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Negative Real Rate of Return on Term Deposits

Investment

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5.5.22 |

Joseph Darby

Term deposits are still losing in real terms

If you're a New Zealander looking to grow your wealth, you might be considering term deposits as a safe and reliable investment option. However, did you know many term deposits have been delivering a negative real rate of return for many years now? In other words, your money is losing value over time, even though the headline-grabbing interest rates paid on term deposits might look attractive at first glance.

What is a Negative Real Rate of Return?

Before we dive into negative real rates of return, let's first define a few key terms. Real interest rates refer to the nominal interest rates adjusted for inflation. Nominal interest rates, on the other hand, are the interest rates that are advertised by banks and financial institutions. Real interest rates are a more accurate representation of the true value of your investment since they account for inflation, which erodes the purchasing power of your money over time.

What is Inflation?

Inflation is the term used to describe a steady increase in average prices throughout the economy. It means that money is steadily losing its value in real terms.

Even the Reserve Bank of New Zealand refers to inflation as the “thief in your wallet”, and provides a handy calculator to help explain how the real value of a NZ Dollar has changed over time.

Negative Returns

A negative real rate of return occurs when the real interest rate is negative. In other words, even though the nominal interest rate might be positive, inflation can still mean your money is losing value in real terms.

For example, let's say you invest $10,000 in a term deposit that offers an interest rate of 4%. However, the inflation rate for that year is 5%. This means that even though you earned 4% in interest, the real rate of return is -1%. In other words, your $10,000 investment is now worth $9,900 in real terms.

Why are Term Deposits Delivering Negative Real Rates of Return?

It’s all about inflation.

Even when inflation rates were different to now, including when they were at historic lows, term deposits were usually delivering negative rates of return – as the nominal return was still lower than inflation.

Tax Implications

But wait, it gets worse for savers!

Resident Withholding Tax (RWT)

RWT is the tax deducted on interest paid to New Zealand tax residents on your savings and deposit accounts, including term deposits. For more information about RWT and which tax rate you should be on, check out the Inland Revenue Department (IRD) website or speak to an accountant or tax adviser.

How Much Tax Will You Pay?

There are different RWT rates for individuals, trusts, companies, and partnerships. You can find the current Personal RWT rates below or refer to the IRD website for more information. Your RWT rate is based on your taxable income for the year, which depends on how much you earn including NZ Superannuation (“the pension”) if you’re over age 65:

Earnings up to $15,600 = 10.5% tax
$15,601 - $53,500 =17.5% tax
$53,501 - $78,100 = 30% tax
$78,101 - $180,000 = 33% tax
Over $180,000 = 39% tax

In other words, even though your real rate of return is already negative because of inflation, you’ll still be taxed at the rates above, depending on how much you earn.

Let’s elaborate on the example we used earlier. You invest the same $10,000 in a term deposit that offers an interest rate of 4%. Let’s assume you’re in the 33% tax bracket. This means that even though you earned 4% in interest, you’ve paid tax of about 1.32% (33% of 4) leaving you with an after-tax return of about 2.68%. Inflation that year is 5%, so if you subtract inflation, then your post-tax real rate of return is about -2.32%. In other words, your $10,000 investment is now worth $9,768 in real terms.

What Can You Do to Protect Your Wealth?

You’re hopefully now asking what you can do to protect your wealth in the current environment with negative real rates of return.

Here are some options to consider:

Diversify Your Portfolio

Instead of relying solely on term deposits, consider diversifying your portfolio by investing in other asset classes such as stocks, bonds, and real estate. By spreading your investments across different asset classes, you can potentially reduce your overall risk and increase your chances of earning a positive real rate of return.

Shop Around for Higher Rates

While the interest rates on term deposits are generally low, some financial institutions may offer higher rates than others. It's important to shop around and compare the rates offered by different banks and credit unions to find the best deal.

Play it safe though! Many non-bank institutions are offering higher interest rates because they’re lending out those same funds for much riskier pursuits. In other words, you get a higher return, though take more risk. This is shown by their lack of strong credit ratings that come with the major New Zealand banks – which are among the best in the world.

Consider Investing in Overseas Markets

If interest rates in New Zealand are low, you may want to consider investing in overseas markets where interest rates are higher. However, investing in overseas markets does require a higher level of expertise. It's important to do your research and seek professional advice before making any investment decisions.

The Bottom Line: Negative Rates of Return on Term Deposits

A negative real rate of return is obviously a challenge for investors looking to grow their wealth. However, by diversifying your portfolio, shopping around for higher rates, and exploring overseas opportunities, you can potentially protect your wealth and earn a positive real rate of return. It's important to keep in mind that investing always involves risk, so it's important to research thoroughly and ensure you understand the risks you’re taking before making any investment decision.