Brent Sheather: Investing in term deposits far from plain sailing

By Brent Sheather

Despite all the hype about Auckland residential property and KiwiSaver, and in spite of how well the local stockmarket is going, New Zealanders still have some $158 billion invested in term deposits. This compares with around $40b in KiwiSaver.

Another way of appreciating the importance of term deposits is to consider that almost a quarter of household wealth is invested therein.

Given their materiality to the wealth of retail NZ investors you would think that investing in term deposits would be plain sailing for mum and dad, retired and living in Tauranga.

Unfortunately that is not quite the case -- the market is not particularly, in the words of our regulator, "fair, efficient and transparent".

So what makes investing in term deposits potentially problematic? The biggest issue is that the term deposit rates quoted on banks' websites can overstate the actual return you will receive and there is no standardisation of returns.

Here is an example: a quote for a five-year term deposit rate of 4.3 per cent with interest paid at maturity or 3.8 per cent for the same term with interest paid earlier. Which is best?

Most retail investors are not able to discern whether 4.3 per cent with interest paid at maturity is a better proposition than 3.8 per cent with interest paid monthly. One needs a discounted cashflow model to calculate which of these options offers the highest return.

So what's the difference and why is when you get the interest payment important?

Using the five-year term deposit as an example if interest was paid at the end of each month after the first month you would get interest on the interest for the next four years and 11 months and so on.

With interest payable at maturity you don't get this compounding "interest on interest" effect and that's why 4.3 per cent with interest payable at maturity is considerably less than if the interest was paid monthly for example.

There is an information asymmetry in the term-deposit market -- a bank knows the actual return of each option but mum and dad almost certainly don't. The potential therefore exists to exploit naive retail investors as so often happens in other areas of finance, albeit in more complex instruments.

The fact that investing in term deposits is not straightforward should concern regulators. Contrast the opaque retail market for term deposits with how banks deal with each other and institutional investors in respect of fixed interest instruments.

When banks sell a government bond in the wholesale market they use a standard discounted cashflow model which has regard to the timing of interest payments and they quote the buyer the yield to maturity otherwise known as the internal rate of return.

Similarly banks should be required to advise retail investors what 4.3 per cent for five years with interest paid at maturity is equivalent to, assuming quarterly compounding.

There are apparently lots of new technology companies waiting in the wings to "disrupt" the market and as we have seen with other new entrants in the finance scene in NZ sometimes the "disruption" is in respect of consumers' welfare.

The information asymmetry with term deposit interest payments means that the potential exists to disadvantage investors.

I asked the Financial Markets Authority (FMA) why, after all of the effort put into making the financial markets safer and fairer for mum and dad, this sort of information vacuum still existed.

The FMA said: "Term deposits are category-two products for the purposes of the FMCA (category-two products are defined under the Financial Advisers Act 2008 and are generally less complex) and therefore banks offering term deposits do not require a PDS. Term deposits are captured by the FMCA Part 2 fair-dealing provisions that cover misleading and deceptive conduct or statements. This means that any description of interest rates must not be misleading." As the FMA has said previously the Financial Markets Conduct Act is something of a minimum standard for institutions and while the law may not compel banks to disclose more fully they should probably do so in the spirit of the law.

• Brent Sheather is an authorised financial adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.