Recently we had a few questions from people who were saving for deposits for their first homes. This week we had another, from Daniel (surname not shared for obvious reasons!), who having read our piece about the impact of inflation on deposit values over the medium term has been moved to get in touch and ask us what are the alternatives!
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This is timely, seeing as this week we have also been contacted by Louise McBride, journalist with The Sunday Independent. Louise was seeking our take on what alternatives are available for people who are not content with deposit. While we will cover low volatility investing options in more detail soon I am keen to try to answer Daniel's question. If you are new here then please do check out our 'Why' and we'd be delighted to have you join our wee community of Informed-Decisioners here! We are on a mission to enable individuals to help themselves with their financial futures, and to help them get whatever they want.
In this episode we will explore specifically Daniel's question which was.....'I plan to save for 5 years then buy BUT if the purchasing power of my money could lose 10% (5 years * 2% inflation) am I better off investing in a ‘safe’ fund with some (almost) guaranteed level of return?'
Before we do we want to welcome you to Informed Decisions, voted as Ireland's #1 Finance Blog & Podcast. We are on a mission to help our readers and listeners to lead fulfilled financial futures, to avoid mistakes, and ultimately to live the life that they want! We issue a weekly update, sharing insights and ideas, click here to join the community, be great to have you!
What Are My Options For Saving For 5 Years?
If you are saving for a period of 5 years, and are building what you hope will be your deposit for a house then there are a couple of options open to you. This is going on the assumption that our reader is building funds from a low level, as opposed to starting off with a large lump sum of €20,000 or so. Ultimately there is some form of deposit account, some form of state savings, or an investment is another asset class, such as equity, bond, property or some combination of these. The first thing worth noting is that they will each have their pros and cons, and that there really is no 'best thing to do' over that period of time. The rates and comparisons outlined are correct as of March 2018......and as sure as God made little apples will change in future!
As outlined in a recent Blog, there is a real danger that at best the value of your money on deposit will keep up with inflation, and at worst you will lose spending power on your funds over the 5 years. Essentially you will have the money you save, no more and no less, but if inflation is higher than the rate you are getting on your deposit (after DIRT Tax 37% of any interest earned each year), then you will lose purchasing power.
What deposits are good for is keeping the money there, accessible, and at a constant. Due to the nature of them there are no dramatic falls in value, nor are there any dramatic increases in value! You put in x, and you can take out x when the time comes that you need it.
The National Treasury Management Agency (NTMA) who manage and administer the State Savings offerings have 2 options for saving regularly. The first is what they call 'Installment Savings' which allows you save for a max of 12 months (max €1,000 per month). After the first 12 months the account is 'closed' to future contributions and you essentially forget about the funds for the next 5 years, after which time you get 5.5% interest (over the 6 years). Hardly going to make you a wealthy person, however the funds can be accessed with 7 days notice. Also worth noting that there is no DIRT on this option, so you get to keep the entire 5.5% after 6 years (you'd need to get 1.45% per year Gross on Deposit account to match this annual rate)
The NTMA also make available a regular saving option which does allow you save into it regularly, instead of just for 12 months as above. This is called Childcare Save Account, and allows you contribute it, and access it at short notice. However the rate is a paltry 0.15%, and is subject to DIRT tax (an effective rate of 0.094%)!!
What Are The Alternatives?
Many people, like our reader Daniel, recognise that the standard options available to them when savings for a period of 5 years or so are attractive in that the money you put in will be there in 5 years. Their downside is that they may very well result in you losing spending power of your savings when you come to spend it or hand it over as a deposit on a home. People will quite-rightly be seeking something that offers more return.
The most common regular savings option that gives a potential for higher rates of return are investment-based regular savings. Many people might feel that betting on the horses may be more fun, and they may be right, but this type of option should prove a little less stressful! These plans give you access to invest in the likes of Property Funds, Global Equities, Bonds and Alternatives. There's no option that is perfect, so lets now explore the Pros and Cons of these bad boys!
- Pick Your Poison: You can essentially pick the level of volatility you want on these investments, from extremely defensive where you would expect minimal volatility (lots of Bonds and little else) through to extremely offensive (lots of global equities and little else) where you would expect lots of volatility
- Potential Returns: Even some defensive funds, with a mix of 80% Bonds and 20% Equity have, over the past 10 years, returned 3-4% growth per year on average. Offensive funds with 100% equity holding have returned average of 7-8% per year over past 10 years. Also, you do not pay tax every year, as you do with Deposit Accounts, allowing the fund to grow without receiving this 'haircut' each year.
- Access: Most regular saving plans of this type, whether they are retail products or platform based offer you access to your funds (possible with a penalty, see Cons!)
- Open-Ended: If you decide not to buy that house in 5 years time you can still leave your fund invested, and add to it or not, totally flexible
- Optimism: When we are invested in the 'markets' (the great companies of the world!) we must be optimistic about the future health and wealth of these companies, otherwise why would we invest in them!? We should have a sense that we are aiming to achieve more than the bank or state are willing to give us for the use of our money...we are being proactive and aiming to do better than we would otherwise
- Volatility: Volatility is our friend, and is what makes investing in the likes of a well diversified Global Equity Fund so rewarding over the long term. Over a 5 year window however volatility is not that welcome. With a crash in values historically occurring every 5 years on average you may well end up with a value well below what you put in
- Charges: Unlike deposit accounts these plans always carry some form, or indeed several forms, of charges. There can be charges on each contribution, charges for managing the funds, charges for the advisor amoung others. There are huge variances of charges, so be sure to check out exactly what charges might apply
- Timing: When we talk about long term investing here we generally mean absolute minimum of 10 years. This usually allows for markets to do what they do, to drop in value and then to bounce back higher. If you are committed to withdrawing your money in 5 years time there is a strong probability that the market could be in a dip at that point in time, meaning you would be withdrawing/selling your stock at the worst possible time, which is not good!
- Penalty: If for some reason you needed to get your hands on the money before the agreed time (only applies to some retail products) you would pay a penalty for that access and can be a significant penalty based on the amount that you are taking out
If you were to opt for a fund that carried a medium level of volatility, that in the past 10 years has returned 5% per annum average growth, and start investing in that now, how might it go for you? Well the truth is that nobody knows! If it continued on it's current form then you might stand to do very well. On the other hand imagine that the markets continued on their path for the next 3 years, and then the values bombed 20% in year 4 and 20% in year 5......your value would be almost halved, and you would all-of-a-sudden be left with a smithereens of a deposit, and your hope of buying that home gone out the window.......unless of course you were happy to leave the funds where they were and wait the few years for them to bounce back dramatically, as they have always shown themselves to do!
Investment-based savings plans are great, they really are a superb option to build your wealth over the long term. However, when your time-frame is 5 years, when you will need to take the money out specifically in 5 years, when the successful purchase of your family home is at stake then this might not be the ideal solution for you.
You might lean toward taking the less sexy and much less attractive route of deposit accounts for the purpose of saving for a deposit for a home. Yes you will more than likely lose purchasing power on your money, and yes you will be browned-off when you hear about 10% returns being achieved elsewhere but if the alternative was putting your ability to buy your family home in 5 years time at risk then it's one to consider very carefully indeed!
Thanks for reading.....
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