A step in the right direction

Falling interest rates may be great news for borrowers but they're yet another blow for those retirees who, battered by the global financial crisis, had sought "safety" in term deposits.

Falling interest rates, low bond yields and market volatility are a "triple whammy" for the over-50s, says the chief executive of National Seniors, Michael O'Neill. "There are two sides to this story - while families celebrate, retirees feel the pinch."

Financial advisers say anyone who reversed into the seemingly simple strategy of living off term deposit interest will need to consider something more sophisticated as their term deposits mature, especially with further rate cuts predicted.

The futures market - which often gets these things right - expects the official cash rate to fall from 3.25 per cent to 2.5 per cent by May next year, and possibly one further step to 2.25 per cent by the second half of 2013.

That would be another 1 percentage point off interest rates, on top of the 1.5 percentage points already erased in the past year.

If you locked in a three-year term deposit at 7 per cent or 8 per cent in December 2009, when "TD" rates were peaking, you might be disappointed to find 4.5 per cent on the table when you go to roll over in two months' time.

The spokeswoman for the financial products researcher RateCity, Michelle Hutchison, says savers lured by generous rates attached to online accounts and bonus savers are also hurting. "Unfortunately, it's increasingly bad news as financial institutions pass on rate cuts to deposit accounts," Hutchison says.

SAVINGS ACCOUNTS

What's more, different styles of account are being affected in different ways.

According to RBA data current to September (just before the latest cut), while the cash rate fell 1.25 percentage points in the previous 12 months, the average online savings rate dropped 1.3 percentage points and the average cash management rate 1.5 percentage points. While the average term deposit fell 0.55 percentage points, the average of the "special" rates offered by the big five banks fell nearly twice as much.

Bonus saver rates, on the face of it, fell just 0.45 percentage points. But researchers say the small move in headline rates on such accounts - and in other "promotional" offers - disguises a steepening in the decline to the base rate once the offer expires or if the conditions for the maximum rate are not satisfied.

ANZ's Progress Saver, for instance, has a generous maximum rate of 5.16 per cent but that plunges to 0.01 per cent if you make a withdrawal or neglect to bank at least $10 a month. Westpac's Reward Saver has a similar gap between its bonus and base rates.

As for term deposits, placing $100,000 for a year will earn you $1000 less interest in the next 12 months than it did in the year before, according to RateCity. Its database shows the average rate on a one-year term deposit falling from 5.62 per cent a year ago to 4.55 per cent after this month's rate cut.

Subtract inflation of 2 per cent and the "real" return on 4.5 per cent is just 2.5 per cent - before tax. (See also Page 8)

"When rates were 7 or 8 per cent, in a very uncertain world, term deposits made more sense," says the chief investment officer at JBWere, Giselle Roux. "Now at 4.5 to 5 per cent it's a much more marginal case."

The maths can be even worse for people in or near retirement, who spend disproportionately more on expenses such as healthcare and power bills, where inflation is higher, she says.

People may be gun-shy of investment markets, "but there are more risks than the risk of loss", Roux says. For a start, term deposits have no potential for capital growth. That means the real value of your money will diminish over time as inflation eats into its spending power - even if you're not touching the capital, only living off the interest.

Then there's liquidity risk: tying your money up means you can't take advantage of better opportunities that arise. Plus, people end up making decisions when a term deposit matures rather than at the most appropriate time to be making another decision, Roux says.

INVEST FOR INCOME

That's not to say there's no place for term deposits, but advisers say they should only ever be part of a diversified portfolio that provides not just income but also some opportunity for growth. Such a portfolio would generate income not just from fixed interest but also from shares (bank stocks, for example), property investments and cash deposits.

A certified financial planner, Andrew Hewison, of Hewison Private Wealth, says this sort of diversification means it's likely the overall cash flow from the portfolio won't really change over time and there's no need to constantly chase the next "hot" asset class.

A senior investment strategist with MLC, Michael Karagianis, says: "I'd love to say that there's simply one product you can go out and buy which has the same risk level as term deposits but is going to give you 100 basis points [1 percentage point] more, but there's not. You've just got to be ... smarter."

People don't want a "wealth shock" just before, or in, retirement, but if they're to live off their money for 20-plus years they can't rely solely on cash and bonds. They need a longer-term investment strategy that provides good yield while also offsetting the "decay" from inflation, Karagianis says.

He, too, emphasises diversification, pointing to income-producing equities, corporate credit and "absolute return" strategies as possible portfolio building blocks. "What we're seeing in the market in Australia at the moment is a number of new funds coming out that are 'equity income' type funds," he says.

These are funds that target the higher-dividend part of the market, where dividend yields are about 7 per cent to 8 per cent - or 9 per cent to 10 per cent once you factor in franking credits for the tax already paid by companies.

"You're getting good quality access to dividends and active management around that to control risk" and reduce volatility, he says. "If you look at the dynamics of these funds, they fit part-way between a conventional equity investment and more of a fixed-income investment."

RISK RETURN EQUATION

Another building block would be corporate credit. Karagianis, like many others, has concerns about the take-up of convertible preference shares or hybrids and he points to the middle ground of investment-grade corporate bonds and floating-rate notes.

Absolute return strategies are also worth contemplating, he says. These funds have much greater asset allocation flexibility - investing in an asset class when it makes sense to do so rather than because they're tied to a certain benchmark for shares, for example. "They don't worry about a benchmark, they're actually managing for total return," Karagianis says. "They only want their money in something if they think it's going to go up."

Finally, consider investing abroad.

"It's something that, often, people tend to avoid in periods of great uncertainty - especially in the current environment, where a lot of the uncertainty is internationally based," Karagianis says. "But we argue that the lowest-risk portfolio you can construct has to include a healthy measure of international assets."

The heavy bias of the Australian market towards mining and banks means you have many eggs in one basket if you invest only at home. Sectors such as pharmaceuticals and technology are either non-existent or underrepresented here, he says.

"If you want 100 basis points above the term deposit rate you could do that without necessarily resorting to much, if any, equity risk," Karagianis says. "If you want a bit more above that you're going to have to start adding in equity risk, but doing it in such a way that it has a minimal impact on total volatility."

- Deposit rates have fallen 1.5 per cent in the past year.

- They could have a further 1 per cent to go.

- Term deposits don't constitute a retirement plan at these levels.

- Portfolios can be structured to favour income.

- Some capital growth is needed to offset inflation.

Terms of endearment: Basel III rule changes

The world of term deposits is about to change because of global regulations that will reward banks for favouring longer-term deposits.

Under the Basel III rules, which will take effect from January 1, longer-term deposits those of a year or more will count for more than potentially "flighty" short-term money when it comes to official measurement of the financial strength of a bank.

"Anything of 12 months or more will be very valuable to a bank," says the JBWere chief investment officer, Giselle Roux. "Therefore it will pay a market-clearing price it will pay a premium [for that] over other term deposits."

However, Roux is concerned that investors will be attracted by big rates attached to term deposits of a year or more without considering carefully what it means for them.

"There will be two things people will need to be careful of," she says. "First, the money will be locked in. Today, if I really need to break a term deposit, I go to the bank and I say I've got an urgent need for this money. Sure, they might not pay me my interest, but usually you can break the term deposit.

"Whereas with these kinds of deposit instruments, so the bank can count it in their capital structure, they will not be broken.

"You're now going to make decisions on 12-months-plus money that is being totally locked away."

People will also need to look much more closely at the terms and conditions, she says.

Some banks will come up with conditions such as it being a "366-day rolling term deposit". That means you have to give 365 days' notice of withdrawal, making day 366 the first day you could access your money or day 396 or day 450 and so on, depending on when you give notice.

"When people enter into these instruments, they'll need to think very carefully about what they actually are," Roux says.