By Henry Ford

A question many New Zealand savers are grappling with in the face of uncertain economic times is whether they should ‘play it safe’ and opt for a stable return on savings by way of term deposits (TDs). Currently, major banks are offering around 6% return which is undeniably attractive to many investors in comparison to seemingly more risky investment alternatives such as property and shares.

While term deposits do indeed present an attractive return, it is essential to weigh this against the growth potential of a diversified investment strategy. In this article, we explore why maintaining a diversified approach may still be the wiser choice, despite the allure of high term deposit rates.

Term Deposits involve depositing a fixed amount of money for a set period in exchange for a fixed rate of return. The predictability of TDs has made them a popular choice for conservative investors who prefer stability and a known return on their investment. However, a downside is the forfeiture of returns or associated penalties, should the need arise to access your funds before the end of the agreed term.

The relationship between inflation and interest rates

With interest rates currently sitting around 6% at the time of writing, TDs offer a predictable return on investment. Although attractive, it’s imperative to understand the relationship that interest rates have with inflation. Interest rates, like inflation, are cyclical and tend to closely follow inflation e.g. when inflation is high, so too are interest rates.

In New Zealand, the Reserve Bank has an inflation target of 1-3%, and to influence inflation, will vary the Official Cash Rate (OCR). The Reserve Bank has in recent times increased the OCR to cool down the economy as higher interest rates make borrowing more expensive and saving more attractive. This in turn reduces spending in the economy and helps bring inflation down.

Although the Official Cash Rate has been stable at 5.5% since May 2023, economic forecasts suggest declines in interest rates over the next few years, particularly through 2025-2026. Therefore, it is expected that TD interest rates will also begin declining.

The effects of inflation on your return

While interest rates and inflation are linked, there are more subtle factors to consider about inflation – the erosion of purchasing power and real value.

To understand the impact of inflation on purchasing power and returns, let’s consider the “milk bottle” analogy. Imagine a one-litre bottle of milk costs $1 today. With 4% inflation (the level of inflation in NZ over the past year to March 2024), that same bottle of milk will cost $1.04 the next year. This means that a dollar today won’t have the same purchasing power in the future.

Applying this concept to savings, suppose you deposit $100,000 into a TD with an annual return of 6%. After one year, you would have $106,000. However, with a 4% inflation rate, the real value of your money has decreased because the purchasing power of that money has diminished. Effectively, you have made a real return of only 2% before tax. After accounting for taxes, the actual gain is minimal, leaving you barely ahead.

To illustrate this further, even with an average inflation rate of 2.83% over the past decade, the purchasing power of your money has decreased by 28%. As a result, your $100,000 from ten years ago could only purchase $75,649 worth of goods today.

Now, let’s consider the “milk bottle” analogy over longer periods:

• 10 years: If one litre of milk costs $1 today and the average inflation rate is 2.83%, the price of milk would rise to approximately $1.32 in 10 years. This means you could buy about 24% less milk with the same amount of money.
• 20 years: The price of the same litre of milk would rise to approximately $1.75, meaning you could buy around 43% less milk with the same amount of money.
• 30 years: The price of milk would increase to around $2.30, meaning you could buy about 57% less milk with the same amount of money.

In conclusion, inflation significantly erodes purchasing power over time, affecting both everyday expenses and the real value of savings. This leads to a substantial decrease in the quantity of goods, like milk, that you can buy with the same amount of money. Therefore, to increase the real value of your savings, the after-tax return must consistently outpace inflation, which can be a challenge with TDs due to their close correlation with inflation rates.

Comparing Returns: Term deposits vs. other investments

When evaluating TDs against other investment options, it is essential to consider longer-term performance data. Historically, growth assets such as equities and property have significantly outperformed TDs. This is particularly relevant in New Zealand’s tax environment, where traditional savings and TD accounts are subject to higher marginal tax rates compared to Portfolio Investment Entities (PIEs) and property investment tax benefits.

The below graph compares the long-term growth of wealth across various asset classes and shows that small and large company equities, and property, have significantly outperformed TDs which grew at 3.2% per year. The substantial difference illustrates the potential for higher returns from alternative investment options.