FOOL'S EYE VIEW
Be Prepared For Lower Investment Returns

By Cliff D'Arcy
July 1, 2003

Last week, the Financial Services Authority (FSA) announced that it plans to review the use of projection rates on investment products. These are important because financial firms use them to illustrate potential future returns from packaged investments (such as ISAs, pensions, and investment trust savings plans). Projection rates are also used in the red/amber/green re-projection letters send to mortgage endowment policyholders.

The current regime regarding projection rates has been around for about 15 years and, during its life, both the regulatory regime and asset mixes have changed greatly. For these reasons, the FSA is examining its role in setting projection rates and the standards it expects financial services companies to adopt when illustrating potential returns to their customers.

That's why the FSA appointed PricewaterhouseCoopers (PwC) to provide an opinion on expected future rates of return for different investment classes, together with an indication of the range of variability of the annual returns. Following PwC's review of long-term market conditions, the FSA has decided not to change the projection rates that it currently requires firms to use. These rates (before charges are deducted) are:

• 5%, 7% and 9% for untaxed products, such as ISAs and pensions
• 4%, 6% and 8% for taxed products, such as mortgage endowments, unit trusts and OEICs.

However, these rates are for packaged investments that hold a big chunk of their assets in shares. Firms must use reduced rates if the above rates would inflate the investment potential of products that, for example, are now largely backed by bonds. You can read more about this issue here.

What's more, the FSA wants consumers to appreciate that no-one can predict the future, so there will always be huge uncertainties surrounding future investment returns. These rates are projections, not promises, and actual returns could fall well short of these figures, especially in high-charging products.

In its report, PwC compares actual past rates of returns with their likely distribution in the future. It puts forward these assumptions:

• that inflation will meet the government's target of 2.5% per year over the long term
• that earnings will rise at 1.5% above inflation (so, at the moment, that's 4%)
• that the 'risk-free' return from index-linked government bonds will be 2% above inflation
• that the equity risk premium (ERP, or the extra return that investors require to take on the greater risk of investing in shares rather than bonds) will be 3% to 4%.

This means that the 'nominal' (pre-inflation) annual returns from bonds are projected at 4.5%, with shares returning 7.5% to 8.5%. For a fund holding 50:50 bonds and shares, the average return is predicted to be 6.25%. For a fund holding 70% of its assets in shares, the average predicted return rises to just under 7% (i.e. the mid-point of the 5%, 7%, 9% projection range for untaxed products).

Of course, these are average returns and actual returns are expected to be higher than these figures around half the time and lower roughly half the time.

At times during the last century, inflation ran wild and exceeded most commentators' predictions. That's why the past is a poor guide to the likely future course of inflation: it's impossible to predict how it will behave hereafter. Then again, it's fairly likely that inflation will steer a very different path to its pattern since the Second World War.

Of course, many collective investment products have various classes of assets in their funds, including cash, bonds and shares. In the past, most with-profits funds held around 70% of their assets in shares and property, with the remainder mainly in bonds. Nowadays, shares account for less than half of assets in most WP funds, which means lower returns for policyholders but less volatility.

So, is it worth investing in shares and coping with the volatile stock markets in order to get perhaps 7.5% a year, when risk-free bonds return 4.5% a year? At the Fool, we would argue that it is, since absolute out-performance by three percentage points a year can make your final pot very much larger:

Investment period          Enhanced return (ERP of 3%)
10 years                            34%
15 years                            56%
20 years                            81%
25 years                            109%
30 years                            143%

As well as considering the underlying growth of investments, it is incredibly important to take account of firms' charges.

One reason why many investments sold in the Eighties and Nineties have under-performed investors' expectations is the excessive charges levied by almost all providers. Firms' charges had to be high in order to give huge payments to commission-hungry salespeople and to compensate for their inefficient administration. What's more, this was the era of mis-selling, with millions of people buying inappropriate personal pensions and mortgage endowments in high-pressure sales environments.

That's why Fools tend to shy away from higher-charging equity-linked investments, such as managed funds, where 20% of your capital can be eaten up in charges in the first ten years. We prefer low-charging, flexible investments such as index trackers, which typically take a mere 5% of your stake over the first ten years.

So, if you want to make the most of the money you invest, you should do these things:

• Review your existing investments to see if their charges are too high. If so, consider switching to low-cost savings plans, such as stakeholder pensions, index trackers and investment trusts.
• Make the most of your tax breaks to boost your returns. You can use a tax-free ISA wrapper to save up to £7,000 a year where the taxman can't touch it.
• If investment returns are going to be lower, you can make up for this by saving more, or saving over a longer term. For some investors, this could mean delaying retirement or the buying that luxury yacht for a couple of years.

Finally, unless you have all your money in one asset class, don't have nightmares. After all, almost half of all our wealth is tied up in property, which has performed pretty well in recent years!

More: A Plain English Guide To Investment | Endowment Shortfalls Set To Soar