The Reserve Bank of Australia (RBA) could cut interest rates next year, which may harm the passive income from cash.
An RBA interest rate cut doesn't seem imminent, with inflation remaining higher than desired. The RBA recently said in its latest monthly rate decision, "inflation is still some way above the midpoint of the 2–3 per cent target range".
A recent Australian Financial Review article suggests the RBA is wary of cutting rates too much because it could cause a resurgence of the property market and lead to an unsustainable boom if people take on too much debt.
Even so, when conditions do allow, I think the RBA will want to cut rates when it can.
At the moment, savers in Australia may be able to get an interest rate as high as approximately 5% from a term deposit. But, that could change quickly if the RBA cuts.
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Cash returns to reduce?
If someone currently has $2 million in a term deposit with a 5% interest rate, they'd be making $100,000 of annual passive income. That's a great return, in retirement or otherwise, compared to where interest rates were three years ago.
However, if the RBA were to cut interest rates by 100 basis points (1.00%) in the short-to-medium term, it could reduce the term deposit interest rate to 4%. That would reduce the passive interest income to $80,000 even if the same amount was invested in term deposits.
If the RBA were to cut rates by more than 1%, the term deposit passive income would be even smaller.
ASX dividend shares can solve the issue
But I think there's a great way to protect income for retirement (or non-retiree investors).
Businesses can keep paying passive income and generating profit, regardless of whether rates are going up or down.
A typical ASX dividend share won't be penalised by lower interest rates. In fact, many businesses could benefit from rate cuts through lower debt costs and increasing customer budgets and desire for spending.
Plenty of high-quality ASX dividend shares have maintained/grown their dividends for a number of years in a row.
For example, Washington H. Soul Pattinson and Co. Ltd (ASX: SOL) has grown its annual dividend every year since 2000. Brickworks Limited (ASX: BKW) has grown its annual payout each year for the past decade. Those are very appealing passive income records.
A number of businesses have high and attractive dividend yields, which could appeal over a term deposit, particularly when interest rates drop. I'm thinking about names like Rural Funds Group (ASX: RFF), Centuria Industrial REIT (ASX: CIP), Charter Hall Long WALE REIT (ASX: CLW), GQG Partners Inc (ASX: GQG) and Telstra Group Ltd (ASX: TLS).
Investors may be able to construct a portfolio with an average dividend yield of 5%, 6% or even more. That means a $2 million portfolio could generate passive income of, for example, $100,000 (with a 5% yield) or $120,000 (with a 6% yield), with potential for income growth in future years.
That's one of the greatest benefits of ASX shares in retirement – they can deliver passive income growth and provide an even greater lifestyle.
