Middle Class Savings Mantras: Have They Stopped Working?

Are the savings mantras of the middle class — savings strategies of the middle class — that were the favorite of our parents and grandparents, still sound and useful these days? The general strategy was to put money in the following avenues as a means for long term investment:

  • Fixed Deposits (also called Bank Certificate of Deposit)
  • Life Insurance (as investment, not for insurance)
  • Gold (as investment, not as jewellery)

Do these make very good sense these days? Let’s do some analysis.

Fixed Deposit Mantra

In order to compare the power of fixed deposits over a time span greater than a couple of years, one has to take at least these three factors into account:

  • Rate of interest of FD
  • Income Tax rate
  • Inflation rate

The analysis proceeds like this, for each year:

  1. Take average 3-5 year FD interest rate
  2. Subtract income tax rate from above – this gives ‘post-tax FD’
  3. And then subtract inflation rate (CPI) – this gives Effective FD rate ‘EFD’

Thus, EFD is inflation-adjusted post-tax FD interest rate.

There are several assumptions and estimates involved in this process, so do not accept the final numbers as gospel truth. Nevertheless it is interesting to see how FD’s, based on this analysis, have performed over the years.

Values for FD rate, post-tax FD, CPI and EFD are plotted in figure 1 below.


Figure 1: Effective FD Interest Rate

From the data, several interesting trends over the past 25 years can be noted .

  • Income Tax rates have dropped more or less steadily from 55% to 33%
  • FD rate roughly tracks the inflation rate (except for CPI glitches in 1998 and 2009)
  • EFD is negative in 20 years out of 25
  • average EFD is -2%

It is easier to study effective FD rate in Figure 2 below, where only EFD is plotted.


Figure 2: Effective FD rate (alone)


So it appears that for those at the top income tax bracket , fixed deposits have negative returns, -2% on average. Is the situation better for a person at zero income tax bracket? Turns out, not by much: FD-CPI is just +1.5% on average.

Personally, I began this analysis expecting to find that FDs had decent returns in previous generations but had became ineffective only in the recent past. But it appears that effective yields from FDs haven’t changed much in 25 years.

Possibly these three factors — CPI, tax rates and FD rates — are interconnected so as to keep the EFD at more or less zero.

Sources for FD rates:

[1] https://wealthymatters.com/2012/04/05/historic-fd-interest-rates/

[2] http://capitalmind.in/2012/01/chart-of-the-day-bank-fd-rates-from-1976/

[3 ] https://www.sbi.co.in/portal/web/interest-rates/base-rate-historical-data

[4] http://www.payscale.com/research/IN/Years_Experience=1-4_years/Salary

[5] http://www.newindianexpress.com/education/edex/article1502534.ece

[6] http://apnaplan.com/income-tax-slabs-history-in-india/

[7] http://www.slideshare.net/boseshankar5/last-25-years-income-tax-rates

[8] http://www.moneycontrol.com/budget2007/taxrates.php

Life Insurance Mantra

-How Opal Mehta Got Life Insurance, Got Wild, and Still Got Screwed

Before we begin, please understand: I am not against the concept of insurance, be it car, house, accident, or life. It is a good idea to mitigate the effect of low probability but high impact black swan events by offering frequent prayers at the altar of an insurance company. But what ‘joss sticks’ or agarbattis ought we to burn at this altar? Only those made from term insurance premiums.

“Term insurance” is “pure” insurance: only the risk is covered. So you get back nothing if the dreaded event did not happen. In general, term insurance premiums are lower.

However, insurance agents get paid commissions that are a percentage of the premium amount paid by the client, and to maximize their income, they would rather peddle high premium policies. I have not met a single insurance agent who is even willing to talk about term insurance. They would rather that the clients do not even know that something like term insurance exists. So what do the agents want to offer? Policies that could be called cover plus investment. That is, pay a term premium plus an investment amount. You get a return on the investment amounts which presumably the insurance company will invest and return back many fold. And this investment is even tax free! That sounds great, but after deducting as much as 25% agent commissions plus operational costs plus insurance cover cost from each premium, the people at the insurance company have to be very very savvy to generate a good return for the client from what is left over.

So here is a true story (some details are changed but the numbers are accurate and will illustrate my point).

One day in 2004 Opal Mehta was still feeling annoyed by an income tax audit and when a life insurance agent promised 7% tax free annual rate of return on premiums, plus possibility of additional bonuses, she trusted him. Especially because FD rates were low, around 6% in 2004.

So from 2004 to 2011, for 8 years, she paid yearly life insurance premiums of Rs. 20,560 and in the ninth year, 2012 she got back a total of Rs. 1,91,100. That amounts to 16% net return in the ninth year. Now, the correct method to estimate the annual returns on regular multiple payouts is to compute internal rate of return or IRR. In this case:

IRR  = 3.32%

Note that the FD interest rates post-tax averaged 5.25% during 2004-2011. Now which would have been a better investment for Opal, even given only these two options?

Gold Mantra

Indians have an emotional and cultural attachment to gold; gold ornaments are an essential part of the Indian psyche. But how has gold done in the long run as an investment avenue? Figure 3 charts the average gold price in India for the last 50 years[1].


Figure 3: Historical Gold Prices since 1964


From the above figure, it is clear that up to 2012, gold prices have shown a more or less steady rise, except for a sideways move during 1997-2002. Compare above prices with gold prices in USA (note: both time duration and price units are different), shown in next Figure 4:


Figure 4: Gold prices in USA, $/g

Note that before 1970, US gold price was pegged to the dollar, so the steady rise in Indian gold prices before 1970 despite the US market being mostly flat, can be explained by the erosion in the dollar-rupee exchange rate.

Gold prices in India have not fallen as steeply as in USA since the high of 2013. This may be due to import restrictions but this difference may not last long.

So what does it all mean in terms of gold as an investment opportunity? Take a look at Figure 5 that charts the average annual price rise over a rolling ten-year period.  As an example, the peak of 25% in 1981 means that had you bought gold in 1971 and sold it in 1981, you would have made an annual profit of 25% (Almost a ten-fold return in ten years). On the other hand, buying gold in 1992 and selling in 2002 would have given very poor returns.

Figure 5: Ten year Rolling Average Gains

So it appears that the gold mantra did hold up well until the eighties, and then again after a lull of a decade, it showed a very unusual upward run during 2000-2012. However, market is going sideways again for the past few years, so today It is difficult to claim that it is a good time to buy gold as an investment. Or that it is a bad time to buy gold.

Sources for gold:
[1] https://www.bankbazaar.com/gold-rate/gold-rate-trend-in-india.html

[2] http://www.macrotrends.net/1333/historical-gold-prices-100-year-chart

[3] http://goldprice.org/spot-gold.html