Negative Real Return: What is Your Real Rate of Return?

We all know (or should know) that having an emergency fund is a good thing, and I think most people would agree that the best place to keep your emergency fund is in a high yield savings account or a short-term CD. However, I try not to keep a lot of money in my emergency fund — or any savings account for that matter. Why? Negative real return. Basically, inflation takes more away than you gain from the low interest rate offered by these accounts, resulting in the reduction of value of your savings.

I think the best way to demonstrate this concept is with a real life example:

  • The best savings account rate is 1.51% APY
  • The Consumer Price Index (CPI) for April 2010 vs. April 2009 is 2.2%

In this case, if you started an emergency fund by putting $10,000 in your Everbank account in April 2009, you would have $10,151 in your account after a year. Unfortunately, things that used to cost $10,000 in April 2009, would cost you $10,220 in April 2010. In other words, your money worth less than it used to a year ago — 0.69% less to be exact — and not to mention that you have to pay taxes on the $151 “gain”.

Better Than High Yield Savings

If saving money in a high yield savings account is a losing proposition, what are some good ways to deal with this? Here are a couple of ideas to make your money work harder:

  1. Pay down your debt. Consider paying off high interest debt (e.g., credit cards, personal loans, car loans, etc.) at an accelerated pace instead of adding to your savings. Paying down debt guarantees you a “gain” equal to the finance charges, which are much higher than what you can earned from savings. Personally, I keep a small emergency fund handy and pay down my debt as aggressively as I could.
  2. Buy TIPS. Treasury Inflation Protected Securities are the safest investments you can make that guarantee a real rate of return (i.e., positive return after adjusted for inflation).
  3. Invest your money. One of the reasons why experts advocate investing your retirement fund in the stock market is the ability to achieve greater than inflation growth.
  4. Put income producing assets into tax-advantaged accounts. One way to avoid taxes on your phantom gains is by putting your income producing assets inside your retirement accounts, such as Traditional IRA or Roth IRA, while putting appreciating (but non-income producing) assets outside of these accounts.

These are just a few ideas I came up with while putting this article together. Please chime in with other suggestions. I’m interested to know how other people deal with negative real return in practice.

About the Author

By , on May 25, 2010
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the owner and publisher of WorkSaveLive.com.

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Leave Your Comment (9 Comments)

  1. JW Collins says:

    Whatever rate you can get from a bank currently, it is a point under inflation, less taxes paid on interest earned. Therefore “thrift” via savings is somewhat foolish…guaranteeing the “thrifty” a loss of buying power each and every year he saves. The Fed, of course, benefits from this as do the big banks who can borrow freshly printed money at the Fed window (and reloan to government at a profit…so they surely don’t need YOUR money, nor do they need to lend). Until this changes, the monetary system is in peril.

  2. Jenna says:

    @pinyo – thanks for clarifying that!

  3. Money markets at best typically keep up with inflation after taxes so the real return on them is close to 0. But where else can you put your safe money? Certainly not in your local bank where your real return is almost guaranteed to be less than zero.

  4. Charles says:

    These are some excellent reminders. It’s really hard to find high yield savings account that’s over 1.5% these days, but even if you do, it still doesn’t keep up with inflation. Some people just don’t like putting money anywhere else due to the risk factor. But still others refuse to put money anywhere other than under their beds…go figure.

  5. Pinyo says:

    @Stephan – there are some penalty-free CD options available. Also, for short-term CDs, an early withdrawal penalty wouldn’t be too bad.

    @Jenna – you should keep a small emergency fund that you’re comfortable with. This article talks about negative real return and cited unnecessary large emergency fund as an example. There are also people who keeps a lot of money in savings without investing it.

  6. Jenna says:

    My only issue with this is, what if you are in a real emergency and need to access your money? Chances are it will take awhile to get out of the stock market (and you might take a hit for that). I’m not sure it’s worth that much risk.

  7. James says:

    you make some great points. these days if you are luck you can find an online savings account around 1.5% with inflation being 2.4% that is a losing battle month over month.

    that being said for most people its better than losing all their money in the stock market.

    so be careful and cautious but don’t be afraid to take some risks and make some money while you do it

  8. Stephan says:

    i think this is a valid post, but i dont think a cd is a good option at all for an emergency fund. cd’s arent always accesible, thats the idea, you promise not to touch the money for a certain amount of time, hence the higher interest rate. so while i agree that having a big emergency fund isnt the right move (5k+), using cd’s as emergency funds isnt a good idea either! just my two cents on the subject=)

  9. Kevin says:

    Other than the buffer I keep in my chequings account, I prefer to invest my money rather than leave it sitting there. This means that I don’t have an emergency account, but I have applied for a low interest line of credit that I will be able to draw on should there be some real emergency.

    It depends on what kind of insurance you have; people in Asia are known to be heavy savers because there are few government social nets. Over here, there is less of a need to keep so much cash lying around, as long as you have adequate insurance covering you.

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