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Secure but Shrinking: The Real Cost of Inflation on Term Deposits

When it comes to growing your money, term deposits have long been heralded as a safe haven for savings. However, as renowned economist Thomas Sowell says, “there are no solutions, only trade-offs”. In the case of term deposits, we must weigh the security they provide against other considerations such as inflation, taxes and purchasing power.

Over the long run, the value of money is not static; your rising grocery bill over the last few years illustrates how the value of money erodes with inflation. When inflation outpaces the after-tax interest earned on a term deposit, the real purchasing power of the deposited funds falls over time.

The Leaky Bucket of Inflation

When it comes to growing wealth, the effect that inflation has on your returns always needs to be factored in. For instance, in December 2022, a 1-year term deposit offered an interest rate of 5.25%. After accounting for taxes at a rate of 33%, the net return was 3.52%. However, with inflation running at 5.6% over the past 12 months, the real return after tax and inflation was negative (3.52% net return minus 5.6% inflation was -2.08%) during that year.

The key to understanding this phenomenon lies in the concept of real interest rates, which take inflation into account. A term deposit’s nominal interest rate may appear attractive, but when adjusted for inflation, its real return may be considerably lower or even negative.

Moreover, the longer the term of the deposit, the greater the risk of inflation eroding its purchasing power. While longer-term deposits often offer higher interest rates than shorter-term ones, they also expose investors to the prolonged effects of inflation. In an environment where inflation rates fluctuate, locking funds into a long-term term deposit can significantly diminish their real value over time.

Building Wealth: Risk vs Reward

So, what alternatives exist for investors seeking to preserve or grow their wealth while mitigating the effects of inflation? One option is to explore investment vehicles that historically have outpaced inflation, such as stocks, real estate, and inflation-protected securities. While these options carry greater volatility than term deposits, they also offer the potential for higher returns that can outrun inflation over the long term.

Another strategy is to diversify your portfolio, spreading investments across a mix of asset classes to minimise risk while maximising potential returns. By combining safer investments like term deposits with higher-risk, higher-reward assets, investors can strike a balance between preserving capital and generating growth.

Crunching the Numbers

If we compare the performance of three different investment strategies over the past 10 years, we must consider not only inflation but also fees and taxes. The key question is which investment strategy will give you the best probability of meeting your financial goals. As shown in the graph above, once inflation and taxes were taken into account, term deposits did not contribute to improving an investors’ spending power. In fact, even with no fees the net real return of money held in term deposits has been negative. In comparison both the balanced portfolio (50/50) and pure growth portfolio (98/2) delivered net real returns above inflation.

In conclusion, while term deposits may offer a sense of security and stability, particularly in uncertain economic times, their ability to maintain or grow purchasing power over the long term is limited, especially in the face of inflation. Investors should carefully consider the real impact of inflation on their savings and explore alternative investment strategies to better safeguard their wealth in an ever-changing financial landscape.

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