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Do Lower Interest Rates mean Lower KiwiSaver Returns?

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With the official cash rate in New Zealand being cut to an all time low of 1.5%, how will KiwiSaver and investment returns be impacted?

 

Firstly, lets look at the direct impact of a lower interest rate on KiwiSaver. Only a very small proportion of KiwiSaver funds are generally held in cash, or term deposits. In the lower risk, or more conservative funds, there will be a higher proportion of cash. Lower interest rates will mean a lower return on the cash part of your KiwiSaver.

Lower rates will also affect the New Zealand Fixed Interest part of KiwiSavers. Fixed Interest, also known as “bonds” pay a regular coupons (similar to interest), which are directly related to the interest rate at the time the bond is issued. If the interest rate drops part way through the term of a bond, then the value of that bond will increase (as it is still paying a higher rate of interest and is therefore in demand). In the short term, lower interest rates will actually increase the value of the New Zealand Fixed Interest part of your KiwiSaver. If interest rates stay low, then returns over the short to medium term are likely to fall, as when new bonds are issued, they will be issued with a lower coupon rate.

This is a good time to reinforce the benefits of diversification, or not holding all of your eggs in one basket. Within most KiwiSavers, you will have NZ Fixed Interest, but also International Fixed Interest. So while rates have dropped in NZ, rates around the world are doing their own thing and International Fixed Interest should not be directly affected by our recent interest rate cut here (other than currency which I will come on to).

One thing you may have seen in the press is about how the lower interest rate has made the NZ dollar fall in value. So why does this happen? If we have really high interest rates in NZ compared to the rest of the world, then everyone wants to deposit their money here to access our higher deposit rates. Increased demand for our interest rates and therefore our currency will put up the “price” of the currency, and the NZ dollar will rise in value. Conversely, if interest rates here fall relative to the rest of the world, then the rest of the world isn’t so interested in depositing their money in New Zealand, as they might be able to get a better rate in another country. The demand for our interest rates, and therefore our currency falls, and so does the “price” of the NZ dollar.

 

How does this affect KiwiSaver?

 

It depends on the “hedging” within the KiwiSaver. Remember I mentioned earlier about diversification and having International Fixed Interest in KiwiSaver? Most of us will also have International Equities (shares) in our KiwiSaver as well., if you have something in your KiwiSaver which is from another country, chances are you own it in a different currency.

If the value of the NZ dollar falls, what does this mean? Well, if your American share was worth US100 yesterday and still worth $100 today, but the NZ dollar has fallen in value overnight, then the NZ dollar value of that share will have gone up.

Working it though…..

Yesterday, if your US share was worth US$100 and the exchange rate was US$1 to NZ$1.5, then converting the value of the US share to NZ$ would make it worth US$100 x 1.5 = NZ$150

Today, your US share was worth US$100 and the exchange rate is US$1 to NZ$1.52), then converting the value of the US share to NZ would make it worth US$100 x 1.52 = NZ$152.

When you check the balance of your KiwiSaver, the value you see is the NZ$ equivalent of all the holdings at the time you check it. Everything is converted back into NZD.

 

So what is hedging?

 

If your KiwiSaver is 100% unhedged it means there is no protection against movements in currency. Therefore if the NZ$ falls in value, it will appear that the value of your KiwiSaver has risen (like the above example). Conversely, if the NZ$ strengthens then when all of your different currency holdings are converted back into NZ$, it will appear that the value of your KiwiSaver has fallen.

If your KiwiSaver has some hedging within it, it’s like there’s some protection against the currency movements, as hedging basically removes some or all of any exchange rate movements.  Every KiwiSaver is different, but most are likely to include some hedging.  This would reduce the impact to your KiwiSaver, but essentially a falling NZ dollar will increase the value of your KiwiSaver if you have international holdings.

More conservative funds are going to be more impacted by lower interest rates, as they will have higher cash holdings, more NZ Fixed Interest, and less foreign investments generally.

More aggressive, or growth funds are likely to be less affected due to minimal cash holdings and (generally) a greater weighting to international investments.

By no means is this a recommendation to go and change the risk you are taking within your KiwiSaver. Rates move all the time, and you should stick with the risk profile that is most suitable for you based on your time horizon, willingness to take risk and capacity to take risk.

Finally, when looking at long term expected returns for KiwiSaver, analysts will generally forecast out for 20 years or more. They will make long term assumptions about what will happen with interest rates. Over the last few years, most KiwiSaver providers have been downgrading their expectations of interest rates given all the indications from the Reserve Bank, and so long term expected returns may not change that much, if at all. It will all depend how long it stays this low, and if there will be further cuts or not.

 

 

NOTE – this blog is very general in nature and does not cover a lot of the underlying detail. It is meant only to give a brief overview of the key impacts to KiwiSaver for NZ investors, without getting too technical or exploring every impact and knock-on effect. You should seek personalised financial advice if you require it; this article should not be considered to be financial advice. A disclosure statement is available free of charge and on request.