By Evelyn Jacks, Knowledge Bureau President
Canada Savings Bonds Rates have been set at 40 basis points, against a backdrop of three consistent months of negative inflation. Further, Canada Premium Bonds are indicating fixed interest rates (1%, 1.4%, 1.8%) which are significantly under the projected rate of CPI inflation over the next three years (1.9%, 2.1% and 2.1% respectively). That sounds like a potential lose-lose proposition for risk-adverse savers, who are attempting to preserve and build wealth while negotiating within this turbulent marketplace.
So what's going on with the purchasing power resulting from these extremely low rates of return on the use of your savings? To help us understand, we have consulted with Knowledge Bureau Faculty Member, Robert Ironside, ABD, Ph.D. (Finance), who is also a headlining speaker at the Distinguished Advisor Conference next month.
Some definitions to help: Inflation is the rise in prices over time, which erodes your future purchasing power. Negative inflation, or deflation, reflects something different: it happens when costs decrease against increased productivity (that's not necessarily bad). Or it can happen when people stop buying; perhaps in anticipation of lower pricing in the future or simply a lack of demand due to uncertainty, job loss, other personal financial factors (that's not good).
Robert Ironside, Knowledge Bureau Faculty member weighs in:
Investors should always seek a balance between risk and return. A common mistake made by many investors is to focus only on return, ignoring risk. The current issue of Canada Savings Bonds (CSBs) is a good example, although the risks attached to the CSB are not those we normally think of.
As just announced, the current Series 120 CSB pays an annual interest rate of just 40 basis points (or 0.40%). The new Series 70 Canada Premium Bond (CPB) has a slightly higher fixed return of 1%, 1.4% and 1.8% over three years. In a world with zero inflation and zero taxes, the return on these issues of CSBs and CPBs would still be well below the returns normally thought of as "risk-free". Of course, these are not normal times, but what happens to return when we introduce both taxes and inflation?
In Canada, we are taxed on the nominal interest earned. Thus as the Table below shows, if we invest $100,000 in CPBs, in year one we earn $1,000 in interest income. The $1,000 of interest income is then fully taxed at our marginal tax rate, assumed to be 40%. After taxes, we end up with $600 of interest income. Our total after-tax investment is now worth $100,600.
We now have to include the impact of inflation. The purchasing power of our entire investment goes down by the assumed increase in the CPI each year that we own the instrument. For example, if we have inflation of 1.9% in the first year, the actual purchasing power of our investment falls from $100,600 to $98,724.24.
If we were to repeat the exercise with the 0.4% annual yield earned on the CSB, the results would be even worse. Now, the real, after-tax value of the $100,000 investment falls to just $98,335.44.
Both of these real, after-tax returns are better than putting the $100,000 "under the mattress", since if we did that, our purchasing power would have declined to $98,135.43. We are approximately $589 better off by buying the CPB and $200 better off with the CSB than from doing absolutely nothing.
However, as investors, we are concerned with both preserving and growing our wealth, not watching its purchasing power be confiscated by inflation.
By being ultra-conservative in our investing strategy, we are incurring the risk of earning too little in after-tax returns to maintain our purchasing power. Of course, the future path of inflation is uncertain. We could enter into a period of deflation, which is characterized by widespread falling prices, in which case a 1% nominal rate of return would be worth more than 1% in real returns.
How likely is it that Canada will slip into a deflationary spiral, given that the total CPI in Canada has declined for three consecutive months, from June through August (the latest figures that are available)? The answer possibly lies in the core CPI, which excludes the eight most volatile components of inflation, including food and energy. Core inflation has shown a very different picture, with annual increases of 1.9%, 1.8% and 1.6% over the last three months (to August, 2009).
With Central Banks all over the world pushing strongly on the interest rate string and employing unprecedented levels of monetary easing, it is not likely that we will see a prolonged period of deflation, although it cannot be ruled out, as Japan has shown in its struggle to curb deflation. The greater risk is that at some future date, inflation will quickly rear its ugly head and consume the wealth of the unwary.
Taking taxes into account, here's what you can expect from this year's CSB/CPB offering:
Example: $100,000 invested in October 2009 in Canada Premium Bonds by a taxpayer whose marginal tax rate is 40%. Inflation rate assumed to be 1.9%, 2.1% and 2.1%.
Current $
Future $
Year
Capital
Interest Earned
Value of investment
Income Tax Payable
Net value after tax
Net value after tax
2009
$100,000.00
2010
$100,000.00
$1,000.00
$101,000.00
$400.00
$100,600.00
$98,724.24
2011
$100,000.00
$1,414.00
$102,414.00
$565.60
$101,848.40
$97,893.60
2012
$100,000.00
$1,843.45
$104,257.45
$737.38
$103,520.07
$97,453.83
Notes:
1. Each year the taxpayer will have to pay the tax on the accrued interest (November to October) in spite of the fact that the interest has yet to be received and is therefore not available to pay the tax bill.
2. The average interest rate (stated as 1.39%) is reduced by income taxes to approximately 0.834%.
3. After 3 years, in current dollars, the $100,000 investment will have grown to $103,520.07 (after taxes are paid). However, if inflation continues at the projected rates, that $103,520.07 will be worth $97,453.83 in today's dollars. If the $100,000 were not invested, its value in today's dollars would be $94,140.03.
EDUCATIONAL RESOURCE: For Advisors: The Economic Policies for Canadian Investors Stemming from The Global Financial Crisis will be discussed at DAC (Distinguished Advisor Conference) hosted by The Knowledge Bureau in Tucson, Arizona November 8-11. Over 15 dynamic experts on the cutting edge of the financial crisis will address leading tax and financial professionals on the technical and soft skills required to embrace Leadership and Opportunity in Turbulent Times.
For Advisors and Their Clients: The MASTER YOUR PERSONAL FINANCE Series of Books provide financial education for decision makers. Published by The Knowledge Bureau, they help investors and their advisors have better conversations about their money and the decisions required to accumulate, grow, preserve and transition it to the next generation.
