Mark Lister, 21 April 2023

Money in the bank is offering a better return than we’ve seen in years.

The six-month term deposit rate is back over five per cent, which is the highest we’ve seen since 2008.

However, it’s not quite that simple. In some ways, savers aren’t much better off than they were when deposit rates were less than one per cent.

That might sound absurd, but to explain why we need to understand the different between nominal and real returns.

Money is only useful if you can exchange it for things you need or want. When you're investing it, what you're really trying to do is maintain (or hopefully grow) its purchasing power.

Working against you in the background is inflation. As prices rise, each dollar doesn't go quite as far as it did before, so you need to make sure your capital grows by at least the rate of inflation just to stand still.

If you prefer to listen to a podcast episode on this topic: 

Alternatively, search 'On Point Podcast' and listen via Spotify or Apple Podcast

Let’s say you’re signing up for one-year term deposit today, for which my bank is advertising a rate of 5.7 per cent.

That’s the nominal return you’ll get, and it looks good on the face of it. The real return (which is adjusted for inflation), on the other hand, could be quite a bit less.

The latest Reserve Bank projections suggest inflation of 4.2 per cent over the coming 12 months. That means the “real” return from that term deposit won’t be 5.7 per cent, but a much less exciting 1.5 per cent.

Don’t forget you’ve got to pay tax on that income too, so at a personal tax rate of 30 per cent the headline 5.7 return falls to 4.0 per cent. Take the 4.2 per cent inflation rate off that, and the real return is now slightly in negative territory.

It’s tough, isn’t it? The best deposit rates in 15 years and savers are still going backwards.

It’s important investors understand the impact inflation can have on their savings, and the difference between nominal and real returns.

Those who remember the 1970s and 1980s will appreciate this, as inflation averaged 11.7 per cent over those two decades.

The 1970s was a particularly difficult decade for investors. Shares, cash and bonds all failed to keep pace with inflation, while house prices only just held their own. The only good investments were commodities and farmland.

In contrast, from 1990 until 2020 the New Zealand inflation rate has averaged just two per cent annually. Those of us under 50 haven’t seen high inflation in our adult lives, so the concept of real returns hasn’t been as important.

However, even at low levels inflation can do a lot of damage to your wealth. At three per cent it will still reduce your purchasing power (and the value of your capital) by more than 25 per cent over ten years.

Over the last 50 years, New Zealand’s annual inflation has averaged 5.6 per cent, dragged higher by the 1970s and 1980s.

New Zealand shares have returned 9.6 per cent over that period, while house prices have increased 8.8 per cent, both beating inflation comfortably and delivering positive real returns.

Cash and deposits are a safe option for your money over short timeframes, as they won’t fall in value the way shares, houses and even bonds have in recent years.

They might be a good place to be for a little longer yet, just don’t get too comfortable or stay too long.

Over any longer horizon, it’s crucial to have an exposure to assets that will deliver positive real returns by growing more than the inflation rate.


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