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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.