“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” Sam Ewig
Middle-class Indians have traditionally shied away from equity investments. According to RBI data, only 5% of financial assets are invested in equities versus 47% in bank deposits or postal schemes. Safety and security of capital are primary emotional needs driving families towards term deposits, along with the somewhat mistaken belief that you can make money grow with fixed deposits.
But do you know that fixed deposits lose value over the long term? The value loss occurs due to the effects of inflation and taxes. Let us explain.
In June 2016, the average bank deposit was yielding between 7 and 7.5% interest. At the same time, retail inflation was 5.77 %. Inflation means you have to pay more for the same things. Money has lost value since it cannot buy the same amount of goods or services as the previous period. After accounting for inflation and taxes. Investors in the 10% tax bracket earned a mere 1%. Those in the highest tax bracket lost .5%.
The features of fixed deposits are safety and predictability of returns. Savvy investors can earn better returns for their short-term fund requirements of less than five years by adding debt funds to their savings mix. The main advantages to using debt funds are slightly higher returns than bank fixed deposits and tax efficiency. Income from debt funds held for more than three years taxed at the long-term capital gains rate, currently at 20%. Investors can benefit from inflation indexation to lower their tax outgo. Income from fixed deposits, on the other hand, are added to income and taxed at the marginal tax rate.
Two relatively low-risk avenues to park short-term funds are liquid funds and Ultra Short Term Debt funds. Liquid funds are an alternative to money idling in savings bank accounts. These funds invest in Treasury bills, corporate debt such as high-quality commercial paper and certificates of deposits, whose maturity is less than ninety-one days. Interest rate risk is low due to the short maturity period. Withdrawal is easy and hassles free. Liquid funds earn between 7-8% vs. savings bank rates of around 4-5%.
Ultra Short Term Funds are similar to liquid funds except that they invest in debt instruments of maturity between ninety-one days to a year. UST Funds are an alternative to short-term fixed deposits. No-load funds do not charge any penalty on withdrawal, unlike fixed deposits. While the three-year returns on Ultra Short Term funds and fixed deposits are similar at around 8.5%, UST funds win due to their better tax efficiency. For an investor in the 30% tax bracket, they add up to 2% more returns at today’s interest rate
Costs of education, housing, healthcare are all racing away more than inflation. Without financial savings that beat inflation by a decent margin, it will be tough for anyone to meet their financial goals. Calculated risks are necessary to get better returns.