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Is it time to grow out of your savings account?

Is it time to grow out of your savings account?

Posted on: March 01, 2016
Author: Allan Leung, Compass and Wealth Lead, ATB Investor Services

For most of us, our first savings experience includes a piggy bank. As we get older, all of that hard-earned money from shovelling snow, taking out the trash and delivering newspapers was transferred into our first bank account. Our savings earn small amounts of interest, and we’re excited to watch those savings slowly grow.

These first experiences teach us the importance of saving and budgeting. And the reliability of a savings account or other short-term savings vehicles like guaranteed investment certificates (GICs) is bar none: you expect to get back whatever you put in.

But what if you’ve moved beyond short-term savings goals and are working up to bigger purchases or longer-term goals? The money in your savings account may be guaranteed, but the return is close to zero. Five year GIC rates hover around a 1.5 per cent return, which isn’t a lot better.

When you factor in taxes and inflation1 (rising prices), over a long period of time, each dollar you save may be worth less than you originally thought. Again, these are great short-term savings vehicles, but longer-term savings goals, like retirement or your child’s education, demand something with more oomph.

Make time (and risk?!) your friend

Reap the benefits of youth for more than just your beauty regimen. The sooner you start saving, the more time your money has to grow before you need to use it. Markets will fluctuate but time allows you to ride the ups and downs and experience a greater return on your returns—this is the law of compound interest. Over time, the ups and downs of your diversified portfolio should move in one direction: up.

So now that we’ve covered the benefits of time, let’s compare low and high-risk savings vehicles. Imagine you have invested $100 in a short-term2 GIC and another $100 in a portfolio of globally diversified stocks3 from the beginning of 2003 to the end of 2015. For simplicity’s sake, assume a uniform tax rate4 (even though you’d pay less tax for capital gains and dividends than interest income).

Illustrative growth of $100, graph

After 13 years and taking into consideration inflation and taxes, the GIC actually loses money! There is a 36 per cent gap between the return from your GIC compared to the portfolio of stocks. A uniform marginal tax rate was applied, but in reality the portfolio of stocks would likely be taxed at a lower rate because of favourable tax treatment on capital gains and dividends. This means the return gap is actually greater than 36 per cent, since you would pay less in taxes.

Deciding what works for you

Perhaps the most important point here is that time and risk work best hand in hand. How you save and invest should always be dictated by your willingness and ability to take on risk. If your time horizon is relatively short and you need guaranteed principal, a savings type account is still a good choice. Alternatively, if you can tolerate more volatility and have a longer time horizon to ride out market turbulence, an investment in a diversified stock portfolio will put your money to work for you.

Our advice? Talk to a financial advisor who knows and understands what you’re saving for and is focused on helping you get there.

1The Bank of Canada (BoC) measures inflation by the Consumer Price Index (CPI) and maintains a target range of one and three per cent. Inflation is the measure of the rising price on a basket of goods. The effects of inflation erodes purchasing power and the value of money.

2Illustrated by Guaranteed Investment Certificate rates provided by the Bank of Canada.

3Compass Maximum Growth Portfolio

4Marginal tax rate of 40 per cent is assumed, however only 50 per cent of realized capital gains are taxable and eligible Canadian dividends receive a dividend tax credit.

Methodology & Disclosure