To make a fair comparison between fixed-return products, it is important to understand a few basic principles as well as the tax implications when investing in interest-bearing investments.
Let’s look at an example of what is currently available in the market for a 60-month fixed-return product. This week, one bank offered its 60-month fixed deposit at a 12% rate. Sounds impressive. If you search for alternatives, you will find that you can invest in RSA Retail Savings Bonds with a five-year fixed rate of 10.25% (August 2024).
Tip 1 – Obtain the maturity value
In this case, before you decide to invest in the bank deposit, delve into the differences between the rates. First, use the institution’s online calculator (if they have one) or ask for an official quotation or written confirmation on the actual maturity rand value.
Let’s assume a R1 million investment with all accrued interest paid out only at expiry in each of the mentioned investments. The returns will be as follows:
- Bank fixed deposit: R1 600 000.
- RSA Retail Savings Bonds: R 1 649 490.
The difference is almost R50 000 in favour of a product that published a 1.75% lower rate.
Tip 2 – Determine what type of interest rate is advertised
To understand the difference, we need to distinguish between the three rate types and how different institutions advertise interest. Here is a basic definition for each rate type:
- Nominal rate – the annual rate before adjusting for the effect of compound interest. (NACM: Nominal annual compounded monthly)
- Effective rate – the annual rate after the effect of compound interest. (NACA: Nominal annual compounded annually = Effective Rate)
- Simple interest rate – an annual rate applied to the initial amount without any compounding.
Now, use the table below to consider the rate of the bank’s fixed deposit. Assuming the interest is compounded monthly, the simple interest rate (sometimes published as “Period effective”) is 12%; it has a nominal rate of 9.44% and an effective rate of 9.85%.
Tip 3 – Know the effect of tax on your investment
For interest earned on most investments (except within products like retirement annuities, living annuities and tax-free plans that are not taxed on interest), there is an annual tax exemption for individuals. For persons under 65, it is R23 800, and for persons 65 and older, it is R34 500. Whatever is not exempt is added to your taxable income.
Basically, this means that should you earn 10% a year (effective rate) on your investment and you are younger than 65 with an investment of more than R238 000, you will start to pay tax at your marginal rate on every rand exceeding R23 800 interest. For investors 65 and over, the same will apply to investment amounts over R345 000 with interest above R34 500.
The interest earned can also result in moving you into a higher tax bracket, increasing your marginal tax rate.
High-income earners should be cautious. If you are younger than 65 earning a taxable income between R857 902 – R1 817 000 per year, it will result in a marginal tax rate of 41%.
With a 60-month investment of R10 million in a fixed deposit advertised with a rate of 12%, the following table shows the effect tax has on the investment:
The investor will be liable for tax on interest during the investment period. The tax paid over to Sars, however, comes at a price over this period. This is known as opportunity cost. If, for example, the compulsory payments to Sars were withdrawn from another liquid investment account with a net effective rate of 7% per year, then the real cost of all the tax payments indicated in the last column results in R2 805 329. This will mean that the investment actually has an effective rate of 5.7%.
Are there alternatives for absolute certainty of a fixed return?
In the case above, you may want to consider a five-year fixed-return endowment policy. Reputable institutions currently offer fixed-return offerings of 6.8%.
This investment is not taxable in the investor’s hands as the policyholder fund (life insurer) pays all taxes to SARS, sparing the investor the hassle of tax liability during the investment period. The quoted rate is also the rate after all costs, including taxes, commissions, and administration fees.
The comparison between the end rand results when investing R10 million looks like this:
- Fixed deposit advertised at 12% return after tax and opportunity cost: R13 194 671.
- Endowment wrapper quoted after tax, cost and advice fee: R13 894 800.
The endowment product’s result over five years is a R700 129 higher return with no tax “stress.”
Unit trusts and exchange-traded funds (ETFs) – non-fixed return
In the unit trust and ETF space, money market funds, bond funds, and income funds primarily consist of interest-bearing assets.
Performances shown on fund fact sheets are annualised after all management fees and trading costs have been deducted. Rates, when considering the nominal, effective, and simple rates as explained above, will be the closest to the effective rate. Keep in mind that platform, administration, and advice fees must also be deducted. Remember that performance takes into account what happened in the past and not necessarily what will happen in the future.
Historically, unit trusts and ETFs have outperformed fixed-interest investments, especially over longer periods, but the investor must be able to tolerate volatility and exercise patience. It is wise for conservative investors to diversify their portfolios with these funds, but it is also appreciated that there might sometimes be a need for fixed-return products in specific cases.
Finally, interest-bearing products fall in the lower-risk category and are generally suitable for conservative investors, even if they hold only a portion of their portfolio. Make sure you compare the maturity rand values, understand the type of rates offered, and know what Sars will claim.