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What guidance is available for someone with only a couple of years until retirement who is already well provided for through a mix of pensions and savings, but would like to generate a little extra for discretionary spending? I have no mortgage and would like to maximise my remaining time in paid employment.
Where is the best place to invest for the short term (two to three years) and what is the best vehicle to use?
Mike
Paul Angell, AJ Bell Head of Investment Research, says:
Being able to use the last few years of your career to focus on earning for the fun stuff is a great place to be. While it makes sense to cordon off that money for spending, when it comes to investing, it’s typically better to look at your portfolio as a whole.
You are hopefully headed into a long and enjoyable retirement, which means some of your savings might not be used for another 20 to 30 years. That means plenty of time to keep some of your money invested in the markets.
It can be helpful to think of your retirement savings in three buckets. One for expenses coming in the next one to two years, one for income that you can use in the next three to seven years to pay for day-to-day expenses like food and transport or a treat such as a holiday, and one for the long term which you might use to pass down money to family at some point, or re-up your income pot. The first bucket is best held in short-term investments, while the income bucket focuses on income funds, and the long-term bucket has your stocks and shares. You can read a bit more about the three-bucket approach in the article Dan Coatsworth wrote in our last issue, but we’ll focus on that first bucket of short-term investments here.
The first bucket is where your question comes into play of investing for the short term. If you’re planning on a big one-off purchase right as you retire, like a shiny new sports car, your strategy might be similar to this short-term bucket. Note that you’ll want to keep your ‘treat’ money separate from that short-term investment money, even though you employ a similar strategy for both. If you aren’t planning on any big purchases and instead will be spending in smaller chunks along the way, you‘ll want to think extra carefully about what goes into your short-term versus your income buckets.
Investing for the short term
Investment options are a bit limited with this time horizon because it doesn’t necessarily give enough time for markets to recover should they fall. For this reason, cash or cash-like investments are good for short-term investing. One option here is a money market fund.
These funds produce a return that is generally similar to central bank interest rates, which is typically much better return than the interest you’d earn from cash in the bank. This is because money market funds aren’t subject to net interest margin (the, higher, interest a bank receives on its own deposits versus the, lower, interest it passes onto its customers). Money market funds invest in ultra short-term, typically between 0-90 days maturity, high quality, deposits and similar instruments to create their return. There’s lots of these funds available, but our investment team includes the BlackRock ICS Sterling Liquidity fund on our Favourite funds list.
Due to the ultra-low risk nature of the investments, these funds can deliver returns without market pullbacks. That said, the exact level of return will differ year on year depending on the prevailing level of interest rates in the UK economy. For example, from May 2021 to 2022, when interest rates were low, the BlackRock ICS Sterling Liquidity fund returned 0.13%. But between May 2023 and 2024 against the backdrop of higher interest rates, the fund returned 5.15%. A good estimate for annual returns is typically the current level of interest rates minus the fund’s fees, however this will fluctuate depending on how interest rates move around over the year, as well as any frictions in the management of the fund. Fortunately, the fluctuations will just be in the level of returns delivered, rather than losses for investors – provided interest rates remain positive.
While most money market funds invest in similar instruments, they are not all the same. When shopping around for the best funds its worth considering the quality of holdings (the higher rated and the shorter maturity the safer), the fees and the yield (a good proxy for the fund’s expected 12-month return).
The sector average return for short-term money market funds over the past five years has been 15.8% to the 20 May, but the BlackRock fund delivered a 17.8% return in that same period, thanks to its low fees and good positioning. Looking at past performance can give you an idea of how well the management team has done, although it’s not a guarantee for investments in the future, and can be indicative of more risk having been taken in the fund, hence the importance of looking at the quality of holdings (as previously mentioned).
What about government bonds?
Another option for short term investments is UK government bonds (gilts) that are maturing in the next two to three years. These bonds are effectively an IOU from the British government, so default risk is infinitesimally small. Gilts are also exempt from capital gains tax, offering big advantages for investors who have used their ISA allowance, particularly for those gilts paying a small amount of income.
Gilts do require a bit more work on your end than a money market fund, because you will have to find and purchase the gilts as your income flows in, but they do currently provide solid returns (above 4%) for minimal risk.
When purchasing, you will want to look at the yield of the gilt to consider if it could keep up with what you expect inflation to be over the next few years. If you don’t want to take that risk, you can also purchase short maturity inflation-linked gilts, which currently pay out a return which matches inflation with a little extra on top.
There are UK government bond funds as well, but these are typically longer maturity, so more volatile and do not offer the same tax benefit. They can also be sensitive to broader economic events. For example, many gilt funds have yet to recover from the pick-up in inflation and interest rates in 2022 exacerbated by the war in Ukraine and the UK’s mini-Budget.
Where should you hold any investments?
Which investment vehicle your money will be best off in depends on your specific circumstances, but there’s a few instances where a SIPP may be a better fit. especially if you’re looking for one final boost to your retirement savings. If you are still getting matched pension contributions from your employer (and they aren’t going towards a workplace pension instead), then that could give a big boost to your savings before they even touch the market.
However, if you won’t be getting contributions from your employer on this investment, the main benefit to watch for is income tax relief. If you are in a higher income tax bracket now than you will be when you retire, that means that you may be able to pay a lower rate of tax by contributing to your SIPP now, getting tax relief, and then paying income tax at a lower rate when you withdraw in retirement. You’ll also be able to withdraw up to 25% of the SIPP value as tax-free cash.
There are, however, limitations on both benefits. Your tax relief will usually max out at £60,000 or 100% of your relevant earnings, whichever is lower. So, if you are putting large sums in your SIPP, this is a restriction to be aware of. Most people have a tax-free lump sum allowance of £268,275, which limits the total monetary value of their tax-free cash across all their pensions.
The benefit of an ISA is flexibility. Although you won’t get the same income tax relief Paulboost on the way in, you can withdraw at any time, and the withdrawal doesn’t interfere with your 25% tax-free cash from your pension. You can also withdraw at any age, whereas you’d need to wait until 55, rising to 57, for your SIPP.
Paul Angell: Head of Investment Research
Paul Angell is AJ Bell's Head of Investment Research. Paul began his investment career with a global investment bank in 2010, holding various roles across London and Hong Kong over the following years. In 2016...
