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The terms they are a-changin’

Come gather 'round people

Wherever you roam

And admit that the waters

Around you have grown

And accept it that soon

You'll be drenched to the bone.

If your time to you

Is worth savin'

Then you better start swimmin'

Or you'll sink like a stone

For the times they are a-changin'.

(From Bob Dylan’s The Times They Are A-Changin’)

The cash rate is heading for 2%, and term deposit rates are next to fall, yet term deposits and cash accounts are still the mainstay of most personal investment portfolios, including about 30% of the assets of SMSFs. Cuffelinks has previously written about alternatives to term deposits (‘Where to now for term deposit investors?’) and how some risks were not well understood (‘Term deposit investors did not understand the risk’). With rates falling and major changes to the terms and conditions of term deposits, investors need to rethink their rollover strategies. As Dylan says, “You better start swimmin’ or you’ll sink like a stone.”

The power of ‘retail inertia’

Back in the good old days, before political correctness, banks used to describe the willingness of customers to accept almost whatever was offered to them on term deposit rollovers as ‘retail inertia’. Banks could have a term deposit special at 5% and rollover similar deposits at 4% and the vast majority of customers accepted the lower rate. Retail inertia is still used by the banks today, even if it’s not called that. Check what it says on a typical term deposit rollover letter:

“If you have a special rate, that rate will generally apply for a single term. Standard term deposit rates may apply for subsequent terms.”

Which is bankspeak for: “You’ll receive a lower standard rate unless you ask for a special one.”

Why do banks offer special bonus rates for the first four months on some at-call deposits? At the end of the four months, customers fall to the ‘standard’ rate, and most don’t leave. A 0.3% bonus for 4 months is only equal to 0.1% per annum, an immaterial cost for gathering genuine retail deposits. It’s the same with credit cards and the ‘six months interest free’ for switching banks. They hope customers can’t be bothered changing again.

There is no incentive for banks to offer their best rates on rollovers. Consider some simple maths to show the true cost of paying up for the less sticky deposits. Assume $100 million of 12 month term deposits mature next week. $90 million of it will rollover if the rate offered is 3% and $10 million of it demands a higher rate, say 3.5%.

Question: If the bank wants to keep the entire $100 million, what is the effective rate (cost to the bank) on the extra $10 million?

Answer: The bank pays 3.5% on the full $100 million ($3.5 million) which is equivalent to 3% on $90 million ($2.7 million)  plus $0.8 million on the extra $10 million, which is 8%. Ouch!

Bank response: Raise the $10 million from new investors at a ‘blackboard special’ rate of 3.75% and rollover the $90 million at 3%.

Don’t ignore the bank letter

The rollover letter is not like the gas or electricity bill where the customer must accept the cost:

  1. Critically review the rollover rate. Most depositors tick ‘rollover for the same term on maturity’ when they open a term deposit, and if no action is taken, whatever rate is offered by the bank will be locked in. Most banks give a one week grace period if the rollover date is missed. When some term deposit offers now start with a ‘2’, the letters can no longer be ignored.
  2. Phone your bank and ask for a higher rate. First, go to a comparison web site like ratecity.com.au or mozo.com.au, and arm yourself with the highest rate. They’re all government guaranteed for amounts up to $250,000. Even if the bank is not prepared to match the offer from a small credit union, it will probably offer more than in the rollover letter.
  3. Watch other changes in terms and conditions. Changing liquidity regulations as part of Basel III mean banks will be far stricter allowing access to term deposits. In the past, banks permitted early access, often with no interest rate penalty (if term deposit access was obtained just after an interest payment, banks would not pay less than face value). Bank regulators realised this was unsatisfactory, as banks report the maturity profile of their deposits assuming none were repaid early. Now, all the banks are writing to customers saying funds cannot be accessed (even with a penalty) inside a 31 day notice period.
  4. Consider another term, although accepting higher rates for longer terms carries risks. Last month, I had a maturing five year investment originally placed with Westpac in January 2010. The previous rate was a handsome 8%, and even at the time, it proved extremely popular with Westpac raising $2 billion in a couple of weeks. Westpac's five year rate is now 3.9% and income has halved. It’s one thing accepting 3.9% (a real return of 2%) for a short-term, but too much market risk for insufficient reward over five years.
  5. Don’t leave the paperwork until the last minute. Although banks usually nominate a grace period to negotiate a rollover, some require attendance at a branch to verify a variation. In today’s online and mobile world of banking, it can be frustrating finding a branch just to sign a form. Also, the interest rate paid during the grace period is nominal, 0.5% to 1%, so act early.
  6. Consider an alternative. Looking at mozo.com.au for terms of 1 to 3 months, most rates are less than 3%. Where term deposits once offered decent rates at negligible credit risk, now they are giving little more than capital security. It’s worth considering alternatives such as corporate bonds, bond funds or listed securities, but they come with more risk. For some guidance, Australia Ratings has assigned risk ratings to 65 ASX-listed securities, all investment platforms have a range of bond funds and there are income-based ETFs.

Whenever you see the words ‘Automatic Renewal’ on a term deposit rollover, there’s a strong chance you can do better. Listen to Bob, who says at the end of the second verse: “For the loser now will be later to win. For the times they are a-changin’”.

 

Graham Hand has worked in banking and wealth management for 35 years and is Editor of Cuffelinks. This article is general information and readers should seek their own professional advice.

4 Comments
SMSF Trustee
February 09, 2015

Inflation of 10-20% over the next 6 months. Nonsense.

Of course rates are going to stay low. The world economy is not generating enough return on capital for them to go up, other than for the occasional trading 'correction' in the market. Certainly the Australian economy isn't generating enough growth for producers to have a snowflakes' chance of putting prices up. Importers have to suck it up.

I'm not going to manage my SMSF based on Bruce's outlook.

Bruce Bennett
February 08, 2015

This article, along with many other commentators, assumes that interest rates are going to stay low, or get even lower. Even the RBA has lowered its projected inflation rate for 2015. These commentators ignore the fact that importers are paying 30-40% more in Australian dollars for their goods than they were 12 months ago. As a result, I expect most companies will have to increase prices by 10-20% within the next 6 months.

And oil prices are also likely to rise from current levels. While some producers need the cash, others will take a longer term view and, with low interest rates, decide to keep their reserves in the ground, or place it in storage, until the price rises to USD60 or USD70/barrel.

Graham Hand
February 06, 2015

Thanks, Richard, for pointing out I had the right answer approached the wrong way. I have corrected it. Cheers, Graham

Richard Lyon
February 06, 2015

You must be an actuary!

The example produces the right answer, albeit scaled by a factor of 10, from the wrong maths.

To keep $100M costs a 3.5% rate = $3.5M.

At 3%, the bank would have kept $90M, at a cost of $2.7M, so the extra $10M has cost $0.8M (which is indeed 8% of the $10M, but is a long way short of $8M).

Paying 3.75% on the new $10M (and ignoring acquisition costs not even canvassed above) costs $0.375M, for a total cost of 2.7 + 0.375 = $3.075M, saving $0.425M (less acquisition costs) against the first option. That is 4.25% of the $10M, or 0.425% of the $100M.

Disclosure: I am an actuary

 

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