How safe is that CD?

Fixed income investments may be riskier than you think
Provided by John Sammut and RBC Wealth Management

Inflation is a “silent tax” that slowly and painfully erodes capital. Just as the sun rises in the east, one can be assured that inflation will stealthily and steadily tear away at the value of fiat money over time. But very few people worry about the grueling pain of inflation until it has become well entrenched in the economic landscape.

The collapse of the global financial system in 2008 and the crisis in Greece that has plagued Europe in 2010 represent significant deflationary forces. However, the policy response of the global monetary authorities to financial disruptions is highly inflationary. As a result of continuing government bailouts, stimulus and money printing, we may see much higher price inflation in the not too distant future. Historically, artificial stimulation ultimately leads to a significant rise in consumer prices, which can result in a serious problem for today’s bond investor.

Let’s look at a hypothetical example to illustrate the effects of rising inflation on a seemingly safe investment: the Certificate of Deposit, or CD. Imagine you have just purchased a new car for a cost of $30,000. Because this is a fantasy situation, imagine the only expense you will have today and in the future is to purchase gas. No mortgage, no food, and because you paid cash for the car, no car payment.

You are retired and have a nest egg of $120,000. Your only expense is fuel, but you must fill the 20-gallon tank two times a month – no more, no less. One final caveat: you must purchase an equivalent vehicle every five years for the rest of your life. Moreover, your life expectancy is precisely 20 years. To keep it simple, let’s assume the value of the car depreciates to zero by the time you need to make the next purchase, so there will be no trade-in value. At today’s prices, fuel costs about $3 per gallon, so your cost for gas will be $60 per trip, 24 times per year, for an annual cost of $1,440.

With no expenses aside from fuel, and three cars to purchase over your remaining lifespan, you are confident that you have enough money to live comfortably for the rest of your life if you invest conservatively. You elect to invest in a single CD that matures in five years to correspond with the next car purchase.  At today’s low interest rates, assume a five-year CD will pay approximately 2.5 percent per year; generating an annual income of $2,250 after taxes, assuming a combined tax rate of 25 percent, on your $120,000 investment.

 

Hypothetical Investment Scenario:

Initial Investment:                                   $120,000

Annual Interest Income @ 2.5%:           $3,000

Income Taxes @ 25%:                          $750

After Tax Income:                                  $2,250

Annual Expenses:                                  $1,440

Let’s assume inflation for automobiles and gasoline steadily rises annually from 3 percent in the first year to 7 percent in year five. Here is an overview of the first five years, with inflation included in the mix:

 

Year

Inflation
Rate

Fuel Cost

After Tax Income

1

3%

$1,483

$2,250

2

4%

$1,543

$2,250

3

5%

$1,620

$2,250

4

6%

$1,717

$2,250

5

7%

$1,837

$2,250

Income remains steady each year as anticipated, while expenses have risen by a cumulative 28 percent. You now have to purchase a new vehicle, and car prices have risen proportionally. So the same car five years from now will cost $38,271 based on the inflation rate above. The portfolio value is $123,051 – a 2.5 percent increase even after fuel expenses are deducted. But while your portfolio value is higher, the purchasing power of the funds has declined by 25 percent due to higher expenses. 

Going into year six, you are left with $84,780 after the second car purchase. Let’s assume interest rates have increased in response to the rise in inflation, and you can now invest this money in a new five year CD at a 5 percent interest rate. The after-tax income is now $3,179 per year. Furthermore, assume inflation stabilizes at 7 percent per annum for each of the next five years.

 

Year

Inflation
Rate

Fuel Cost

After Tax Income

6

7%

$1,966

$3,179

7

7%

$2,103

$3,179

8

7%

$2,250

$3,179

9

7%

$2,408

$3,179

10

7%

$2,576

$3,179

With the higher CD rate, the cash flow generated from the investment is enough to cover fuel expenses.  At the end of year 10, the portfolio value is $89,371 ($84,780 for the maturing CD and $4,591 reflecting income in excess of fuel costs). But vehicle costs have escalated proportionally to $53,677. So after making the car purchase in year 11, you are left with $31,103 – with another car to purchase in five years and gas to buy along the way. “Houston, we have a problem.”

Suddenly, that CD doesn’t seem so safe. The investor in the above scenario hasn’t lost a dime in “portfolio value” due to market fluctuations. The investments selected did exactly what they were supposed to do. Yet the brutal reality is this:

 

1) The purchasing power of this money has declined substantially;

2) The income will no longer be enough to keep up with expenses; and

3) This investor still has 10 years of life remaining.

 

Seemingly low-risk investments like CDs, U.S. Treasuries, and Municipal Bonds are appealing to conservative investors, especially those who have been punished by the violent turmoil of the global stock markets.  Make no mistake; CDs can be a sound investment, certainly for known expenditures needed within a short time period – say 5 years or less. But taking the “long view”, investors would be wise to accept near-term volatility in favor of potential long-term peace of mind when price inflation is taken under consideration. In terms of purchasing power protection, especially at today’s low interest rates, investing exclusively in fixed income securities may be a high risk strategy that could lead to very unpleasant surprises down the road.

 

John Sammut helps individual investors, families and corporations protect their purchasing power and improve investment results. You can reach Sammut by telephone at (315) 423-1425, by email at john.sammut@rbc.com or visit him on the web at www.johnmsammut.com

 The opinions expressed in this report are those of the author and are not necessarily the same as those of RBC Wealth Management or its research department. RBC Wealth Management did not assist in the preparation of this report and makes no guarantees as to the accuracy or the reliability of the sources. This information should not be construed as a research report, as it is not sufficient enough to be used as the primary basis of investment decisions. Clients should work with their financial consultant to develop investment strategies tailored to their own financial circumstances.

 

RBC Wealth Management, a division of RBC Capital Markets Corporation, Member NYSE/FINRA/SIPC

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