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Why chasing income could ruin your wealth

Cliff D'Arcy
by Lovemoney Staff Cliff D'Arcy on 20 February 2013  |  Comments 3 comments

Bored of naff savings rates, many are looking to take more risks to get a better return on their cash. But sticking your money in stocks and shares, corporate bonds or structured products without knowing what you're doing could backfire spectacularly!

Why chasing income could ruin your wealth

Unhappy with the ultra-low rates on offer at the moment, many savers seriously shop around to raise the returns from their savings.

Some turn to Cash ISAs, to avoid handing over 20% to 50% of their savings interest to the taxman. Others reach for higher rates by locking away their cash in long-term savings bonds. By putting your money in handcuffs for, say, one to five years, you can grab fixed rates of up to 3% a year.

It's not enough

Howver some pensioners (and others who rely on their savings to meet their everyday expenses) simply can't live with earning a mere 2% to 3% a year, so are taking greater risks to boost their income.

In this rush to higher returns, savers leave behind the safety of cash deposits and turn to riskier investments. This is a dangerous move, as cash savings are practically 100% secure, thanks to the £85,000 guarantee provided by the Financial Services Compensation Scheme (FSCS).

The critical difference between saving and investing is that saving keeps your capital safe, while investing means you may get back less money than you put in. For elderly and risk-averse Brits, gambling with their wealth by chasing higher yearly income could be a very dangerous game.

Bad advice and big losses

The big problem is that moving from being solid savers to unwitting investors brings two key risks. First, there is the very real risk of being badly advised.

In the past two decades, financial advisers at banks and other financial firms have produced multiple mis-selling scandals, from payment protection insurance (PPI) and mortgage endowments, to personal pensions, high-income bonds, with-profits policies and others.

As well as the risk of being given poor advice, the second problem facing investors is that they may not fully understand how risky their new investments may prove to be.

Since the Eighties, many investment schemes boldly advertised as 'safe' later produced losses of up to 100% of the sums invested. For example, investors in high-income bonds backed by bust US investment bank Lehman Brothers sought compensation from the FSCS for losses totalling hundreds of millions of pounds.

Three risky roads

With savings rates diving to record lows, I am concerned that savers-turned-investors are setting themselves up for nasty falls. In particular, I am nervous about savers rushing into these three financial products:

1. Stocks and shares

Many of the UK's biggest PLCs (public listed companies) pay yearly cash dividends to shareholders. Usually distributed twice-yearly or quarterly, these dividends can produce yearly incomes above 5%. Here are five well-known firms paying generous dividends to their owners, including private shareholders:

Company

Industry

Dividend

yield

Aviva

Insurance

7.3%

Vodafone Group

Telecoms

5.8%

GlaxoSmithKline*

Pharmaceuticals

5.0%

Royal Dutch Shell

Oil

5.0%

Sainsbury's

Retailing

4.9%

* DISCLOSURE: I own shares in GSK.

These five British giants pay yearly dividends ranging from 4.9% at supermarket Sainsbury's to a tidy 7.3% at Aviva, the UK's biggest insurer.

Unfortunately, dividends are not guaranteed and when company profits start falling, then dividends can be axed. Likewise, there is no guarantee that these companies' shares will rise from here -- and falling share prices could easily wipe out even the biggest dividends.

You should only buy shares with the full understanding that you could lose up to 100% of your stake. As the official wealth warning goes: "Share prices, and income from those shares, may go up or down at any time, and potential investors should be aware that past performance is not necessarily an indication of future performance."

2. Corporate bonds

Bonds are IOUs issued by countries, companies and other organisations to help fund their financial needs. Bonds pay a fixed, regular income (the 'coupon') throughout their lives, followed by a return of the original amount invested on maturity (known as the 'par value').

With yields on safe Government bonds so low (the UK pays just 2.2% a year on its ten-year gilts), many investors are taking more risk by buying corporate bonds issued by companies. Typically, these bonds provide annual yields ranging from 4% for solid, low-risk companies to 10% or more for 'junk' bonds issued by risky firms.

The problem with buying bonds is that investors expose themselves to these four key threats:

  • The risk that the bond issuer will default, causing investors to suffer losses of up to 100%.
  • Bonds are not covered by the FSCS or any other state-sponsored safety-net.
  • Dealing commissions and other charges when you buy and sell bonds will reduce your returns.
  • Rising inflation (currently 2.7% a year) eats into bonds' fixed coupons, while higher interest rates push down bond prices.

Buying bonds is like taking a triple bet on the future direction of a company, UK inflation and interest rates. It is certainly not a route old-school savers should go down, because bondholders buying today could get badly burned in future.

3. Structured products

These hybrid products are promoted as a 'halfway house' between savings accounts and shares, offering higher returns than cash savings with lower risk than directly investing in shares.

While these packaged plans provide some downside protection against market falls, they are certainly not risk-free, despite claims of being 'guaranteed', 'protected' or 'secure'. When counterparties providing market guarantees fail, so too can these investments -- as happened with Lehman Brothers in 2008.

Scarily, a leading financial adviser admitted to me in 2011 that this market was "85% complete junk". Worried about future losses for investors, the Financial Services Authority has cracked down on the marketing of structured products. With more fines and reprimands expected in this field, investors should buy these plans only after taking advice from a specialist adviser.

 

More on saving and investing:

The best Cash ISAs

Top 10 index trackers

The best instant access savings accounts

Savers get better returns with credit unions

The top fixed-rate savings bonds

Premium Bonds winners

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Comments (3)

  • gola
    Love rating 6
    gola said

    Re "as cash savings are practically 100% secure, thanks to the £85,000 guarantee provided by the Financial Services Compensation Scheme (FSCS)": Only "practically" 100% secure? Can someone please explain?

    Report on 20 February 2013  |  Love thisLove  0 loves
  • Mike10613
    Love rating 626
    Mike10613 said

    That last paragraph makes now sense to me: "a leading financial adviser admitted to me in 2011 that this market was "85% complete junk" then it goes on to say, "investors should buy these plans only after taking advice from a specialist adviser." Would that be a different one to the 'leading' financial advisor?

    I would avoid anything promoted by financial advisor's like the plague.

    You can have a mixture of investments. Bank accounts, cash ISA, social lending and shares in different sectors to make your saving and investments fairly diverse. It is more risky to go into social lending than a bank account, but you do get double the return. My shares lost 20% this month after putting on 50% in January. They have gone up nearly 5% today. It is a very volatile market run by traders who wet themselves at a bit of bad news. It's not for the faint hearted, but it could be for people with a lifetime of experience and a bit of common-sense. The important things when buying on the stock market is to keep an open mind and learn every step of the way. You don't do well with every investment and so expect to pick a lemon occasionally.

    Report on 20 February 2013  |  Love thisLove  0 loves

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