What are your two biggest challenges when saving?
Arguably capital preservation and generating long-term, “after inflation” returns in the order of 3% to 5% per annum. What is inflation? Simply, the periodic increase in the cost of the goods and services that you buy. If inflation rises faster than your income (and/or your investment returns), your purchasing power is not keeping pace with your cost of living. Are your living expenses different to the official inflation rate calculated by the national statistician? You bet, which makes evaluating your actual purchasing power more complicated.
In my first chart below I have compared the official inflation rate with four “cost of living indices” published by the Australian Bureau of Statistics. These indices cover, respectively, “employees”, “aged pensioners”, “other government benefit recipients”, and “self-funded retirees”. The black dotted line is the inflation rate.
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As you can see, our cost of living has generally appreciated more rapidly than the headline inflation numbers (observe how three of the four cost of living indices are above the black dotted line). While the inflation rate since 1998, which is when the cost of living measures start, has averaged about 3% per annum, employees, pensioners and other welfare beneficiaries have seen their living expenses accrete by between 3.3% and 3.4% per annum. Over time, this wedge compounds up into significant differences. Only self-funded retirees have had their living costs track inflation. It is worthwhile adding here that the 3% annual inflation rate recorded over the 1998 to 2012 period is hardly comforting (underlying inflation estimates are similar): in particular, it is way above what most OECD nations regard as acceptable.
The key thing to take away from this analysis is that you need to punch out consistent returns of 3-4% per annum from your savings just to keep pace with the rise in the price of the goods and services you need to buy to survive.
The bad news is that doing so in the current environment, which is characterised by global “deleveraging” (i.e., higher savings and, where possible, reduced indebtedness) is bloody hard. Central banks around the world have cut interest rates to near-zero, which means that in the UK, North America, and Europe savers are going backwards on their cash accounts once they account for inflation.
In Australia the situation is only a little better. In my next chart I have illustrated both the “average” bank deposit rate, which is the red line that refers to the right-hand-side axis, and the return you get on the average bank deposit after paying living expenses (the yellow bars that relate to the left-hand-side axis). Here I’ve assumed that you are an “employee”, as defined by the ABS.
As you can see from the yellow bars, the “real” return you get on the average bank deposit has been very low since the start of 2011. While you can currently get a 1% annual return above the cost of living, this is being driven by the decline in inflation recorded in the second half of last year and the first quarter of 2012. That reduction was in turn an artefact of the sharp appreciation in the Aussie dollar, which is now being reversed. The likelihood of higher cost of living rates in future quarters (compared to the recent past) combined with declining returns on bank deposits means that real interest rates are likely to once again converge towards zero, and possibly turn negative.