Money in the bank: Is cash the best long-term option?
Many investors concerned with protecting their nest eggs, who have moved their savings from equities into lower-risk assets such as term deposits. Yet, as things start to change in the markets, now may be a good time to look at some alternatives.
One of the key tenets of behavioural finance states that investors would rather receive a small, certain reward now rather than a potentially greater return in the future. Over the past few years, this has made sense to many investors concerned with protecting their nest eggs, who have moved their savings from equities into lower-risk assets such as term deposits. Yet, as things start to change in the markets, now may be a good time to look at some alternatives.
Cash and term deposits play an important role in most investors’ portfolios. These assets can help you with short-term cash flow needs, and provide relative stability and certainty during times that other investments are volatile. Term deposits have traditionally played a role in short- or medium-term savings for those looking to put money away for goals such as a holiday, house deposit or new car. However, over the past few years, the lines between investing and saving have been blurred, as Australians have moved significant portions of their superannuation and investments into term deposits.
Yet now that the cash rate is half what it was in 2008¹ and may fall further, term deposits may not continue to provide certainty, particularly when it comes to growing your long-term wealth.
If you are investing for a medium- or long-term goal such as saving for a house deposit or your retirement, you’ll need your savings to grow enough to reach your target, and to keep up with inflation.
We believe the best way to do this is to have a mix of assets that provide both capital growth and income to help you reach these goals.
The effect of rate cuts on your savings
When interest rates fall, the impact on cash investments has a cumulative effect over time.
Whether you are saving towards a goal or you are a retiree who depends on your savings to draw an income, a reduction in cash rates will have an effect on your financial situation.
Even over the medium-term of three to five years, the impact is significant.
For example if you have a cash deposit of $100,000, a 0.25% cut in interest rates reduces your return by $250 in the first year, and by the fifth year your account balance would be $1,430 less. A 1.0% cut in interest rates reduces your return by $1,000 in year one, and in year five you would have $5,800 less in your account balance.
Over the long term the effect on your savings is even bigger, as you can see in the following table.
Exhibit 1: Impact of rate cut on cash investment over time
Source: AMP Capital
As Exhibit 1 shows, if you have savings of $500,000 invested in cash, and you draw an annual income of $30,000 from these savings, a 0.25% per annum rate drop would mean a loss of income of $1,175 in the first year, or 4% of your annual income. That’s quite a large loss to your income.
And the larger your savings the larger the impact of a rate cut. For instance, if you have savings of $700,000 invested in cash and draw the same income, you would lose $1,675 in the first year, or 5.6% of your annual income.
A 1% drop in the official cash rate would have an even greater impact. If you have $500,000 invested in cash, you would lose $4,700 in income in the first year, and with $700,000 you would lose $6,700 in income. That’s a 16% and 22% reduction of annual incomes respectively.
It’s also important to consider the effect of inflation on your investment over time. The real rate of return on an investment is what you will earn once inflation is taken into account.
If, for example, your bank pays you 5% on your investment and the inflation rate is 3% then the real rate of return is 2%—significantly less than what you may expect.
Where to from here?
While we believe term deposits can be a useful anchor for your investment portfolio, providing stability and a regular income, it’s likely they may not provide enough growth to keep up with inflation over time, particularly if the cash rate continues to fall. Therefore, along with your financial adviser, you may like to consider other assets such as corporate bonds, property, infrastructure and equities to help grow your savings over the long term.
Here are a few options you may like to speak to your financial adviser about:
Corporate bonds may be a good stepping stone for those looking to move back into investing. They can be a good alternative to investors seeking higher yields than term deposits but who don’t want the volatility of equities. Unlike term deposits, corporate bonds can generate capital growth, provide income and can act as a portfolio diversifier when share markets are down.
Australian real estate investment trusts (A-REITs) were a popular alternative to bank deposits several years ago, when they had high yields and stable capital value, but this ended abruptly when prices fell during the Global Financial Crisis. However, we believe that A-REITs are back on track and they have lowered their debt levels and focused on their main business of managing buildings, collecting rents and passing income on to their investors.
Unlisted commercial property also offers attractive yields and doesn’t suffer from the overvaluation of residential property.
Listed and unlisted infrastructure generally offer strong long-term yield, underpinned by investments such as toll roads and utilities where demand is relatively stable.
Equities are, in our view, may be a good option if you are looking for an investment with the potential to provide higher returns over the long-term. Australian equities are offering some attractive income through dividends, which also offer potential tax benefits for you at tax time.
We believe that it is well worth considering these alternative investment options to help diversify your investment portfolio and protect your future income stream.