Smarter Saving Strategies
Why I created this guide From childhood, we’re taught the importance of saving for the future. Back then it was so simple – we filled our piggy bank with money made from odd jobs around the house and when it was full, we got to indulge in the instant gratification of buying something special that was all ours! For generations, the piggy bank was our first introduction to savings. You’d think that with all the practice we’ve had, we’d be in a good position as adults to know the strategies behind saving and how to maximise our hard earned money! But through the fog of flashy marketing and convoluted vernacular thrown at us by the big banks, the simple process of savings has become downright confusing. With so many options drowned in fine print, it’s no wonder Australians aren’t saving to their full potential. That’s why I’ve created this guide - to explain the savings process and debunk some of the myths in the market today. I have always been of the mind that every Australian deserves to have their money work as hard as they do. So if yours doesn’t, now is the time to kick your savings strategy into high gear! In this guide, we’ll go through the different kinds of savings options from popular online high interest savings accounts to some of the more sophisticated strategies used by the pros. I’ll also give you some insight into what all those flashy marketing terms actually mean and how you can cut through the clutter to devise the best strategy for you and your family. Whether you’re saving to buy your first home, looking to support your children’s future education, or even if you’re a small business owner wanting to maximise your capital, there is a solution for you. So here’s my first tip. You don’t have to be an expert to get your best return on investment – you just have to know where to look. At Yellow Brick Road, our goal is to democratise the secrets of savings and bring the inside source straight to you. So forget about having to decipher the big bank’s lingo because the tricks of the trade are contained right here in this booklet. Quite simply, there is a better way to save and we’ll show you how.
Mark Bouris Executive Chairman, Yellow Brick Road
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How savings work The basic business of banks is to take the cash you deposit with them and lend it to other borrowers - be they individuals or businesses - at a higher rate of interest than they pay you. In this way, banks take our savings and convert them into loans. When you put cash into a savings account, you are actually lending money to a bank. You are the bank’s ‘creditor’, and they are your ‘borrower’. The bank may pay you an interest rate of, say, 2.95 percent per annum. This is obviously a cheap loan for the bank to get from you. In addition to a bit of interest, you receive some certainty of repayment in return. If you have your money in a ‘transactional’ bank account, you typically earn an interest rate of zero percent per annum. That is, you are effectively giving the bank a free loan. Of course, they give you the convenience of being able to conduct transactions from that account, and you have peace of mind in knowing that your money is normally safe. When a bank then lends your money back out to, say, a home loan borrower, they charge around 5.10 percent. If they are lending to a small business, they charge a higher 7.95 percent rate. Personal loans and credit cards attract the steepest rates of them all up to 19 percent.1
1. Based on Reserve Bank of Australia data as at March 2014. 2
But nothing is ever that simple. As you would expect, there are lots of hidden tricks and traps in the savings trade. Here are some that I have discovered over the years: • A ccording to the Reserve Bank of Australia, the major banks make, on average, a significant 2.25 percent per annum ‘net interest margin’ over their cost of funds: that is, the major banks earn 2.25 percent per annum more than they pay you on your deposits. The 2.25 percent is an average that measures the gap between many different sources of bank funding and bank lending. However, the fact remains: the banks pay you far less for the money you lend to them via your deposit than what they charge when they lend the same money back out to their own borrowers.
What Banks Pay You vs. Wha
t Banks Get
22% 20%
Annual Rate
18% 16%
Returns banks get
14% 12%
Returns you get
10% 8% 6% 4% 2% 0%
0%
Margin Loan
Credit Card
Personal Loan
Home Loan
chart are sourced from the Rese rve
SME (variable)
SME (resi)
Av. ‘Special’ Rate
Av. Rate
12mth TD
6mth TD
3mth TD
1mth TD
Online Savings
Bonus Savings
Transaction
Source: Interest rates illustrated in this
Bank of Australia, February 2014
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• B anks have an incentive to pay you the lowest interest rate: when you accept a low rate on your savings, you may be helping the banks make more profits than if you demanded a higher rate. Irrespective of whether you are getting zero percent or 2.95 percent, the banks naturally charge the highest rates possible on their loans to small businesses, home owners, companies, and individuals. That is, after all, how they make their money. You should, therefore, make sure you are getting the best possible deal. If you push them hard enough, some banks will even let you negotiate a rate!
• T hey don’t call it a ‘term deposit’ for nothing: not only can the bank chase the best interest rates for itself while locking you into a fixed return via a term deposit, but they also have the ability to prevent you from withdrawing your money from a term deposit. In particular, the ‘fine print’ in many term deposits says that the bank can lock you up until the term deposit expires. So don’t assume that you will always be able to get your money out early.
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• Y ou may suffer large penalties if you withdraw your money early: if the bank does agree to allow you to take your money out of a term deposit early, they can charge you large penalties that amount to 90 percent or more of the interest rate you were promised. With some major bank products, if you take out your money four months into a 12 month term deposit, the bank has the ability to only pay you 20 percent of the original, say, 2.95 percent interest rate you were promised. In this example, you would only earn a 0.59 percent annual interest rate. Over four months that means you will get a total interest rate of just 0.20 percent! In dollar terms, you were originally promised $98 on a $10,000 term deposit over the first four months. But because you are withdrawing your money early, you only earn $20.
• A n interest rate is not always an interest rate: When aggressive banks promote their high ‘annual’ interest rates on ‘bonus’ or ‘special’ savings accounts, the promised interest rate is typically for a very short introductory period before reverting to a much lower rate – not unlike a ‘honeymoon’ rate on some mortgages. The actual ‘annual return’ you earn in these bonus accounts is far lower than the advertised annual ‘bonus’ rate. In fact, you cannot normally earn the ‘bonus’ interest rate over any 12 month period. For example, there are products where you are offered a 4.35 percent per annum ‘bonus’ rate, but this rate only lasts for four months. After this period, the rate drops to a much lower 2.75 percent. So the annual rate is actually only 3.30 percent in the first year, which is often lower than these same banks’ 12 month term deposit rates. And no, you cannot simply start a new account to get the bonus rate again!
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• T he banks want small, unsophisticated customers that they call ‘sticky’ money. Why offer a bonus annual rate of 4.35 percent for only the first four months and then pay you just 2.75 percent thereafter? Surely people will see through this trick! The banks evidently don’t think so. They use these strategies to attract unsophisticated customers that they hope will stay with them even when their interest rate drops significantly.
I will explain why in a moment.
• T he banks cap the amount you can invest in these ‘bonus’ savings accounts precisely so they can classify you as small and unsophisticated. Under the new global banking rules, banks are rewarded for attracting smaller and less sophisticated deposits. The bankers and their regulators think there is a lower chance that this not-so-smart money will flee a bank if it gets into trouble. The smarter money, which is believed to be provided by institutional investors, is classified as flightly or non-sticky. That’s because the bankers think this money will run out the door at the first sign of adversity. In almost all bonus savings accounts you will notice that the maximum you can invest is between $200,000 and $250,000. This is precisely because the bank wants to be able to categorise your deposit as a smaller, less sophisticated, and sticky client.
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KEY FACTS
When you put money into a bank deposit, you are lending money to the bank You want to consider what a ‘fair’ interest rate is on your deposit in exchange for letting the bank borrow from you Banks take the money and lend it out to businesses, home owners, and people with personal loans and credit cards at much higher rates than they pay you On average, the major banks make 2.25 percent in annual interest over and above what they pay the people that lend them money, such as you (via your deposit) Many banks have the ability to lock you into a term deposit until the full term expires; ie, you may not be able to take your money out If you do withdraw your money early from a term deposit, banks can charge you penalties of 90 percent or more of the interest you were originally promised The ‘bonus’ annual interest rates offered by some banks cannot actually be earned over any 12 month period. This is because the bonus rate disappears after an initial ‘teaser’ term (and/or if you don’t meet other conditions) and is replaced by a far lower rate You are limited to investing a maximum of $200,000 in most banks’ bonus savings accounts so that the bank can classify you as a small, unsophisticated and ‘sticky’ depositor 7
DIFFERENT SAVINGS SOLUTIONS As I have shown, there are many tricks and traps associated with saving. All saving is a trade-off between ‘risk’, which means the chance you lose money, and ‘return’, which refers to the prospect of growing your money. The higher the returns you seek, the greater the chance you may end up getting either a lower return than you expect, or even lose money. Alternatively, if you want to remove most of your risk, you will normally get poorer returns that may not meet your long-term financial needs. Access to funds is another important consideration. A 12 month term deposit might promise high returns and low risk, but you forego access to your money for an entire year. And, as I explained before, banks can lock you into these products for the whole term. In contrast, transactional accounts give you the freedom to access your money on any given day, but normally pay you a super low, or no, return. In fact, after all fees and charges, your transaction account may hit you with a negative interest rate.
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Of course, you don’t have to focus purely on just minimising your risk, or maximising your returns. The smartest thing to do is to bring together investments that help you achieve your overall risk and return objectives. Remember that you have many different sources of saving: the money invested in your home, the bank’s transaction account, your super, direct shares, and so on. One aspiration should be to ensure that your overall savings can weather future financial storms while still achieving your financial goals. To do this, you usually need to ‘diversify’. That is, you don’t put all your eggs in one basket. You should spread your savings across multiple investment categories, each with different risk, return and access characteristics. So what are some of your options? In the next section I will look at four different solutions at the safer end of the investment spectrum: transactional bank accounts, term deposits, government, bank and corporate bonds, and cash and fixedincome managed funds. There are others, such as direct property or shares, but they have been well covered elsewhere.
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• T ransactional bank accounts: Two common ‘at-call’ bank solutions are the standard transaction account, which you can link your bills to, and the online savings product, which typically offers a better rate with the cost of fewer features (and other terms and conditions). You have no guarantee what interest you are paid in either of these products since they are ‘variable rate’, and usually tied to movements in the RBA’s official target cash rate. One advantage of these accounts is that you can usually access a government guarantee of up to $250,000. A disadvantage is that they often offer lower returns compared with bank products that tie your money up for longer periods of time. • T erm deposits: With a term deposit, you are again lending money to the bank, but this time for a fixed-term and at a fixed interest rate. It is like a fixed-rate home loan, just in reverse. The interest on a term deposit may be distributed to you monthly, quarterly, or only when the product’s term ends. Normally, the term deposit pays you a higher interest rate the longer you are prepared to keep your money in it. Returns on term deposits are also usually at the higher end of what an investor can earn in a bank savings account. The most common terms are 30 days, 60 days, 90 days, 180 days and 360 days. But remember banks can lock you into these products. If they do let you withdraw your money early, you can be stung with hefty penalties.
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• Government, bank and corporate bonds: Rather
than lending money to the banks via savings accounts and term deposits, you can often earn higher interest rates by lending to very big, high-quality companies (eg, Telstra or Woolworths) via ‘bonds’. In fact, you can invest directly in the major bank’s bonds and usually earn better returns than you get in their savings accounts! While these investments are broadly known as ‘fixedincome’, the interest rate you receive may be fixed or variable just like with bank deposits. More formally, a bond is a loan agreement between you (and the other investors in the bond) and the company that issues the bond to raise money for itself (eg, CBA). The level of interest you receive depends on the company’s riskiness, which is usually assessed by a ‘credit rating’. A lower risk company like CBA will pay lower interest rates on its bonds. If a bond is listed on the Australian Stock Exchange (ASX), you can buy and sell exposures to it at your leisure. Unfortunately, most bonds are not listed on the ASX. And the current minimum investment is $500,000.
So to get a safer and better diversified exposure to high quality bonds, you might want to invest in a professionally managed fixed-income fund, just like you do with shares.
• Managed cash and fixed-income funds: A cash
or fixed-income fund takes your savings and invests them like a bank does: in loans and debt securities. These funds are managed by professionals who invest in government bonds, bank bonds, corporate bonds, home loans, and even bank deposits. Some funds are extremely safe and only invest in ultra-secure and liquid bonds that have their returns tied to the RBA’s cash rate.
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Others funds are riskier, with the promise of higher returns, by investing in less secure and less liquid bonds that have their returns tied to the longer term interest rate markets. Some funds lock you in for a minimum three months, while others offer you the convenience of moving your money in and out regularly (eg, daily). Generally, these funds have slightly higher risk than a bank deposit, but much lower risk than shares. They also charge fees to recoup their costs and to earn an acceptable return. The chart below illustrates the performance of two different investment classes between 2000 and 2011. The very jagged red line is the Australian sharemarket, including dividends.
The orange line is an index comprising 90 percent high quality, Australian variable rate bonds and 10 percent bank bills. This orange line gives you an idea of how a low-risk managed fund that invested in variable-rate bonds would have performed over time.
Shares vs. Bonds
Floating-Rate Bonds
Australian Shares plus Dividends $25,000
$20,000
$15,000
$10,000
$5,000
to the UBS Floating Rate Note Index.
29-Jan-11
29-Jan-10
29-Dec-10
29-Dec-09
29-Dec-08
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29-Jan-09
UBS Bank Bill Index and 90% line) is an index weighted 10% to the Sources: Floating-Rate Bonds (Orangeline) is the ASX All Ordinaries Accumulation Index. Australian Shares Plus Dividends (Red ance. perform future of e indicativ Please note: past performance is not
29-Jan-08
29-Jan-07
29-Dec-07
29-Jan-06
29-Dec-06
29-Dec-04
29-Jan-05
29-Jan-04
29-Jan-03
29-Dec-03
29-Dec-02
29-Dec-01
29-Jan-02
29-Dec-00
29-Jan-01
29-Dec-05
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KEY FACTS
All saving involves a trade-off between the risk of losing money and prospect of growing it You should try and diversify your savings - don’t put all your eggs in one basket Diversification can help you reduce your risks while maintaining your returns—it can be a ‘free lunch’ The least risky, yet typically lowest returning, investments are transactional bank accounts Term deposits usually offer better returns, but with the cost of tying up your money for longer periods Fixed-income investments include ‘investment grade’ bonds issued by governments (like Australia), the banks (like ANZ), and big companies (like Telstra) Investment grade bonds are much safer than shares and often provide better returns than you’ll get in a bank account But the minimum investment in a bond is normally $500,000, and you still need to understand the risks associated with investing (eg, the risk of default) Managed cash and fixed-income funds invest in bank deposits, bank bills, and bonds, and are overseen by professionals like managed share funds Some fixed-income funds are safe while others carry greater risk 13
HOW TO SAVE
Risk, return and access to funds are three keys to smart saving. You should think very carefully about what you need tomorrow, in a month, 12 months, and five years time. In fact, you should carefully work out what nest-egg and income you require in order to happily live during your retirement, especially if you think there’s a chance you will live for a very long time. Your savings strategy should focus on not only ‘diversification’, but also your specific savings objectives and goals, and the amount of risk you are willing to assume. Important things to consider include: • W ork out what level of risk is right for you: if you are in your 20s or 30s, you need to build a savings plan for the next 40-60 years. This is a very long time, and has ramifications for how much risk you can tolerate. Normally, it will mean that you will have significant exposures to more volatile investment classes like shares and real estate that offer the prospect of higher returns commensurate with their risk. In contrast, if you are in your 50s or 60s, you will want to preserve the wealth you have accumulated over time, and to start generating income security in preparation for retirement. This means you will likely have lower exposures to volatile investments in preference for the dependability afforded by cash, bonds and annuities. An independent financial advisor can help you work out what level of risk is right for you. • S ave in a way that beats the rise in the cost of the goods and services you need to buy over time (ie, inflation): if inflation rises faster than the returns you earn on your money, you will not be able to keep pace with the price of the goods and services that you pay for in everyday life. In Australia, inflation has averaged around three percent per annum since 1993. You should be looking for returns that outstrip inflation. Because taxes and fees take a chunk of your earnings, you should also be looking for solutions that give you net returns above inflation once you account for all your costs.
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• S ave in a way that minimises your tax burden: you want to keep every dollar you are entitled to, so make sure of your tax status and get professional advice if you are confused. Don’t be heavily taxed when you don’t need to be. For instance, who does your saving — you or your partner? If you have a partner on a lower income, perhaps some of your savings should be in their name? Once again, there is no substitute for good, independent advice.
KEY FACTS What investments you hold will depend on how old you are and how much risk you are willing to take Younger savers in their 20s and 30s will normally have substantial exposures to riskier investments like shares and real estate Mature savers in their 50s and 60s are more focussed on wealth preservation and income security, which implies larger investments in safer assets like cash and bonds An independent financial advisor can help you tailor a life time plan that satisfies your goals and risk profile You should be targeting returns on your savings that, as a minimum, beat the rise in the cost of the goods and services that you purchase in everyday life (ie, inflation) Tax can be a complex area, and you should check with a professional to ensure you are not paying it when you don’t need to
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final thoughts If you’re a saver like me, you may be earning less on your money and paying more in fees than you need to be. You may not fully understand all the catches that come with the many different products that are available in the market. And you may not have all the wealth diversification you need to weather future storms. That is, you may be able to get the same overall returns while materially reducing your risk simply by spreading your money around more. In between low risk and low returning bank deposits and very high risk and high returning shares, there is a big world of cash and fixed-income alternatives, encompassing short and longterm bonds issued by governments, banks and large companies. One way to better plan for your future is by getting some financial advice from a qualified professional. They can explain the risks and rewards associated with various savings solutions. They can also prepare a plan that is especially tailored to meet your financial goals and risk profile. By getting more informed, you will save smarter – so start today and get on the road to your better future!
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DISCLAIMER The information in this document has been prepared by Yellow Brick Road Wealth Management Pty Limited ABN 93 128 650 037 AFSL 323 825. It is general information only and is not intended to provide you with financial advice. The information has not been prepared taking into account your specific objectives, financial situation, or needs. Before acting on any information in this document, you should consider its appropriateness to you, and seek independent financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. March 2014.