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CHAPTER
3 DEPOSIT ACCOUNTS ARE VERY RISKY DUE TO THE IMPACT OF INFLATION
When people
think of an investment being risky, they think of the Wall Street Crash,
the loss of money in eircom or the bursting of the dot.com bubble. They
see the stockmarket as risky and so put their money on deposit. But deposits
are much more risky if you consider risk to be the permanent loss of value.
Look at Table 3 to see how much a long term investor would have lost by
putting their money in a "safe" deposit account.
Table
3 How inflation erodes the real value of deposit accounts
|
From
1971 to 2000 |
From
1981 to 2000 |
From
1991 to 2000 |
Compound
deposit rate: |
394% |
150% |
18%
|
£10,000
would have grown to: |
£49,400 |
£25,000 |
£11,800
|
Compound
inflation |
887% |
174% |
31%
|
Real
value of £10,000 after inflation |
£5,000 |
£9,100 |
£9,000
|
Real
loss |
50% |
9% |
10% |
Table
3 shows the impact of inflation on the value of deposit accounts. If you
had put £10,000 on deposit in an Irish bank on 1/1/1971 and left
the interest to grow, you would have had £49,400 in your bank account
30 years later at 31/12/2000. But £49,400 would only buy half of
what £10,000 would have bought in 1971.
£100
would have bought you 500 pints of Guinness in 1971. £494 in 2000
would have bought you only 250 pints.
In calculating
the above figures, we have deducted income tax at 20% of the deposit interest.
So although your money is declining in real terms, you are paying tax
on it. (The average tax rate was much higher, but we used the 20% rate
as it is the current rate of DIRT and will make comparisons easier)
THE CURRENT
SITUATION IN IRELAND
The year
2000 was one of the worst years for depositors in Ireland. Deposit rates
were often less than 1% while inflation was 7%. So depositors saw the
real value of their money drop by a massive 6%.
At the time
of writing, a typical deposit rate is about 3% a year or 2.5% after DIRT.
Inflation is running at about 7% a year. That means that a saver who reinvests
his deposit interest is still losing about 4.5% a year in real terms.
Between 2000 and 2001, it is likely that a depositor will have lost 10%
of his lump sum.
And there
is a significant risk that things could get worse. Inflation might rise
beyond 7% and deposit rates are expected to get lower, so the loss of
4.5% a year, could increase. Up until recently, Irish inflation rates
and Irish interest rates tended to rise and fall together. But since we
joined the euro, that link has been broken and the Irish authorities can
no longer increase interest rates to calm inflation. So there is a significant
risk that inflation might rise while interest rates decline.
THE EXPERIENCE
IN OTHER COUNTRIES
Since 1869,
deposits in Britain have declined in real value in one third of 10 year
periods. If history repeats itself, if you put your money in a British
deposit account and accumulate the interest, there is one chance in three
that it will be worth less in 10 years time.
In America,
savers have earned just under 2% a year in real terms. And they have gone
through long periods where they watched their money decline.
THE WORST
CASE SCENARIO
Look at the
unfortunate German millionaire pensioner in 1922. The Reichsmark was devalued
by one trillion to one, so his £1m in the bank became completely
worthless and he became penniless !
After the
second world war, the poor Japanese millionaires lost 99% of their wealth.
They weren’t wiped out, but their £1m was reduced to the equivalent
of £10,000 !
In more recent
years, similar devastation has happened to savers in Russia and South
America.
There is a low risk of this happening in Ireland , but it is a risk and
because its effects are so devastating , you must protect against it.
THE RISK OF BANK FAILURE
And there is also a risk of banks collapsing. This is a risk which is
quite small in a well regulated economy like Ireland. But although it
is small, it is still a risk and should not be ignored. Irish savers lost
their savings in two bank collapses Irish Trust Bank Ltd in 1976 and Merchant
Banking Limited in 1982. In the 1990s, British depositors in the BCCI
lost their entire savings. In 1982, Ireland’s largest bank, AIB ditched
the Insurance Corporation of Ireland because its losses were threatening
to engulf the entire bank.
Some Irish
banks and building societies are very heavily dependent on property and
a property crash could hurt them. While they have very strong reserves,
there is a small risk, that some institutions might not be able to weather
a sustained property crash.
If an Irish
bank collapses, the first €20,000 is covered by the Deposit Guarantee
Scheme, but any amount over €20,000 will be lost.
Appendix
3 Real Consumer deposit rates in Ireland
Nominal
interest rate |
Inflation
rate |
Real
return |
Year
|
Value
after 1 year |
Value
after 5 years |
Value
after 10 years |
Value
after 20 years |
| 4% |
3% |
1% |
1966
|
101 |
100 |
79 |
65 |
| 4% |
3% |
1% |
1967
|
101 |
95 |
72 |
68 |
| 5% |
5% |
1% |
1968
|
101 |
93 |
67 |
71 |
| 6% |
7% |
-1% |
1969 |
99 |
89 |
65 |
71 |
| 6% |
8% |
-2% |
1970 |
98 |
86 |
66 |
75 |
| 5% |
9% |
-4% |
1971 |
96 |
79 |
65 |
79 |
| 8% |
9% |
-1% |
1972 |
99 |
76 |
65 |
86 |
| 8% |
11% |
-3% |
1973 |
97 |
72 |
64 |
88 |
| 11% |
17% |
-5% |
1974 |
95 |
73 |
67 |
94 |
| 8% |
21% |
-10% |
1975 |
90 |
76 |
71 |
97 |
| 8% |
18% |
18% |
1976 |
92 |
82 |
83 |
107 |
| 7% |
14% |
-6% |
1977 |
94 |
85 |
95 |
116 |
| 7% |
8% |
-1% |
1978 |
99 |
89 |
105 |
120 |
| 12% |
13% |
-1% |
1979 |
99 |
91 |
110 |
121 |
| 14% |
18% |
-3% |
1980 |
97 |
93 |
113 |
120 |
| 14% |
20% |
-5% |
1981 |
95 |
101 |
122 |
117 |
| 16% |
17% |
-1% |
1982 |
99 |
111 |
131 |
|
| 11% |
10% |
1% |
1983 |
101 |
118 |
138 |
|
| 10% |
9% |
1% |
1984 |
101 |
120 |
139 |
|
| 10% |
5% |
5% |
1985 |
105 |
122 |
137 |
|
| 9% |
4% |
5% |
1986 |
105 |
120 |
129 |
|
| 8% |
3% |
5% |
1987 |
105 |
118 |
121 |
|
| 5% |
2% |
3% |
1988 |
103 |
117 |
115 |
|
| 6% |
4% |
2% |
1989 |
102 |
116 |
110 |
|
| 8% |
3% |
4% |
1990 |
104 |
112 |
105 |
|
| 7% |
3% |
3% |
1991 |
103 |
107 |
96 |
|
| 7% |
3% |
4% |
1992 |
104 |
103 |
|
|
| 3% |
2% |
2% |
1993 |
102 |
98 |
|
|
| 1% |
2% |
-1% |
1994 |
99 |
95 |
|
|
| 1% |
3% |
-1% |
1995 |
99 |
94 |
|
|
| 1% |
2% |
-1% |
1996 |
99 |
89 |
|
|
| 1% |
2% |
-1% |
1997 |
99 |
|
|
|
| 1% |
2% |
-1% |
1998 |
99 |
|
|
|
| 1% |
2% |
-2% |
1999 |
98 |
|
|
|
| 0% |
7% |
-6% |
2000 |
94 |
|
|
|
EXPLANATION
OF TABLE 3
In 1966 you
would have received 4% if you had placed at least £25,000 on deposit
in one of the banks. But as the rate of inflation was 3% that year, the
real return was only 1%.
If you left it on deposit, it would have been worth £100 five years
later,£79 ten years later and £65, twenty years later.
No account has been taken of tax.
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