Fairly often I page through a group of financial magazines in search of interesting or novel financial viewpoints. Occasionally I'll find fascinating or motivating pieces, but for the most part it's just the standard reiteration of widespread financial "wisdom." As it turns out, this offering of customary advice is frequently highly unspecific. That is - aside from a handful of insightful observations - because most articles try to cast a wide audience net they turn out to be misleading at best and downright harmful for many individuals. During my most recent weekly magazine foray, I happened upon such an advertisement from Ally bank. It read:
"Can You Really Call It A Savings Account If It's Only Earning .01%?"
Below that statement it had "0.84%" in large font followed by "annual percentage yield" in much smaller print. Then, the advertisement got to the punch line:
"Call us crazy, but we believe a savings account should actually help you save."
And to the average person, perhaps this advertisement might provide some appeal. They might think along these lines: "Hey! I can get 84 times the amount of interest over at Ally! What a deal!" But for me, I was simply dumbfounded. Its advertisements and ideas like this one that guarantee a great amount of people will continuously struggle in the financial world.
Now before I begin, I would like to be perfectly clear: in establishing one's personal finances, an emergency fund is the quintessential first step. In turn, it is likely that this type of liquidity is best served by some type of savings account. There is no greater satisfaction than knowing that you will be financially OK in a time of need. In fact, I believe this so much that I devoted an entire chapter of my book to this endeavor. However, once you reach a comfortable, liquid emergency fund level - whatever that amount might be for you personally - I would strongly advocate that any additional funds not be committed to this venture.
The underlying reasoning is relatively simple: savings accounts, especially at today's rates, don't do a particularly good job of keeping up with inflation. So while people might believe that they are protecting principal, what they are truly doing is locking in a losing proposition. It's not principal that they are guaranteeing, but rather the loss of purchasing power over time.
Let's work through an example to better underscore what I mean. I would agree with Ally bank in that a .01% interest rate isn't going to do anything for a person's savings. However, it should become readily apparent that a 0.84% rate is effectively the same thing and certainly not a solution to the problem at hand.
For instance, let's assume that an individual is comfortable with a $30,000 emergency fund. With this money you can put it under the proverbial mattress (a savings account yielding .01% or 0.84% for instance), in a CD ladder or some other type of liquid account. That money should be nominally protected and easily available. Yet what I'm interested in are the next marginal dollars - the extra $5k or $20k or whatever amount that goes above and beyond your necessary rainy day fund. If one was drawn to the Ally bank ad, they might then be persuaded with some logic along these lines: "your principal is guaranteed by the FDIC and our rates our substantially higher than your banks." In turn, they might decide that this is a reasonable place for all of their savings - after all, it is called a "savings" account.
So let's say that a thrifty-minded person skips some unnecessary wants, stays frugal and is able to sock away $10,000 a year. They diligently put this money into a "savings" account earning 0.84% a year for the next two decades. At the end of 20 years, they might be delighted to find out that their account is worth $216,793.89. They put in $200k and the bank added nearly $17k to their balance. Well technically their money added this extra amount, but assuredly you see the problem.
According to the Bureau of Labor Statistics consumer prices have inflated anywhere from 1.2% to 2% over the last year of rolling 12-month periods. Given that we're in a historically low rate environment, let's call it 2% for illustrative purposes. So how is that diligent saver rewarded after two decades of consistent saving? Well, that same nominal $216,793.89 is now worth just under $150,000 in today's purchasing power. In other words, that person did nearly everything right - made more than they spent, delayed gratification and consistently put the money aside - and yet they are worse off today than 20 years ago. Said differently, by using a "savings" account they have protected not just principal but also the assurance of being able to buy less stuff.
Of course the obvious criticism to this example is that low rates won't persist forever. Yet it should be made clear that the math is the same. Whether inflation is 2% with a 0.84% interest rate or yields are triple that much but inflation runs at say 3.8%, one still can't buy as many hamburgers at the end of the day. Expressed using a Warren Buffett quote:
"The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn't seem to notice that 6% inflation is the economic equivalent."
So what is the solution? Easy, find investments that have a great chance of beating inflation over the long-term - in whatever form that might allow. Usually one would think of equities but certainly bonds, real estate and other productive assets could fit the bill. In my personal experience, this usually means partnering with the best companies that I can find that have not only paid but also increased their dividends for many years. You know the names; a core dividend growth portfolio would usually look something like this: Coca-Cola (KO), Johnson & Johnson (JNJ), Procter & Gamble (PG), PepsiCo (PEP), McDonald's (MCD), Chevron (CVX), Walgreen (WAG), Colgate-Palmolive (CL), 3M (MMM) and Kimberly-Clark (KMB).
These companies have significant pricing power and the ability to reinvest in a profitable business. More than that, these types of companies have a solid chance of increasing their payouts at a pace quicker than inflation - after-all they have already demonstrated this ability for decades. In exact opposition to the previous "savings" account example, any investment that provides returns above inflation will continuously increase one's purchasing power.
For instance, if one reaches a total portfolio value of $1 million, has $30,000 of yearly expenditures, invests for an aggregate yield of 3% and expects these payouts to increase at a rate equal to or greater than inflation, then the individual is effectively good. On the other hand, any payouts that trail inflation - whether nominally increasing your principal or not - will always require a drawdown of capital. More specifically, "savings" accounts are only appropriately named in the respect that they normally require you to keep putting more money in to retain one's purchasing power.
Given a long enough time period, equities - or otherwise productive assets - are the vehicles that offer true savings. For instance, here's a look at the S&P 500 index returns over the last two decades using F.A.S.T. Graphs:
A hypothetical $10,000 investment would have grown to over $46,000 as compared to the $15,799.53 required to keep pace with inflation. Additionally, note that the aggregate payout grew every year but two - despite not having a singular focus on dividend growth. Owning productive assets at reasonable prices have a tendency to protect you from unproductive endeavors.
Incidentally, I have previously used this logic in suggesting that an investor treat dividend growth stocks like a 10-year CD. Given my other published work, it follows that I will continue to work towards illuminating this sometimes transparent obstacle of inflation. In this particular example, I wanted to highlight the fact that a "savings" account should really be called an "emergency fund" or something of the sort. When using such an account beyond a comfortable cushion, it's not principal that you are saving yourself but rather the ability to buy more stuff in the future. I agree with Ally bank in that a .01% interest rate shouldn't be advertised as saving the accumulator anything. However, I would further promote that any account expected to lose purchasing power over time would simultaneously fall into this "non-savings" characterization. Given our current environment and expectations moving forward, I ask you: "can you really call it a savings account if it's only earning 0.84%?"