposits generate a return based on interest rates. If interest rates increase, the returns on these income assets also increase. And if interest rates fall, the returns on these income assets also fall.

Example - The effect of interest rates on an income investor

Joe, a retiree, has living costs of around $25,000 pa. He invested his retirement savings of $200,000 in an interest-bearing term deposit in early 1990 at a rate of 18% pa. This met his retirement income needs. 

However, by late 2009 interest rates had fallen dramatically. He could no longer meet his income needs with the interest from his short-term income investments alone.

Different investors can be affected differently by interest rate movements, eg income investors versus those who have borrowed to invest (geared) for growth. This is why diversification is important across asset classes.

The effect of falling interest rates

The cash rollercoaster

The figure below shows the movement of interest rates since the end of December 1990. Over this period they have ranged from a high of 12% to a low of 3% at the end of December 2010. If you were relying on interest rates only to provide you with a ‘salary’ to meet your cost of living, you wouldn’t want to see your salary drop so steeply. This is why it’s important to have some of your portfolio allocated to investments that can provide capital growth and a growing income stream over time – like shares.

The cash rollercoaster
Interest rates have moved dramatically over the past 20 years

Source: Reserve Bank of Australia. Data from 31 December 1990 to 31 December 2010.