Put your money in the bank and you lose!

There is currently around $207 billion held by households in the banking system and this number has held steady despite low interest rates. There are several reasons why, us Kiwis, are such fans of having money in the bank.

Going back a few decades, there was not a lot of choice as to where to put investment money. The managed fund industry did not really gain momentum in New Zealand until the 1980’s, and most of today’s investors grew up in households where the bank was seen to be the safest place to keep money for the long term, especially for retirees.

New Zealand has one of the strongest banking regulatory systems in the world. This means term deposits are safe. They are also simple in that they require no specialist knowledge, and they can provide a regular income through the payment of interest.

However, times are changing and while term deposits have a place in most investment portfolios, they are not fit for all investment purposes. At the most basic level, there are two investment goals – to grow your investment capital and to produce an investment income.

While term deposits have historically provided a safe way to generate investment income, there are a number of factors which mean they are increasingly less likely to be able to achieve this in the long term.

Anyone reaching the age of 65 today can reasonably expect to live close to 90, and as time goes on, life expectancy will increase further. This means that investments made for retirement have to keep ahead of inflation for 25 plus years.

Interest rates tend to move in tandem with inflation, as the Reserve Bank of New Zealand raises interest rates in order to combat inflation by slowing down the economy. In general, the higher inflation goes, the higher interest rates go and vice versa.

Interest from term deposits is taxed, and the net return from a term deposit after deducting tax and after allowing for inflation is minimal. If you choose to use all the interest from a term deposit as income, instead of holding some back to allow for inflation, the value of the sum invested will decline in terms of its purchasing power.

For example, if you invest $100,000 at 3% interest per annum, your tax paid income will be around $2,475 after tax ($3000 less tax at 17.5%). If you choose to use all of this to top up your income, the purchasing power of your $100,000 will fall by the rate of inflation. If inflation is 2%, after one year your $100,000 will only be worth around $98,000 in purchasing power.

Not only that, but the purchasing power of your income drops. If you are receiving 3% interest on $100,000 in 25 years from now, you will still receive $2475 interest after tax, but in terms of purchasing power it will only be worth about $1,493 in today’s dollars.

Put your money in the bank and you lose! Term deposits do not stack up as investments over the long term because they don’t keep up with inflation.