As a financial planner, one of the more difficult questions clients ask today is, “Where can I go to earn a higher return on my cash?”
Whether parked in a savings account, certificate of deposit, or even a short-term government bond, it is impossible to find a safe cash investment option with an attractive rate of return these days.
After clients ask that difficult question, they often follow it up with a version of the ensuing statement: “It was so much easier in the good old days when CDs and even some savings accounts returned five or six percent a year.”
But simply observing historical CD yields or savings account rates overlooks two critical – and often neglected – pieces of the return puzzle. To provide a truly accurate assessment of any investment return, it is vital to adjust the gross return for two variables: taxes and inflation.
Neither taxes nor inflation is static. They are moving targets that impact how much of your gross return you get to keep as an investor. By taxes, I mean income taxes, and by inflation, I mean the cost of goods and services the average American purchases. Both can eat away at your returns.
To demonstrate the damage that taxes and inflation can inflict, I dug up short-term interest rates, income taxes, and inflation rates going back to 1977. The results are in the nearby chart. I used two-year Treasury bill rates as a proxy for short-term interest rates, the median federal tax bracket for households filing jointly as the income tax rate, and the consumer price index for the annual inflation rate.
The last column in the chart, titled “Return,” takes the annual interest rates and nets out taxes and inflation. This is the true measure of historical returns on short-term investments.
Again, fondly recalling the good old days when interest rates were above 5% fails to account for taxes and inflation. But those two variables are real, and they can rob you of your wealth. See the years 1979 and 1980 in the chart as proof.
What else does the chart tell us? First, the past 11 years have been rough. No surprise there. After subtracting taxes and inflation, short-term investors have been losing money recently. But this is not the first time that has happened. Negative adjusted returns occurred in the late 1970s, early 1980s, and even in the early-to-mid 2000s.
The sweet spot – and the timeframe I suspect most savers remember longingly – is the mid-1980s. Interest rates were high, taxes were relatively low, and the rate of inflation was falling. It was an ideal environment for short-term savings. But even the heyday was fleeting, lasting only five years or so.
As history shows, things change. For anyone with a meaningful amount of cash savings, hopefully they soon change for the better. Until then, the only safe place to find attractive returns on cash today is in our memories.