What is the 'effective' rate of return?

Comparing interest rates products like on-call deposits, term deposits and cash Portfolio Investment Entities (PIEs) is often difficult because of:

• When interest is paid
• The appropriate tax rate to be applied
• When tax is deducted
• The term of the investment

In order to compare rates we have calculated one year 'effective rates' for 38% tax payers, 33% tax payers and 21% tax payers invested in the Cash Advantage Fund and in an on-call deposit product for one year. This enables investors to compare the Cash Advantage Fund and an on-call deposit against a traditional one year term deposit (assuming interest is paid at maturity on the one year deposit). The 'effective rate' answers the following question:

"If I held this investment for a one year period earning a rate of y%, then to get the equivalent return from a traditional one year term deposit the rate would need to be x."

The "effective rate" methodology enables 38%, 33% and 21% taxpayers to compare different investment options on the same basis. Below are three scenarios, one for a 38% taxpayer, another for a 33% taxpayer and the last for a 21% taxpayer. The assumptions that are common for each scenario are set out after the scenarios. Note for taxpayers on the 12.5% tax rate (from 1 April 2009) investment in a PIE fund may result in more tax being paid than if the investor held assets (or investments) directly. Given that, in this circumstance you may pay more tax in a PIE, rather than other forms of investment it is important to consult your tax adviser to determine whether a PIE is best for you.

In each scenario, the investor makes an investment of $100,000 at the beginning of the year, and leaves this invested for the full one year period.

The scenarios are summarised in the table below*:

	38% Tax Payer	33% Tax Payer	21% Tax Payer
Effective rate at 3.00% from the Cash Advantage Fund	3.43%	3.17%	3.09%
Effective rate at 3.00% in an on-call bank deposit	3.03%	3.03%	3.03%
Effective rate at 3.00% in a one year term deposit	3.00%	3.00%	3.00%

* All figures have been rounded. The rate is subject to change.

Note a 12.5% tax payer may pay more tax in a PIE than if they held assets (or investments) directly.

38% tax payer

PIE Cash Advantage Fund

• Because tax on the Cash Advantage Fund is capped at 30%, a 38% tax payer has tax on their investment deducted at 30%. 30% tax on a gross return of $3,040 is $912. The investor would receive approximately $2,128 of net income.
• The 'effective rate' calculation reflects the amount of gross income that a 38% investor would have to receive from a one year term deposit of $100,000 in order to receive net income of $2,128. This equates to $3,432 (i.e. $3,432 x (1-38%) = $2,128). Expressed as a percentage this is approximately 3.43%.

On-call bank deposit

• An on-call bank deposit pays simple interest monthly at 3.00% p.a. and tax is deducted from these interest payments at 38%. With an initial deposit of $100,000, the interest for the first month would be 1/12 x 3.00%. This equates to $250 of gross interest in the first month, against which $95 of tax is deducted (leaving a net payment of $155). Accordingly the balance at the beginning of the second month would be $100,155, and interest would be earned on this - which is where the compounding effect comes from.
• Taking the compounding effect into account, the net income that a 38% tax payer would earn on $100,000 placed in an on-call bank account over a one year period would be approximately $1,876.
• The 'effective rate' calculation reflects the amount of gross income that a 38% investor would have to receive from a traditional one year term deposit of $100,000 in order to receive net income of $1,876, assuming the investor's tax rate is 38%. This equates to $3,026 of gross income. Expressed as a percentage this is approximately 3.03% pa.

One year term deposit

• Tax is deducted when interest is paid on maturity after one year. A one year term deposit of $100,000 earning 3.00% pa would generate $3,000 of gross income. Tax would be deducted at 38%, leaving net income of $1,860.
• The 'effective rate' in this scenario is 3.00% pa.

33% tax payer

PIE Cash Advantage Fund

The following steps outline how to calculate the effective rate for the Cash Advantage Fund:

• Because the tax on the Cash Advantage Fund is capped at 30%, a 33% tax payer has tax on their investment deducted at 30%. 30% tax on a gross return of $3,040 is $912. The investor would receive approximately $2,128 of net income.
• The 'effective rate' calculation reflects the amount of gross income that a 33% investor would have to receive from a one year term deposit of $100,000 in order to receive net income of $2,128. This equates to $3,176 (i.e. $3,176 x (1-33%) = $2,128). Expressed as a percentage this is approximately 3.17%.

On-call bank deposit

• An on-call bank deposits pays simple interest monthly and tax is deducted from these interest payments at 33%. With an initial deposit of $100,000, the interest for the first month would be 1/12 x 3.00%. This equates to $250 of gross interest in the first month, against which $82.50 of tax is deducted (leaving a net payment of $167.50). Accordingly the balance at the beginning of the second month would be $100,167.50, and interest would be earned on this - which is where the compounding effect comes from.
• Taking the compounding effect into account, the net income that a 33% tax payer would earn on $100,000 placed in an on-call bank account over a one year period would be approximately $2,029.
• The 'effective rate' calculation reflects the amount of gross income that a 33% investor would have to receive from a traditional one year term deposit of $100,000 in order to receive net income of $2,029, assuming the investor's tax rate is 33%. This equates to $3,028 of gross income. Expressed as a percentage this is approximately 3.03% pa.

One year term deposit

• Tax is deducted when interest is paid on maturity after one year. A one year term deposit of $100,000 earning 3.00% pa would generate $3,000 of gross income. Tax would be deducted at 33%, leaving net income of $2,010.The 'effective rate' in this scenario is 3.00% pa.

21% tax payer

PIE Cash Advantage Fund

• A 21% tax payer whose taxable income is less than $38,000 and when combined with income from PIE investments total income is less than $60,000 (over last two income years) has tax on their investment deducted at a PIR of 19.5%. 19.5% tax on a gross return of $3,040 is $593. The investor would receive approximately $2,447 of net income.
• The 'effective rate' calculation reflects the amount of gross income that a 21% investor (with taxable income less than $38,000) would have to receive from a one year term deposit of $100,000 in order to receive net income of $2,447. This equates to $3,098 (i.e. $3,098 x (1-21%) = $2,447). Expressed as a percentage this is approximately 3.09%.
• Note a 21% tax payer whose taxable income is more than $38,000 will have a PIR of 30% and may pay more tax in a PIE than if they held assets (or investments) directly.

On-call bank deposit

• An on-call bank deposit pays simple interest monthly and tax is deducted from these interest payments at 19.5% (Resident Withholding Tax (RWT) rate). With an initial deposit of $100,000, the interest for the first month would be 1/12 x 3.00%. This equates to $250 of gross interest in the first month, against which $56.06 of tax is deducted (leaving a net payment of $201.25). Accordingly the balance at the beginning of the second month would be $100,201.25, and interest would be earned on this - which is where the compounding effect comes from.
• Taking the compounding effect into account, the net income that a 19.5% (RWT) tax payer would earn on $100,000 placed in an on-call bank account over a one year period would be approximately $2,441.
• The 'effective rate' calculation reflects the amount of gross income that a 19.5%(RWT) investor would have to receive from a traditional one year term deposit of $100,000 in order to receive net income of $2,441, assuming the investor's tax rate is 19.5%. This equates to $3,033 of gross income. Expressed as a percentage this is approximately 3.03% pa.
• If you are required to file a tax return additional tax may be payable to top up your effective tax rate to 21%.

One year term deposit

• Tax is deducted when interest is paid on maturity after one year. A one year term deposit of $100,000 earning 3.00% pa would generate $3,000 of gross income. Tax would be deducted at 19.5% (RWT), leaving net income of $2,415.
• The 'effective rate' in this scenario is 3.00% pa.
• If you are required to file a tax return additional tax may be payable to top up your effective tax rate to 21%.

12.5% tax payer

A 12.5% tax payer will have a PIR of 19.5% and will in all likelihood pay more tax in a PIE investment than if they held the assets (or investments) directly.

Common assumptions

Cash Advantage Fund

• We have assumed the daily "blackboard rate" for the Cash Advantage Fund is 3.00% pa and this is constant for a one year period.
• Over a one year period, investors in the Cash Advantage Fund receive the benefit from the fund compounding on a daily basis. This benefit is calculated as 3.00% pa compounded daily for a year which equates to approximately 3.04% pa.
• Interest is said to "compound" when it is added to the principal amount of a deposit. Interest on the Fund's deposit compounds daily on Tuesday, Wednesday, Thursday and Friday. On Monday, three days' interest compounds (for Friday, Saturday and Sunday). Interest does not compound on public holidays - interest accrued on a public holiday compounds on the next non-public holiday on which interest compounds.
• The 3.04% pa is then applied to the original investment amount of $100,000 resulting in a gross return of $3,040. This is the approximate amount (in dollar terms) that an investor would receive from investing in the Cash Advantage Fund for a one year period, assuming that the "blackboard rate" is a constant 3.00% pa.
• PIEs are not the same. They do vary in terms of how they compound interest, and timing of paying tax. The Cash Advantage Fund scenarios are based on the features and mechanics of that fund.
• For the Cash Advantage Fund we have elected to pay tax annually (at 31 March). Investors also pay tax on any withdrawal made during the year. For comparative purposes we have assumed no withdrawals are made.

On-call bank deposit

• The on-call bank deposit pays simple interest monthly (based on the average daily account balance). This monthly interest rate payment then compounds through the year.
• For the comparative on-call bank deposit rates, we have used the rates quoted on www.interest.co.nz.
• We assume the comparative on-call bank deposit rate is 3.00% pa.

Term deposit

• Term deposits typically pay simple interest normally at maturity (note some one year deposits pay interest more regularly, creating a compounding effect).
• In the scenarios, simple interest is paid on maturity after one year.