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Money: Term deposits don’t work for the long term

23 Jan 2020

Term deposits were never designed to provide cash in retirement for the medium to long term.

Whenever you take the interest from a term deposit to spend it ends up costing you money, not making you money, because you are eating into your capital.

Let me show you what I mean.

The current term deposit rate across all the banks looks to be around 2.6% for one year. Look what happens when you take tax off – you end up with 1.7% and this is less than the current rate of inflation.

            Interest payment            2.6%

            Tax payment (33%)        0.9%

            What’s left                     1.7%

            Less inflation                  1.9%     (a consensus estimate, due to come out on Friday 24 January)

            What’s really left            -0.2%

Negative real interest rates are here ladies and gentlemen. Last year there was talk of actual headline interest rates going to zero or negative. That hasn’t happened but we have negative real interest rates when we account for tax and inflation.

We have savers paying the bank to hold their money. Even if these savers re-invest all their after-tax interest payments their capital is still going backwards at a rate of -0.2% per annum.

If those savers take all their interest and spend it their capital is going backwards at the rate of inflation, 1.9% per annum currently.

If you are on a lower tax rate the picture is a little better. Currently rates would leave you with 0.25% per annum after tax and inflation.

You can bet your bottom dollar that New Zealand banks are making a reasonable return after tax and inflation. Why not term deposit savers?

Because they are not meant to. There is a cost to knowing what your return is going to be in the future. The privilege of knowing your return in advance has to cost you heaps.

Term deposits are great for short periods of time when certainty is essential, where the return after tax and inflation is less important. Where at least the return is contributing to the cost of inflation.

Are higher term deposit rates the answer?

“It was great when bank term deposit rates were decent,” a client told me recently. So, let’s do the sums when 1-year bank term deposit rates were over 8% per annum in 2008?

Interest payment            8.4%

Tax payment (33%)        2.8%

What’s left                     5.6%

Less inflation                  5.1%

What’s really left            0.5%

He was right. There was half a percent a year to grow the underlying capital back then (or 1.8% if you are on a lower tax rate).

Although some periods were better than this, a lot were worse.

If you live longer than you thought, or if interest rates go down, or inflation goes up, you could run out of money very quickly.

Leave bank term deposits to cover your known short-term spending needs and diversify the rest of your money into a mix of bonds, property and shares including global examples of all the above.

Forewarned is forearmed.

Keep asking great questions …

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