It's Purchasing Power that Counts

If you could send your savings back in time to 1980 when Vanguard's Prime money market fund returned 13.1%, would that be a smart savings move? If you say "Yes!" too quickly, you're making a common mistake. What really matters isn't your "apparent" return, but how well your savings investments protect your net purchasing power. To determine that, you must take into account the effect of both taxes and inflation.

For example, after taxes Vanguard Prime's 13.1% yield would have shrunk to about 9.0% (assuming a 25% federal and 6% state rate). Further, after subtracting 13.5% (the inflation rate in 1980 as measured by the Consumer Price Index) you'll find that you would actually have lost 4.5% of your purchasing power that year, despite what appeared to be a generous yield.

Now that you're mindful of the difference between "apparent" return (the published rate) and your net "real" return (your return after taxes and inflation), you might be less enchanted with the high rates offered in the past — and perhaps feel a little better about the record-low yields of 2009.

The table below puts the savings rates from last year into perspective. First, note that the rate of inflation for 2009 was negative, that is, we experienced deflation for the first time since 1955. This had the effect of boosting the real return. As a result, the net real return was higher than the apparent return for two of the three classes of savings vehicles shown.

This, of course, is the rare exception. If you look at the past five years as a whole, the real returns significantly lag the apparent returns. Since 2005, inflation as measured by the CPI has averaged 2.5% (column 1). This was less than the 3.0% average return on money market mutual funds (column 2). But after adjusting for taxes, the average MMF return is reduced to 2.0% (column 3). This represents an annual 0.5% loss in net purchasing power (column 4). SMI's recommended money market funds (listed each month in our Best Rates table ) fared better, coming in only 0.2% behind inflation in real terms (column 7).

The top-performing money-market savings accounts offered by banks (also listed each month in the Best Rates table ) fared better in this low interest-rate environment. To get these top returns, however, savers must be ready to regularly shop nationally for the best deals and move their accounts among banks accordingly.

Level 2 savings accounts are meant to be a safe haven, not a means of generating high returns. Nevertheless, by shopping carefully you have a better chance of protecting the purchasing power of your savings accounts.

Austin Pryor is the founder and publisher of the Sound Mind Investing newsletter and website. His desire is to help people understand and apply Biblically-based principles for making spending and investing decisions, ultimately helping them have more so they can give more.

Former SMI staffer Joseph Slife is now the senior producer and co-host of The World & Everything in It, a weekly radio program produced by WORLD magazine that can be heard here. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting.

• Of Greater Interest: Better Rates in Bank Money Market Accounts
• Liquidity Matters: Will You Have Money to Face an Emergency?
• Three Ways to Boost Your Savings
• Current Best Rates tables 
• SMI's Savings Accounts page

Related Articles

Of Greater Interest: Better Rates in Bank Money Market Accounts

Liquidity Matters: Will You Have
Money to Face an Emergency?

Three Ways to Boost Your Savings

Current Best Rates tables 

SMI's Savings Accounts page

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