Australian banks have recently reduced their Term Deposit interest rates further where the average sits at under 2.4% per annum, which begs the question - are Term Deposits worth investing in?
How Term Deposits work
Australian Deposit Taking Institutions (ADI's) use Term Deposit money as a low-cost source of capital to fund their investment activities. When Mayfair 101 did some research into the Big 4 Australian Banks recently we identified they were sitting on over $1 trillion in deposits, meaning Australian investors have provided the banks with over $1 trillion in low-cost capital to finance their investment activities. These investments include home loans, car loans, credit cards and other financial products.
What about the Government Guarantee?
After the Global Financial Crisis hit in 2009 the Australian Government introduced the Financial Claims Scheme, which meant to the average person that the Government would guarantee an individual's bank deposit in an ADI to the tune of $250,000.
It was effective in bringing confidence to Australia's banking system, except when we looked more closely it seemed the numbers didn't quite add up given the Australian Government isn't exactly flush with spare cash.
After doing some research into the Financial Claims Scheme, including surveying an audience of approximately 700 people at a recent event, it seemed almost no one (except for one audience participant) knew there was a limit per ADI. Considering the Big 4 Banks sit on an average of around $400 billion one might expect the guarantee to be somewhere close to this, however it isn't. The Financial Claims Scheme is limited to just $20 billion per ADI. Besides, the Government doesn't exactly have billions of spare capital floating around to bail out a mis-managed bank.
What does this mean for investors?
The Financial Claims Scheme has, in our opinion, been a success in steadying the economy and guiding the country through what was a challenging period post-GFC. However fast-forward 10 years and it seems that the limitations surrounding the Government Guarantee have received little attention, and that the lack of information for larger investors wanting to make an informed decision is somewhat concerning.
Take for example an investor with $1 million in a Term Deposit in a top 4 ADI. Firstly, 25% of their capital is covered according to the Financial Claims Scheme (and the bank websites confirm this). However, given the Government will only cover $20 billion of the approximate $400 billion, the guarantee is in fact a lot less than the quoted $250,000, as it is dependent on the level of deposits held at any point.
It begs the question - don't the banks have an onus to disclose this to their customers just as other financial services companies do?
Advantages of a Term Deposit
Term Deposits are a good option for investors that are happy with a return marginally better than inflation, which was 1.8% in 2018.
Using our $1 million example in a Term Deposit earning a competitive 2.5% per annum, this equates to a CPI-adjusted return of approximately $7,000 per year (or one average overseas holiday a year for a couple).
Term Deposits are also a good option for those with limited investment experience that need a quick place to park idle funds. They provide the ability to withdraw at the end of the term or roll over for a new term, with minimal involvement.
Disadvantages of a Term Deposit
The biggest disadvantage of a Term Deposit is opportunity cost, where a little more research could provide a substantially higher rate of return whilst still maintaining a comfortable level of risk.
Term deposit rates are only marginally better than standard transaction accounts in part due to banks having significant overheads. The capital pool provided by term deposits provides banks with the ability to leverage their position to invest and make record-breaking profits, which is of course great if you are a shareholder.
Investors should also be aware that banks typically have early exit fees which can erode some or potentially all of the interest earned during the period. It is important to read the Terms and Conditions prior to investing in a Term Deposit.
What are the alternatives?
Whilst there are many other asset classes to invest in (e.g. property, stocks, bonds etc.) some fund managers have structured their investment products in a way that provides investors with similar term-based alternatives to Term Deposits.
Companies such as La Trobe Financial and Trilogy are property-backed investment companies that provide term-based investment options using Australian property as their primary underlying asset. The advertised returns of these companies range from 3.20% (for a 48 hour account) to 7.00% (for a 4 year investment) per annum, which is a considerable step up from current Term Deposit rates. Whilst they are not ADI's their real estate portfolios are not dissimilar to a banks in terms of their exposure to Australian real estate.
Investors Central is another offering that is modelled on Term Deposits by way of its time-based nature, providing investment terms from 3 months to 60 months and advertised returns ranging from 4.25%-8.00% per annum.
IPO Wealth, Mayfair 101's wholly owned subsidiary, is of course another competitive offering in the space with terms from 3-60 months and similar returns being offered to those above. A key difference is that IPO Wealth is focused on Wholesale & Sophisticated investors only and the funds are deployed via Mayfair 101's private equity investment strategy. IPO Wealth doesn't have any exposure to the Australian property market, which is currently very appealing given the state of the market.
With any of the above offerings, if the same $1 million referenced earlier was invested at a conservative 5.00% per annum, this would return a CPI-adjusted rate of 4.3%, or approximately $43,000 per annum. That's 6 overseas holidays a year, or enough to take the whole family.
Are Term Deposits losing their appeal?
As more alternatives enter the market it is no doubt that Term Deposits will become less attractive, particularly as generational shifts continue to take place. With investment more information readily available than ever Australian investors are become more sophisticated and savvy in their investment decisions.
That said, Term Deposits have been at record levels recently, showing the big shift towards cash investments in uncertain times. This presents an excellent opportunity for those alternative offerings to gain momentum and for investors to benefit from potentially higher rates of return.
Importance of doing your homework
Before investing it is important to understand how the investment works and the associated risks. We recommend requesting a copy of the PDS or Information Memorandum of any company before investing, and ensuring you understand how they can generate their returns. In some instances it can be useful to see if you like the initiatives they are supporting as this is what you money will be used to support.
Diversification is key
Term Deposits can be a good means of parking idle money short or long term, however as they say, the only thing guaranteed in life is death and taxes. It is prudent to spread your investment capital into products you understand, management teams you believe in, and initiatives that align with your interests. It doesn't take much research to find many alternatives to Term Deposits to invest your hard-earned money into and you may pleasantly surprised with how much faster this can help build your wealth or fund your lifestyle requirements.
The content of this website is general in nature and does not take the personal situation of any user of this website into consideration. A user of this website should seek financial advice specific to that user’s situation before making any financial decision.