The financial markets are full of surprises - especially for commentators and experts who think they know it all.

We have seen commentators forecast that interest rates can't go any lower only for them to fall further, that quantitative easing will cause hyper-inflation only to see inflation fall to record low levels, that Britain will stay in the EU etc etc.

This column has grandly declared, on a number of occasions in the last 10 years, that we are in an era of low returns only to see bond and equity markets record double digit returns in the following 12 months. However with interest rates in much of the world's government bond markets negative and shares going into reverse it seems that the era of low returns has finally arrived.

How then does Mum and Dad, retired and living in Tauranga maintain their standard of living in such an environment?


Some "experts" are saying that the correct response is to focus on total return and regularly harvest capital gains.

This isn't a new idea, indeed it is the usual rhetoric from high cost wealth managers. It is de rigueur because even in a more normal environment, depending on the asset allocation, the total annual fees implicit in the standard financial plan can consume a large proportion of the after tax income.

Having said that there is no denying things have got a lot worse of late. In the last year we have seen one year bank deposits decline from 3.7 per cent to 2.3 per cent and 10 year bond yields plummet from 3.5 per cent to 2.3 per cent.

Just how bad things have got was made clear to me the other day when I met an investor with $2.5m invested with the wealth management arm of one of the big four banks.

Unsurprisingly the independent AFA at the bank had decided to invest most of the client's money in his employers own products. Thus far this sort of bad behaviour hasn't attracted the attention of the regulator, providing you work for a qualifying financial entity, otherwise known as a bank.

The new improved laws requiring financial advisors to put their client's interests first don't seem to apply to financial advisors working for the banks. This is obviously wrong but not altogether surprising given that many of the architects of the new laws either worked for the banks, or shortly after drafting the legislation, scuttled off to a job at a bank.

Indeed our financial markets policeman, the FMA, recently reviewed the KiwiSaver advice market where, if you go to a bank, you get sold that bank's KiwiSaver products, and didn't see that there was an issue here.

Indeed the latest word from the Commerce Minister on the new, improved Financial Advisors Act is that financial advisors will be putting client's interest first even if they can only sell one providers high cost product.


In contrast recent reports by overseas regulators, notably the FCA in the UK, ASIC in Australia and even the SEC in the US illustrate that these regulators take a somewhat different view of this type of bad advice.

Overseas regulators think, quite reasonably, that actually putting clients' interests first involves a financial advisor choosing from all the investment instruments available not just those that maximise the profits of their employer.

Read More:
KiwiSaver advice criticised in new FMA report

But I digress. Back to the man with $2.5 million. It is a lot of money, even today, so you would think that it would generate a large amount of income.

The problem was it was split equally with the financial advisor, the tax man and, last in the queue, the person who actually owned the money. His income return, after tax, was about 1.3 per cent pa.

There is no obvious answer to cope with lower interest rates but a combination of moving to a diversified portfolio, reducing fees and reducing outgoings, is probably the best strategy.

This is an extreme case but due to the asset allocation recommended by the advisor, the low yields prevailing and the nuances of our tax law that was the situation confronting the investor.

The bank advisors solution was that he should harvest capital gains to supplement his income which seemed a good theory but the reality was, despite buoyant markets, there had not been much in capital gains to harvest so it eventually dawned upon him and his trustees that he was effectively depleting his capital to live.

Back in the last extended bear market many clients of private wealth firms were confronted with this inconvenient fact - despite the spreadsheets showing that their portfolios could sustain regular capital gain harvesting the truth was that the spreadsheet did not model reality.

The reality of the financial markets is that shares don't go up in a straight line - they can go down for some time and in these times there are no capital gains to harvest.

When retail clients find that reality has been mis-represented and they see that much of their income is disappearing in fees and they are using up their capital in drawings they often pull the plug.

Behavioural scientists say selling out like this is irrational behaviour but perhaps the original decision to invest based on these assumptions was the irrational behaviour.

So we are now apparently in a low interest rate environment but what does that mean in actual income and do the other asset classes offer salvation? Let's see.

Check out the table below:

The table shows that there is substantial yield pick-up available from buying NZ property and Australasian shares but these asset classes are more risky than cash deposits or NZ bonds and dividends and capital can fall. Furthermore the average weighting in NZ property is usually limited to 10 per cent and Australasian share exposure rarely exceeds 20 per cent in most professionally managed funds.

Furthermore if we deduct another 2 per cent or so for annual fees balanced investors are often left with a similar income to bank deposits but higher risk, like the $2.5 million man.

Some financial planning firms' answer to the low interest rate environment is to recommend hedge funds, private equity or long short equity funds.

Their marketing material argues that hedge funds can give higher return than bonds with less risk than shares, private equity claims to outperform the listed markets and the long/shorters can apparently deflect the impact of falling stock markets.

Most of these claims are false and need to be taken with a very large grain of salt. Indeed a good rule of thumb is, as with IPOs, not to invest in any hedge fund you are able to get access to.

Alternatively the temptation many retail investors apparently have at times of low interest rates is to buy lower quality debt with finance company debentures a good example.This ignores risk. Indeed you could argue that a diversified portfolio of NZ shares is a very much lower risk option than owning one finance company debenture or similar instrument.

There is no obvious answer to cope with lower interest rates but a combination of moving to a diversified portfolio, reducing fees and reducing outgoings, is probably the best strategy. If it's any consolation remember that everything is relative ... in NZ, with relatively high interest rates, savers are much better off than investors in most of the rest of the western world, before we consider inflation.