Cash has traditionally been considered a safe investment as it provides relatively consistent returns and protects capital.  However, from a retirement portfolio perspective, cash is anything but safe, says Prasheen Singh, Head of investment consulting at RisCura. “Cash is risky because its purchasing power is eroded by inflation. Retirement funds should avoid holding cash over the long-term because its returns will seldom outperform inflation, particularly in the current low interest rate environment,” Singh says.

Even if a fund is able to invest its cash at 5% per annum, it doesn’t compete with the current average inflation rate of 6% per annum. Yes, the capital amount will never disappear, its nominal value will always remain, but its real value  and the real value of the interest it earns will become less and less over time as inflation drives costs up and erodes the value of that cash. In addition, if interest rates were to drop even further, the income that capital could produce would be significantly reduced.

In the traditional retirement fund space cash has been considered a low-risk asset, with corresponding low levels of return.  Then, as you get increasing levels of volatility so you are likely to experience increasing levels of returns until you get to equities as the highest volatility but correspondingly one of the highest potential return asset class. 

“Instead of looking at return profiles in the nominal space, they should be viewed in the real space, with inflation factored in, and in relation to the liability profile of a pension fund.  Looked at this way, cash becomes inefficient – it’s no longer the lowest risk, lowest return asset class.  In fact, the risk level of cash increases while still offering low and sometimes negative real returns depending on inflation.

“Over the long-term, income preservation should be top of mind when putting together a pension fund investment portfolio and strategy,” Singh says.  Focusing on income preservation means focusing on three main risks to members’ income and its purchasing power; namely interest rates, inflation and longevity.

“Accordingly focusing on income preservation as opposed to capital protection means looking carefully at alternatives to cash.”

From a liquidity point of view, retirement funds are likely to hold some cash but this should be kept to the minimum required to meet the monthly liquidity needs of the portfolio. A portfolio that is positioned to adequately deal with the requirements of retirement fund members, will include exposure to growth assets that are able to deliver returns that at least keep pace with inflation such as equities and inflation-linked bonds.

“Retirement funds holding inflation-linked bonds will see some capital depreciation and appreciation over time with the price of bonds fluctuating, but the coupons included in inflation-linked bonds are steadily increasing at the rate of inflation.”

“Inflation-linked bonds have coupon growth that is linked to inflation. This means that as an investor you’ll have an income stream that actually has a link to inflation,” Singh concludes.

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*This article appeared on Cover, on 26 June 2013; and ITI News on 25 June 2013.