Best Term Deposits: The Surprising Truth

Have term deposits done their dash?

When it comes to securing your financial future, term deposits have long been considered a safe and reliable option. Traditionally, term deposits have been a popular strategy for many New Zealand retirees and those who weren’t quite sure about how to choose or access other investments or needed to access the money soon. But is this still the case in today’s economic environment, when there’s much easier access to different investment solutions?

Let’s dive into the numbers and see if term deposits truly live up to their reputation.

The Illusion of Term Deposit Safety

At first glance, term deposits seem like a no-brainer. You lock in your money for a set period, earn a fixed interest rate, and walk away with more than you started with. However, this simplistic view overlooks two critical factors: tax and inflation.

The Impact of Tax on Term Deposits

In New Zealand, the interest earned on term deposits is subject to tax at some of the highest rates. For an investor in the 33% tax bracket, a term deposit rate of 5.7% nets only 3.8% after tax. This significantly reduces the effective return on your investment. For those in the 39% tax bracket, the net return drops even further to 3.5%.

Let’s consider a $10,000 term deposit, for example.

• ‍At a 5.7% interest rate, you would earn $570 in interest over one year. However, after paying 33% tax on that interest ($188.10), you’re left with just $381.90. This means your effective interest rate is only 3.8%, not the 5.7% you initially expected.
• For someone in the 39% tax bracket, the tax on $570 would be $222.30, leaving you with $347.70, or an effective interest rate of 3.5%.

To put this into perspective, compare the top tax rate of 39% with the headline tax rate on a couple of other investments:

• Most capital gains on assets such as shares and property: 0% tax
• PIE-structured funds: 28% maximum tax

(We appreciate this comparison is simplistic, as tax can be a complex area, but you should still conclude term deposits are inefficient from a tax perspective).

The Inflation Monster

The Devaluation of Money Over Time

By now, we all should be no strangers to inflation.

Inflation erodes the purchasing power of your money over time. Even if your term deposit earns a decent headline interest rate, high inflation can negate these gains. For example, with an inflation rate of 6.0%, a 5.75% term deposit results in a negative real return of -0.25% before tax. This means your money is effectively losing value.

Consider the same $10,000 term deposit with a 5.75% interest rate. After a year, you would have $10,575. However, if inflation is at 6.0%, the purchasing power of your $10,575 is equivalent to just $9,961.50 in today’s dollars. So, despite earning interest, your money has actually lost value in real terms.

This example covers just one year. Over longer periods, the numbers can be dramatic.

To illustrate this, consider the cost of groceries. In 1975, a typical grocery shop in New Zealand might have totalled around $6.56. We all know that today, a usual basket of goods would cost significantly more, reflecting the burden of inflation over the decades.

Similarly, the cost of housing has experienced a healthy increase due to inflation. In 1975, the average house price in Auckland was around $24,300. Fast forward to today, and again we all know the average house price so much more! This is yet another illustration of how the purchasing power of money decreases over long periods.

Combined Impact of Tax and Inflation

Now, let’s combine the effects of both tax and inflation.

Suppose you have a $10,000 term deposit with a 5.7% interest rate. After a year, you would earn $570 in interest. For an investor in the 33% tax bracket, the after-tax interest would be $381.90. However, with an inflation rate of 6.0%, the real value of your $10,381.90 (initial deposit plus after-tax interest) would be equivalent to $9,783.99 in today’s dollars. This means that, after accounting for both tax and inflation, your investment has decreased in real value by $216.01.

For someone in the 39% tax bracket, the after-tax interest would be $347.70. With the same inflation rate of 6.0%, the real value of your $10,347.70 would be equivalent to $9,764.92 in today’s dollars. In this case, your investment has decreased in value by $235.08.

Remember, this example is just over one year, over the decades this degradation in value will be amplified.

Learn more: Term deposits could be your worst enemy

What Other Options Are There?

Stocks and Shares

Investing in the stock market can offer higher returns compared to term deposits. While stocks come with higher risk, they also have the potential for significant growth. Over the long term, the stock market has historically outperformed other asset classes. After all, shares represent ownership in businesses, which are the driving force behind societal progress.  

In years gone by, investing in shares was challenging, mainly due to challenges in obtaining sufficient research and information. The advent of the internet has changed all this, removing what was a substantial barrier for many smaller investors.

Bonds

Bonds are essentially just a loan to a government or large corporation for a set amount of time. Bonds are generally less volatile than stocks, come with less risk, and can provide a steady income stream. Government and corporate bonds can be a good option for those looking for a balance between risk and return.

Real Estate

Property investment can offer both rental income and capital appreciation. While it might require a larger initial investment and comes with its own set of risks, real estate can be a valuable addition to a diversified portfolio.

Managed Funds

Managed funds pool money from multiple investors to invest in a diversified portfolio of assets. This can include stocks, bonds, property and other assets. Managed funds are commonly actively managed by professional fund managers and have taxes and fees automatically, which can be beneficial for those who prefer a hands-off approach.

KiwiSaver is a form of managed fund, though managed funds also come in ‘unlocked’ varieties where you can withdraw your money at any time. KiwiSaver has been a fantastic tool in helping New Zealanders save for their retirement, and in showing New Zealanders the benefits of sticking the course with investing in managed funds. After launching around the time of the GFC, KiwiSaver has shown investors that if you stay the course with a mixed portfolio of shares and more defensive assets, while there will be some ups and downs, over the longer term you should easily beat the return you’ll get with term deposits.

Index Funds and ETFs

These funds track a specific index, such as the NZX 50 or the S&P 500. They offer diversification and typically have lower fees compared to actively managed funds.

When Term Deposits Are a Good Idea

Despite their limitations, term deposits can still be a good option in certain situations:

Low-Risk Investment

If you are a conservative investor looking for a low-risk option, term deposits can provide a guaranteed return without the volatility of investment markets.

Short-Term Savings Goals

Term deposits can be suitable for short-term savings goals where you need to ensure your capital is preserved, such as saving for a holiday or a down payment on a house.

Diversification

Including term deposits as a small part of a diversified investment portfolio can help balance risk, especially if other investments are more volatile.

The Bottom Line: Term Deposits Have Done Their Dash

Term deposits may offer a sense of security, though they have done their dash as a long-term financial solution. After factoring in tax and inflation, the returns are often disappointing. It’s crucial to explore other investment options that can provide better protection against inflation and offer higher after-tax returns.

For example, investing in a diversified portfolio of assets can offer higher potential returns and better protection against inflation. While investments such as stocks, bonds, and property come with higher risk, they also provide the opportunity for growth that can outpace inflation and taxes over the long term.

So, the next time you’re considering a term deposit, remember to look beyond the headline interest rate. Your future self will thank you.

To book a complimentary initial consultation with one of our team to discuss anything mentioned above, including better long-term solutions to build and keep wealth than term deposits, simply get in touch.