With interest rates near zero and staying there, retirees and investors should revisit portfolios

2 November 2020

I’ve been investing client funds for over 35 years. In that time, I’ve seen a lot of financial records set be it share market highs and falls, or events that have caused extreme volatility. However, with the emergence of interest rates on bank deposits and Government bonds falling towards zero in 2020, I have never seen such low returns on offer for low risk assets.

The top five New Zealand high street banks are offering on average only 1.0% for one-year term deposits.

And with the Reserve Bank’s new ‘Funding for Lending’ program (low cost ‘helicopter money’ for the banks to lend) soon to start, interest rates are set to decrease further.

In fact, we believe 2020 will not only be the year of record low interest rates but with interest rates trending down gradually over the last ten years and the pace of change accelerating with the COVID-19 economic recession, the resultant relaxation of monetary policy plus the introduction of ‘unconventional’ monetary policy tools might mean near zero interest rates are around for many years.

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Table 1: Average interest rate of one-year term deposit at top five New Zealand high street banks[1]

What international markets tell us about the outlook for interest rates

Between 2007 and 2009, the average US one-year bank CD rates fell dramatically from 3.7% to 0.8% during the Global Financial Crisis (GFC). Since then, they have ranged between 0.2 to 1.0% despite a good rate of economic growth between 2010 and 2020.

Similarly, in the UK, the central bank base rate, which was 5.75% at the start of the GFC (late 2007), has ranged between 0.1% to 0.75% since 2010.

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Table 2: Average CD rates from 2010-2020[2]

In each instance, general inflation has remained suppressed despite reasonable to good economic growth so there has been no requirement to raise interest rates. Given the present weak medium-term economic outlook for New Zealand, I see no reason the same will not occur here for much of the next decade.

The opportunity cost of near zero interest rates for investors and retirees

Since August 2019, resident household deposits with banks have risen from $182 billion to $197 billion. So, despite returns declining, households, with all the uncertainties of COVID-19, were prepared to squirrel away more of their savings into a secure investment such as the bank even though it would increasingly return less.

Makes sense in an uncertain world and over the short term the opportunity cost is not likely to be too high. However, over medium to longer periods, this cost can rise to become a material gap.

Take a hypothetical example of two couples, who are 50 years’ old and each have $500,000 invested for their retirement.

One couple is highly concerned about the COVID-19 recession, so they’ve deposited their money in the bank for safety. The other couple have chosen to invest their money via a Balanced portfolio under the presumption they won’t be touching it until they retire.

From the age of 65, both couples are hoping to draw $50,000 a year on their savings for their retirement income needs.

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Table 3: Growth of $500,000 investment in bank compared to balanced portfolio[3]

At the end of year one, the bank couple are only $20,000 behind the balanced portfolio couple in their portfolio value. Not great but not a disaster. By the end of year five, the potential difference is starting to get significant and the opportunity cost between the two scenarios has risen to $110,000 or 21% of original capital. By the end of year ten, the potential difference in accumulated wealth between the bank couple and the balanced portfolio couple has risen to $251,000 or 48%.

Assuming the two couples stay with the same investment strategy in retirement, the couple with the bank deposit-based strategy can anticipate the following retirement outcomes.

  • They will possibly run out of retirement funds at age 72 and from that time on could be purely reliant on NZ Super going forward.
  • Given the average longevity for a 50-year-old female today is 90 years there is guaranteed to be significant income shortfall for this couple for most of their retired life.
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Table 4: Projected wealth and expenditure of bank deposit-based strategy[4]

The balanced portfolio-based couple are likely to:

  • Have their income needs met into their 80s when their lifestyle is expected to slow down, and expenditure will probably decrease.
  • Have the capacity to save more between now and retirement plus have reasonable KiwiSaver balances to draw on.
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Table 5: Projection of wealth and expenditure of balanced portfolio-based strategy[5]

By taking on more risk the couple using the balanced portfolio-based strategy are probably going to have the retirement lifestyle they’ve always planned on. Conversely, the couple using the bank deposit-based strategy are heading down a problematic path and likely to run out of money too early.

While many of us have enjoyed the security of bank deposits as a place to achieve a steady, low risk income in the lead up to retirement in the past, a bank based investment approach will no longer achieve the goals of many retirees given global trends,

If you have significant funds on bank deposit that are not generating the level of return you require, the Findex Wealth advice team would be more than happy to take you through our comparative analysis and risk profiling, so you can better understand your options. Get in contact with our team today.

[1] RBNZ

[2] www.bankrate.com

[3] The projection analyses have an average bank deposit rate of 1% and balanced portfolio return of 4.5%. Tax rate is 17.5%.

[4] Xplan calculation

[5] Xplan calculation

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November 2020