Portfolios under pressure in inflationary times

After decades of low inflation, wealth managers and investors are having to rethink their strategies

Wealth managers and investors are facing a set of circumstances that very few of them will be old enough to have encountered before. After some 40 years of living with low inflation and low returns, the coin has flipped, as it were, and we are suddenly in a world where inflation is north of 10 per cent.

It is hard to overstate just how dramatic a change this is. When a wealth manager has spent one or two or even three decades aiming to help clients to secure returns that are two or three per cent above inflation, it comes as a shock to realise that an investment will now need to return at least 10 per cent or better to break even. The returns might even need to be above 13 per cent to provide a positive return.

Can it be done? Probably not, or not without taking on levels of investment risk that would likely end with disproportionate losses. However as Neil Grant, a senior advisor with Acumen Financial Planning notes, with long-term investors, the high inflation of 2022, and probably 2023, may well turn out to be a blip.

“The vast majority of our clients are long-term investors and they will see any number of economic and political cycles over the course of their working lives. The key today is to adopt investment strategies that are appropriate to combat the chal-lenges that are inevitable with high inflation,” he comments.

For Grant and his colleagues, this means that it is now more critical than ever to talk to clients about risk and reward strategies. “What you want to do as an investor is to have your savings outpace inflation over the long term. Remember, the Bank of England’s long-term target for inflation remains at two per cent.

“Yes, the cost of everything is sky-rocketing and we have a real cost-of-living crisis, but the forecast is for things to return to relative normality by 2025. It is very hard to have an investment portfolio outgrow inflation under current conditions, but the aim is not to destroy value by overreaching.”

He points out that equities have proven to be the best asset class over the long term, so clients should not be panicked into making rash changes. “Nothing at the moment is going to outpace inflation, but over the long term equity portfolios will deliver the best return over inflation,” Grant advises.

It is worth remembering that the S&P 500 index has gained about 10.7 per cent on average annually since it was introduced in 1957. Over the last ten years, the returns have been better still, coming in at around 14.7 per cent annually.

One of the trickier challenges for savers who are nearing retirement is to work out how to take money out of their pension by way of drawdown. “You do not want to be doing drawdowns from an equity portfolio as you near retirement,” Grant says.

“This is where we would adjust a client’s portfolio to make it more defensive. We would increase the allocation to cash and bonds, for example. These are very low-growth investments, but they provide the liquidity and security that you  need for drawdown. These are all things that we work out in close consultation with our clients,” he emphasises.

For those fortunate enough to have significant wealth to pass on to the next generation, wealth management often includes both succession planning and inheritance tax planning.

Claire Macpherson, a partner in the law firm Burness Paull’s private client team, points out that success-ful business people tend to compartmentalise their work and their private life. However, there are key events that really require an advisor to take both the client’s private life and professional life into account.

One instance is when it comes to succession planning to sort out who is going to run the business when the owner retires. Another is on the sale of a business. “The value of a trading business is generally free of inheritance tax on death or lifetime gift due to reliefs available. However on sale, then comes the question of what you are going to do with the lump sum which is then potentially subject to inheritance tax. How do you pass that on and how do you protect the family wealth effectively,” she says.

There are any number of factors that come into play in these decisions. How do you pass on assets to the children effectively while retaining some control? If a family has older children, what happens to the child’s inheritance if they marry and the marriage fails?

“Our approach when having these kinds of consultations with clients is to collaborate and combine advice from our corporate finance, tax, family law and private client teams so we can really dig deep and find the best solutions for the client and their particular circumstances,” Macpherson says.

Trusts used to be a universal way of controlling how money was passed to the next generation. However, in 2006 trusts were retroactively attacked. Today when a trust is set up it immediately creates a tax liability. This has impacted lifetime trust planning, but Macpherson points out that a very good alternative, in many instances, is to set up a family investment company.

“This can be a very sensible alternative to a trust when families are looking to protect their assets for the future,” Macpherson comments. This is simply a private company, limited by shares, with the directors and the shareholders generally being family members.

The chief benefit, she explains, is that the founder of the business can retain a degree of control over the company through his or her lifetime by having a controlling shareholding. This enables them to guide the passing of wealth to the next generation without the value being considered to be in their estate for inheritance tax purposes. They are also much more tax efficient than trusts.