‘A LOOK AT LONG-TERM RETURNS ON CASH,’ in the Wall St. Journal via

In Uncategorized on January 21, 2010 at 16:34


Is cash really safe?

Everybody knows the risks of keeping too much money in the stock market. And if inflation rears its head again they may rediscover the risks of keeping too much money in bonds, as well. But what about cash vehicles–savings accounts, money market accounts and certificates of deposits? At least they’re safe, right?

Not so fast. These may be secure from “volatility,” and they may even be safe from risk of default–especially where they are backed by federal deposit insurance. But cash comes with its own drawbacks, which don’t get enough coverage.

Inflation and taxes aren’t exciting topics. They rarely make much news. But over time they take their toll. This matters. American households hold about $7.7 trillion in deposits like savings accounts, CDs and money market accounts, according to the Federal Reserve. That’s more than the $4.8 trillion they hold in equity mutual funds or $2.2 trillion in bond funds, according to the Investment Company Institute.

Interest rates are very low at the moment. But that may be temporary. What’s the longer-term story? To find out, I analyzed data compiled over 45 years by the Federal Reserve and Labor Department. Since 1964, money held in short-term savings accounts, such as one-month CDs, has earned average annual interest of about 6.15%. Someone who put $100 in a typical account back then and just left it there, rolling over the interest, would have about $1,600 today. Such are the joys of compound interest. Alas, over the same period the Consumer Price Index has risen from 31 to 218–or, to put it another way, a dollar has lost about 86% of its purchasing power. So in real terms that $100 has really only grown to about $220 in constant, purchasing-power terms.

And that’s not all. Savers are taxed on interest. And they are taxed on nominal interest, not the real, after-inflation interest. So if you earn 6% on your money in a year, but consumer prices also rise 6% during that time, you may feel–understandably–that you have just been running in place. But as far as Uncle Sam is concerned, you have just made 6%.

Tax rates have risen and fallen dramatically over the past five decades, and shelters have opened and closed. The point of this exercise is not to take a trip down memory lane but to see how it may affect us today. So it’s instructive to see how current marginal tax rates would affect savers’ returns. Someone paying 15% tax would have earned net interest of 5.2% instead of 6.15%. Since 1964, their $100 would have grown to a more modest $1,040 in nominal terms. But as each dollar today is only worth about 14 cents in 1964 money, their actual reward for saving $100 for almost 50 years was to see it grow to just $146 in real purchasing-power terms. That’s a rate of return of less than 1%. And that’s for someone paying pretty low taxes (I’ve ignored state taxes too, plus bank fees. Deduct as appropriate).

Someone paying 25% tax sees his or her effective interest rate fall from 6.15% to about 4.6%. That turns $100 into around $800. And in real, purchasing-power terms that’s a mere $112. In other words: “Don’t enjoy your money today. Tuck it away for half a century, till you’re old and grey–and we’ll pay you an extra $12.” Some deal. When you apply higher tax rates, the effective real return may end up negative. (And the numbers don’t improve that much even if you give up liquidity and lock your money away for longer than a month. For a 25% tax payer, money kept in six-month CDs only grew to $120 in real terms).

What does this mean for you? First, it’s something to remember the next time you hear an investment–like a stock or a bond–described as “risky.” All investments come with risks or drawbacks, cash included. (The “risk” here is that you will end up with too little saved for your retirement.) As an old investment saw has it, there is no such thing as a “safe investment”–only one whose risks are not yet apparent.

Second, it’s something to keep in mind when you are building your emergency fund. Certainly it’s a good idea to keep some money available in cash, but I am amazed at how some commentators raise the bar. Should you keep six months’ expenses in cash? Nine months? How about a year? This advice sounds prudent, but it comes at a high cost.

Third, it’s another reminder to make full use of your tax shelters. Roth IRAs are especially useful because your original contributions can be tapped without penalty or taxes (there are caveats: You can only do this once a year, and it only applies to the contributions, not to any investment profits).

The poor long-term returns from cash are why it makes sense to include other assets–such as some bonds and blue-chip equities–among the emergency lifelines you can tap in a crisis. Yes, they are more volatile than pure cash. But they may offer much better long-term returns.


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