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Reply to letter of the week - Eureka Report Item

June 25, 2008
Letter of the week
By subscriber Leon Herbert

I am a fan of Scott Francis and read his recent book High Income Investing, but I was puzzled by his latest article on the mixed attractions of term deposits, Credit crunch's silver lining. A glaring omission was that it failed to deal with the superb value offered by online banking. Rabobank and BankWest are offering rates for on-call accounts that are than those available from the bigger local banks.

Moreover, although Scott mentions that full tax that must be paid on term deposits for retirees over the age of 65 in the pension phase, their income as well as their super are tax-free. Hence, he postulates that the discount for tax of about 50% (or maybe less) is by no means universal for those who are 65 or more and pass the work test.

Given these high rates, absence of tax and no fees, is it valid to argue that term deposits or call accounts, particularly online, offer returns far in excess of index funds at present and show attractive and better than share returns, at least for the next year or maybe more?

I know in the long term the argument is valid that money diminishes because of inflation and the compound factor, but even allowing for inflation an older retiree will sleep much better in these volatile investment times and is not likely to see his/her savings eroded by market slides that could be ruinous.

- Leon Herbert

Scott Francis replies: I am aware of the interest rates being offered on Rabobank's and BankWest's at-call accounts and they are attractive. Rabobank, with a AAA rating (higher than any of the Big Four banks) is interesting.

However, it is also worth noting that both BankWest, a subsidiary of London-based HBOS, and the Dutch-based Rabobank are overseas owned banks, so the Reserve Bank may not offer the protection offered to Australian-owned banks in the event of a "run" on the bank.

I am very conservative in putting together portfolios for clients. One risk I like to avoid is "institutional risk" - that is getting a bad outcome because any one bank might collapse. On that basis I will still use a low-cost, well-diversified exposure for the core of the fixed interest and cash return, and then use some term deposits or investments like the Suncorp or Westpac hybrid notes. I want the fixed interest/cash part of the portfolio to be low risk and let the investor sleep at night.

You are correct about different rates of tax meaning a different after-tax return, and that is why I included the after-tax return in both articles, based on after-tax rates. It is a good point that you make: in a tax-free environment there are some sound returns to be had from term deposit-style investments.

The comment that I hold a slightly different opinion about is whether shares or fixed interest will be the best investment over the next 12 months. Not that I disagree; I just don't know. There is so much evidence that people are bad at forecasting markets that it is better to not be overconfident and try to do it; rather to be reasonably well-placed regardless of what happens.

While the economic outlook for the next nine to 12 months is pretty gloomy, this is already "priced" into sharemarkets. They have already reacted to a possible US recession, problems borrowing money (credit crunch), possible consumer slowdown, oil at $US135 a barrel, etc. As things improve, you would expect sharemarkets to improve. Just as you would expect markets to fall if something unexpected comes on the downside.

In the long run I see shares as being a crucial way of funding retirement. For someone with a 30-year retirement in front of them, it is almost certain that shares will outperform cash/fixed interest over that period. (That becomes the case statistically from a period of 15 years, not the five to seven years that many financial planners suggest.)

Keep in mind that the current 7-8% cash/fixed interest returns are probably historically high, so if you rely on funding retirement from cash and fixed interest investments your income might even fall if interest rates fall. Five years ago 4.5% was a good return on a cash account. After 12 interest rate rises in a row, I know that it feels like interest rates only rise, but they do fall as well.

Shares in the Australian context also pay great income - a little over 4% at the moment on average, plus another 1.5% in tax credits plus they tend to grow over time, which makes them very attractive.