The Role of Bank Term Deposits
Introduction
Terms deposits are a savings product from a bank, credit union or building society which simply involve you agreeing to invest an amount for a fixed term in return for a fixed rate of interest over that term - payable at negotiable intervals (monthly, annually or at the end of the term). Only a "Authorised Deposit- taking Institution", or ADI for short, can offer term deposits. APRA provides a list of ADI's and don't confuse term deposits with a raft of other "term" investments, sometimes offering attractive headline rates, which are not as secure. When placed with an ADI all deposits up to $250,000 are guaranteed by the Government; and this cap applies per person and per ADI.
Now we are going to be topical by suggesting that, unless your investment time frame is very short or special circumstances apply, then term deposits should not be looked on as an investment - they should largely be used to ensure that any liquid funds you retain within your portfolio earn a reasonable return.
We do not believe that term deposits adequately protect you from inflation risk and that is an absolute concern when you are looking at an investment period of over 20 years. This is entirely separate from the problem many retirees experienced until relatively recently in terms of returns on term deposits - see the chart below which looks at interest rates offered on a $10,000 bank term deposit since 2000 (Source: RBA). Interest rates have increased but at nothing like the pace of mortgages - leading to significant criticism of local banks for profiting from the disparity.
We believe that most retirees, unless they have a very short horizon, will be better served by a diversified investment portfolio with a continuing, but gradually declining, exposure to growth assets. This requires that retirees retain adequately liquidity to cope with the additional volatility. The need to sell equities or other assets to provide cash flow on a "fire sale basis" must be avoided - and term deposits are a secure way of ensuring that liquid funds generate a return and even if you need to break a term deposit, for emergency/immediate access, the cost is relatively low.
How much Cash do you need to retain?
As a rule of thumb we think that most retirees with a diversified investment portfolio will want to retain a minimum 2 years worth of forward income as cash or cash equivalent investments - having regard for any planned "lumpy" expenditure in that period, such as a car or home improvements. Beyond this much depends on your investments and should be discussed with your adviser. For example, if you have an SMSF dominated by real estate investments which can be illiquid, you may require significantly more cash to absolutely ensure you can meet minimum payout requirements.
Best Rates and Strategy
In very basic terms it is important to shop around when taking out a term deposit and to do so when the deposit matures. There are websites such as Canstar that will provide you with a very good view of competing offers, and you must ensure that you don't pay the "lazy tax". This includes not simply accepting the the automatic rollover of your funds if you "do nothing" - they may be rolled over at a lower interest or for a term duration that no longer suits you. Banks in Australia make a lot of money from "client inertia".
In terms of how any investment is made, you will typically find - with some exceptions - that the longer the investment period the higher the interest rate. One way of balancing return and liquidity in these cases is to "ladder" or "stagger" your investments and place a portion of your money at different maturities rather than to simply put one large lump sum into one term deposit. It's more work but provides both liquidity and access to the longer term rates.
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