With the Reserve Bank of Australia’s (RBA) February 2015 decision to reduce interest rates to 2.25% the question becomes how long do we expect low interest rates to last?

The best way to look at interest rates is to use real interest rates. Real interest rates are calculated by taking the actual interest rate and taking away inflation. For example if interest rates were 10.00% but inflation was 11.00% then effectively you are receiving -1.00% in interest. In contrast if interest rates are 2.25% but inflation is 1.70% (as at the time of writing) then the real interest rate would be 0.55%. Even though the nominal interest rate is lower (2.25% vs 10.00%) the real interest rate that you are receiving is higher and therefore better for you.

If we take a brief look at history, we can see that interest rates were a lot higher than they are currently. In 2008 interest rates got up to 7.25%, and before that it was not until 1991 where interest rates reduced to below 10% after being extremely high for years. However as discussed before, the nominal interest rate isn’t important, it’s the real interest rate that is important.

If we have a look at the last 14 years, the real cash returns (Government interest rates + a small margin) were 1.9%. That is if you were to invest $10,000 the average real return that you would get would be $1,900 p.a.

However if you go back and have a look at the 20 years before that (1980 – 2000) the real cash returns are approximately 4.9%. If we average out the 2 periods we can say that the real interest rates since 1980 are around 3.66%. Given that this is considerably higher than the 0.55% that is currently on offer it is fair to say that interest rates are probably about 2% lower than the historical norm.

If we dig a little deeper though, the results change. The real cash rate returns between the years of 1910-1980 (a 70 year period) is -0.9%.  This is considerably lower than the 4.9% and 1.9% for the later periods. Sure there were 2 World War’s in their as well as the Great Depression which would have had an impact on things, but over a 70 year time period the impact of these events would be small.

So from our historical research we can see that the low rates that are currently on offer may actually be closer to normal than we originally thought. If this trend of low interest rates continue as we believe it may, this can potentially have disastrous effects for retirees.

Unless you have planned well and have a comfortable amount of money to live on, and therefore do not require any investment returns, you cannot have all of your money invested in cash or term deposits. The returns may not be there to fund your expenses and you will eat into your capital very quickly, especially if the rates on offer cannot keep up with inflation as has been the case in the past. You will need to invest some of your money in growth assets to ensure that inflation does not erode the purchasing power of your savings.