Earlier this week the Reserve Bank of Australia (RBA) announced that the cash rate will remain at 3.5 per cent, a result universally expected. The RBA cut its key lending rate at four of its previous seven monthly meetings, with the lending rate now at its lowest level since November 2009.
Much of the reporting and analysis on the topic of interest rates has been focused on borrowers, and not depositors. What does the future look like for those who are living off the interest earned from money in the bank?
Unfortunately for those living off the interest earned from money in the bank, challenges are starting to emerge as interest income slides. The chart below shows official interest rates going back to 1985. The linear trend line shows the rates falling in those twenty-seven years, however, there are three distinct economic periods.
Source: Reserve Bank of Australia
Firstly, the period up until mid 1992. This is when rates normalised and the RBA started to manage the rates on a monthly basis as they do now. During this period home loan and term deposit rates did not automatically follow the RBA. Australian borrowers felt some pain with the average RBA rate being 15% for the period – on the other hand Australian depositors were reaping the rewards.
In the second period from mid 1992 until mid 2008 rates were very steady and the banks largely followed the RBA rates, times were good, the banks could do as they pleased, funds were available from many sources and everyone thought this was normal. The RBA rates averaged 5.8% during this period.
The third period is from mid 2008 until now. The average rate is 4.3% and our working assumptions are that these lower rates will continue for some time. The irrefutable fact for those receiving income from term deposits and bank accounts is that interest payments are falling significantly. In the current environment term deposit rates are sub 5%, whereas two years ago an attractive 7% or more was the standard. A person with $500,000 invested in a bank now would have an average income of $21,500 per annum. Before the GFC the same deposit would have generated an average of $29,000 per annum; a 25% reduction in interest income. The chart below projects the future impact on this scenario if interest rates remain at their current low level.
20 Year Capital Projection
Source: Robert MacLean, Equitas Wealth Pty Limited
The projection assumes inflation of 3%, a continuing low interest rate of 4.3%, and that the depositor does not adjust spending patterns to reflect the lower annual interest income earned. The green line shows the capital growth required to preserve the capital in real terms over the twenty years. The blue line shows the depletion of the capital if the depositor continues to spend in excess of actual interest earned. What is the moral of the story? If you have not reduced your expenses in line with this trend, you will be spending your capital and your funds will rapidly dwindle. In all scenarios, one or two years has little effect on capital values, however, over time the dual impact of unadjusted spending and inflation will start to bite and in ten years you will lose half of the capital value of your money.
So what can be done?
- In times past Government bonds provided good returns, however at the moment 10 year Government bonds are about 3%, so are not a strong option.
- For those with a longer term view and who are comfortable with the market volatility, Australian shares are paying 5 – 6% dividends plus another 1% franking credit.
- Having a comprehensive budget can go a long way to managing your cashflow, expenses and financial commitments. Time spent reviewing financial commitments and fixed and variable expenditure will be time well spent.
For those who want to preserve their capital a choice must be made between taking some risk on investments, spending capital to survive or reducing total expense by 25% now and a further 3% every year – or looking the other way and hoping it will all be OK in the end.
In all cases your individual financial objectives, needs and circumstances need to be considered. Knowing the financial implications for each option – including doing nothing – is the key to navigating the fall and fall of interest rates. If you would like to discuss this or any other matter with me please do not hesitate to call or drop me a line.