An image of the 1980s video game figure Pac-Man gobbling up everything in sight reminds me of the effects of inflation, tax and fees on investment returns. Gobble, gobble, gobble.
Too many savers and investors have no idea just how much of their returns are eaten up by Pac-Man.
The financial services industry for its part can be a bit disingenuous. Return on investment graphs produced by these companies rarely include inflation and fees, although showing post-tax returns is becoming more common. As a result the graphs show an inexorable march towards gaining a fortune.
The reality is that many investments are losing money after the three evils are taken into account.
In a year such as 2011, with 4.6 per cent inflation (to the end of September 2011), your lump sum investments lost 4.6 per cent of their purchasing power to inflation. The interest rate or other return needed to be 4.6 per cent just to make up for the inflation effect.
Add tax to that equation and a 17.5 per cent taxpayer would have to get a 5.6 per cent gross interest rate just to break even. A 28 per cent taxpayer would have needed 6.4 per cent gross. If not, their investment would be going backwards.
The NZ Institute of Economic Research (NZIER) has a very simple explanation of how inflation affects the buying power of your money. "You have $1 and an apple costs 50c. You can buy two apples. Next year the price of apples doubles to $1. Your $1 now only buys one apple, so your purchasing power has fallen. Inflation erodes the value of savings."
Hard-earned and saved lump sum investments are worth less every year. Sadly, $1 million will buy a whole lot less than it does today when those people in their 20s, 30s, and 40s retire. According to the Reserve Bank's inflation calculator, a basket of goods and services that cost $10,000 in 2002, would have cost $12,948.81 at the same month in 2012.
Like all investments, KiwiSaver returns are gobbled up by Pac-Man. Before-tax returns for the five best performing KiwiSaver funds for the year to September 2011 were between 2.41 and 3.48 per cent, says Russell Hutchinson, consultant at Chatswood Consulting. After tax even the best one fell to just 1.97 per cent. Take inflation off and the fund goes backwards by more than 2 per cent.
This year is better thanks to lower inflation at 0.8 per cent and higher investment returns on many KiwiSaver funds. The top KiwiSaver funds in Canstar's annual KiwiSaver ratings have all more than broken even post-Pac-Man. Just how well they're doing can be seen on Fundsource.co.nz.
As an approximate measure a fund that has returned 8 per cent gross in the past year at today's inflation rate would return 5.4 per cent net to a 17.5 per cent taxpayer and 4.56 per cent net to a 28 per cent taxpayer.
These are very approximate measures, however. Every KiwiSaver fund is affected differently by tax. For example, a conservative fund has a different mix of investments and will be taxed one way on New Zealand-based investments and another for a United States-based fixed-interest investment. New Zealand equities are taxed differently from overseas ones that are subject to Foreign Investment Fund (FIF) tax. And so on.
KiwiSaver returns should never be viewed over one year alone. It is a long-term investment.
One year's returns may be spectacular and well and truly make up for a previous year's poor showing.
This year, some funds have done well indeed in the year to September and the returns are back in positive territory, especially when the low inflation is taken into account.
What's more, KiwiSaver is a special case because those returns don't include the member tax credit and employer contributions, both of which can make KiwiSaver much more profitable than a similar managed fund or investment.
Today's low inflation rate is probably a bit of a blip, however, says Jeff Matthews, senior financial adviser at Spicers Wealth Management. The Christchurch reconstruction in particular is likely to boost inflation.
There is no guarantee inflation won't be a percentage point or two higher next year.
Saving and investing in a low-inflation environment is a different exercise to higher-inflation years. The high dollar is keeping inflation low. Should the currency devalue we could also see higher inflation. In the meantime it is people on fixed incomes and those saving to buy homes or businesses who are struggling most.
Matthews cites the case of a retiree with $1 million invested for income, who might have been getting a 7.5 per cent gross return three years ago. That person's before tax income may have dropped from $75,000 to $45,000. For such a retiree equities can be a good proposition as an investment in low-inflation times, especially shares in New Zealand companies that have relatively high dividends, says Matthews. "But shares spook some people."
There are "inflation-linked" investments available such as inflation-linked New Zealand Government Inflation Indexed Bonds, which mature in 2016.
Mark Brighouse, chief investment officer at Fisher Funds, says: "This is a timely debate because this week a new tranche of New Zealand Government Inflation Linked Bonds begins trading. They mature in 2025 and can be purchased in amounts from $10,000 upwards.
"These bonds provide a return that is specifically linked to the inflation rate so investors don't need to worry about how the investment will perform if inflation rises," Brighouse adds. The problem with such bonds is that they come at a price - that being a low yield.
"There are other investments that provide some inflation hedging and generally higher overall return. Our view is that shares in companies with strong industry positions will find themselves better placed than those that are unable to pass on cost increases."
Many managed and KiwiSaver funds invest in equities and should, in theory, have inflation-beating qualities. So, too, does paying down the mortgage. If you put available savings into a revolving credit loan or simply pay down another type of mortgage your return on investment is equivalent to the mortgage interest rate and that is tax-free return.
If investors aren't getting a return ahead of inflation they may as well spend the money or invest it in something that is an inflation hedge such as property, says Hutchinson.
He adds that more investment property isn't what the New Zealand economy needs. "The central message [New Zealand] is trying to convey with KiwiSaver is that saving is good and you should save for your future. Yet when we have a year with a result like 2011, it says you would have been better off spending the money or buying property."
Leveraged investments such as property do better during higher inflationary times. That's because the value of the outstanding debt on the property is eaten away by inflation while the property price typically keeps pace with inflation. "If you are in a lower inflation environment it makes it safer to save and safer to invest," says Hutchinson.
If interest rates are low savers might want to avoid locking their money into term deposits. Other options include cash-based investments on floating rates or bonds whose yields move with economic conditions.
Another issue worth thinking about when calculating the return on an investment post-Pac-Man, is tax bracket creep. That's the effect that pay rises have on your taxes. As your income increases both your marginal tax rate and Pie tax rate may increase, which means you need a higher interest rate or other return just to break even.
Some people structure their income so it falls below the new tax bracket. That's what investors do with loss-making properties or businesses. Providing they're in the right ownership structure, losses can be offset against income from their day jobs and elsewhere to reduce the overall dollar figure "earned" each year.
Another issue is that most people find that their individual costs may rise in old age thanks to health care. Their personal inflation is higher than government measures.
Whatever inflation is doing, investors need to include it, fees and tax in their investment planning. It can't be controlled, but investment strategy can.