By Jean Strock
On the surface, the interest rates on term deposits look pretty good, certainly better than they have been for many years. They also look better than the short-term returns from residential property or a diversified portfolio as these assets have generally been repriced downwards because of rising interest rates and other factors.
There is no doubt cash has a role to play in your financial plan. It is highly liquid and stable. The value of cash does not fluctuate every day like a typical diversified portfolio.
However, liquidity is compromised when you move from an on call account to term deposits, especially for terms greater than twelve months. According to the banking ombudsman, banks are not legally required to allow customers to break term deposits. If the bank agrees to an early break, they may require a notice period and may also seek to recover the interest previously paid for the period of your investment. This is worth keeping in mind!
Let’s dig a little deeper into the returns. Here are the interest rates from two major NZ Banks, from Interest.co.nz as at April 2023.
|Bank||Min Deposit||1 year||18 mnths||2 years||3 years||4 years||5 years|
The shorter terms currently offer the most attractive rates. Do the banks expect rates will be lower when the deposits are repaid? If or when central banks start to drop interest rates, perhaps in response to recession, the five-year rate may prove to be the best choice. However, you would have to think carefully about losing access to your money for such a long period.
In finance we talk about nominal and real interest rates.
Nominal Rate – is the published interest rate. Let’s use Bank A’s two-year rate as an example which nominally is 5.20%.
Real rate – takes into account inflation and therefore the impact on your purchasing power over time.
Currently inflation (the change in price of goods and services) is running at 6.7% having dropped from 7.2% at the end of the December 2022.
Bank A’s two-year rate of 5.2% minus inflation of 6.7% provides a real rate of return of negative 1.5% per annum. So theoretically you would lose 1.5% of your purchasing power over the course of the investment, unless inflation falls substantially.
And what about tax? This is deducted from the nominal return as resident withholding tax at your marginal tax rate. The table below shows the impact of both tax and inflation on returns.
|5.2% Nominal interest rate||After tax Nominal return||After tax Real interest rate|
|Withholding tax of 17.5%||5.2 x 17.5% =0.91%||4.29%||4.29% -6.7% = negative 2.41%|
|Withholding tax of 33%||5.2 x 33% = 1.72%||3.48%||3.48% -6.7% = negative 3.22%|
So, taxation makes the real return even more negative.
Up until 2022 we were in a very low inflation environment for well over a decade yet even then, cash and term deposits (after tax) struggled to maintain purchasing power.
The chart below uses RBNZ data since March 1965. Over this time period the average annual return for a six month term deposit taxed at 17.5% is negative 0.07% per annum. The average return taxed at 33% is negative 1.13%.
While it is clear that inflation erodes the value of cash and term deposits, investments such as property and shares generally maintain their purchasing power over time due to a combination of higher returns and because typically only part of their overall returns are subject to tax.
So while a diversified portfolio can be scarily volatile at times, you need these assets for longer term capital growth and the maintenance of your purchasing power.
For more information about preserving the purchasing power of your capital get in touch with one of our expert financial advisers.
The views expressed in this article are the views of the author. The information provided is of a general nature and is not intended to be personalised financial advice. You may seek appropriate financial advice from a Financial Adviser to suit your individual circumstances.