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A Consideration of Term Deposits versus Investing

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Two important considerations

Although term deposits are very popular in New Zealand, there are two main reasons why you may not want to invest the bulk of your long-term investment or retirement assets in term deposits.

  1. You want a more secure investment
  2. You want a better lifestyle

A more secure investment

It’s a bold statement, but a diversified portfolio could be more secure than a term deposit.

Let’s look at how this is the case.

In the last 30 years we’ve lived through two large scale banking disasters.  One was called the Savings and Loan Crisis, and the other, the Global Financial Crisis.

You may be thinking, “They were global.  How does that affect us locally?”  Well, when it comes to assessing the security of your money, all the experience we can gather counts.

In the Savings and Loan Crisis, 1,043 out of 3,234 savings and loan associations in the United States failed.  Over 1,000 other similar organisations also failed.

In the Global Financial Crisis, many banks defaulted and failed.  There were 25 such banks in 2008, 140 in 2009 and 157 in 2010.

From a New Zealand term deposit investor’s point of view, this experience is highly relevant.  The Reserve Bank suggests that the chance a bank with a lower credit rating (ie, a BBB rated bank in the table below) defaults on its obligation to pay back a term deposit or bond over five years is 1 in 30.

 

Chance of default within five years

Credit rating Example banks Approximate probability of default over five years*
AA- ANZ / ASB / BNZ / Westpac 1 in 300
A Rabobank / Kiwibank 1 in 150
BBB Heartland / Co-operative 1 in 30

* The approximate, median likelihood that an investor will not receive repayment on a five-year investment, on time and in full, based on historical default rates published by each agency.

Source – RBNZ Explaining Credit Ratings https://www.rbnz.govt.nz/-/media/ReserveBank/Files/regulation-and-supervision/banks/3498179.pdf?la=en&revision=67d0f881-1dc3-4b29-b1d5-e23b214c237c

 

Banks with stronger credit ratings (ie, a AA- rated bank in the table above) have a probability of default of 1 in 300, which is much better than 1 in 30.  However, BNZ is a AA- bank and it has been bailed out by the government twice in its 156 year history[1].

Compare this to a diversified share portfolio;  A diversified portfolio may own shares in upwards of 10,000 underlying companies.  Among those companies will be many publicly traded banks including ANZ, Westpac, ASB, etc, and the portfolio will also include over 200 other industries across 44 countries.

Such a portfolio may drop in price over the short term but should never suffer permanent capital loss.

On the other hand, if you hold your term deposit in a bank which defaults, permanent capital loss could very well be what you experience.

For a diversified portfolio’s value to drop to nothing, almost every company in the world would have to simultaneously go bankrupt; capitalism would cease as we know it.  In that world, no banks, agriculture or manufacturing would exist; no technology companies, utility companies or transport and logistics companies would exist.  If such a thing were to occur, and you were still alive, you would have greater concerns than your portfolio balance!  Furthermore, in such a world, your deposit at the bank would also be completely worthless.

So we can see that, unless the apocalypse occurs, a portfolio of the world’s greatest businesses can never be worth $0.  It can go down in price, but it can never go to $0.

Your term deposit at a small bank has up to a 1 in 30 chance of default.

Which seems less secure?  We would say it’s the term deposit.

While a diversified share portfolio can lose value, it’s temporary.  If you are a long-term investor and have a time horizon which allows you to stay invested, those temporary dips are only an inconvenience.

 

A better lifestyle

If the greater security that comes from diversification isn’t persuasive enough, you may like to combine it with the prospect of a better and more secure lifestyle in retirement.

When people look at a term deposit, they see the offer of a 3-4% gross return, or similar.  That sounds safe and certain.  Many have no idea what kind of return to expect, long term, from a diversified portfolio.

We can shed some light on that.  Based on an extensive analysis of the current environment and the historical returns from taking various risks, we have concluded that a diversified portfolio containing 98% shares has an expected return of around 9.8% per annum.

You may look at this and think, “I only get a little over twice the return for investing mainly in shares compared to a term deposit, and it’s only expected return rather than certain return”.

While that is true, you also must consider that the returns above do not account for the effect of either taxes or inflation.

  • As the capital gains made by holding a diversified portfolio aren’t taxed, the tax burden on a term deposit portfolio is, relatively, very high.
  • Inflation affects all investments in the same way, no matter what they are comprised of.

Accounting for both these facts tips the balance even more in favour of the diversified portfolio over the term deposit.

The graph below shows the returns available to investors after subtracting the combination of taxes, inflation and advice/custody/investment management fees (which apply to the diversified portfolio only).

As you can see, the diversified portfolio consisting of 98% shares no longer has a little over two times the expected return of the term deposit, it now has nearly nine times!

With some calculations, you can see that makes a very big difference to the long term outcome.  Someone with $500,000 in term deposits, getting a 0.47% net real return (after inflation), could spend $23,000 a year over 30 years of retirement.  However, with the same size investment and a 4.95% net real return, they could spend $38,250 a year.  That’s a 66% ‘improvement in lifestyle’.  If you planned to live on $38,250 a year but only invested in term deposits, you’d run out of money within 15 years! This is an extreme example with a much higher risk investment, but you can get the point, I’m sure.

If we defined risk as the chance of running out of money, or not having the money you need, when you need it, term deposits are far riskier.

Term deposits still have a place in investing – they are a great tool for addressing short term needs.  They are, however, not an appropriate basis for a long-term investment/retirement strategy.  They are more likely to result in an investor having to compromise their lifestyle or running out of money completely.  They are also more likely to suffer from an unexpected catastrophe that could result in a permanent loss of your capital.

If term deposits are the backbone of your retirement strategy, take advice: your future may not be as secure as you think it is.

[1] http://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Bulletins/2009/2009dec72-4hunt.pdf

 

This article should not be considered to be advice. We strongly recommend you seek personalised financial advice before making any changes to your financial plans. A disclosure statement is available free of change and on request. Contact us to arrange an appointment.