Should we be worrying about inflation? Retail prices index inflation (RPI) spent 2012 fluttering up and down between 2.6 and 3.9 per cent, and currently sits at an unremarkable 3 per cent. But while there is little sign of drama in the short term, some commentators (including the IC's Alistair Blair in his final column) foresee a sea change towards higher inflation in the longer term, with governments embracing rising prices as the most effective and least contentious means of eroding their enormous national debts.
SAVINGS PROTECTION ELUSIVE
That prospect is a big potential problem for savers, and particularly retirees who depend on investment income. "Since 2008, inflation has caused prices to rise by 14.7 per cent, so someone who retired last year would need an annual income of £21,400 to have the same buying power as someone who retired in 2008 on £18,700," says Vince Smith Hughes, Prudential's retirement expert.
National Savings & Investments (NS&I) index-linked savings certificates have long been a popular choice for retirees seeking inflation protection, because not only are they government-backed and pegged to inflation but they are also tax-free. But they are currently unavailable to new investors, and it's "highly unlikely" there will be further issues this tax year, according to an NS&I spokesperson.
In the meantime, cash offers little joy, with no savings products available that guarantee a return above inflation, and most savings rates paying significantly less than inflation, even before tax.
"The best that savers worried about inflation can do is to be diligent about checking for the best rates, and always to make full use of their cash individual savings allowance (Isa). It's only £5,640 for tax year 2012-13, but it does mount up over time," says Patrick Connolly, chartered financial planner at AWD Chase de Vere. However, even the best tax-free cash Isa (a 60-day notice account from Coventry Building Society) barely pips the current RPI, paying only 3.1 per cent.
Mr Connolly adds that if inflation starts to become a more pressing issue, providers are likely to reintroduce fixed-term inflation-linked savings bonds - but again, gains are taxable. Moreover, your money is tied in for a fixed term, typically five years.
INDEX-LINKED BOND OPTIONS
The principal alternative is index-linked government gilts, but the broad consensus for some time has been that they are pretty expensive by historical standards and therefore by no means a perfect inflation solution. Indeed, yields dropped to their lowest since at least 1992 earlier this month due to news that proposals to change the way RPI is calculated will be dropped.
"Ten-year UK index-linked gilts are now paying a real yield of -1 per cent, which means that although they’ll pay out in line with inflation, they are so expensive that you'll still lose 1 per cent a year for the next 10 years; and you'll pay tax on the income too," explains Chris Kenny, private client director at Smith & Williamson. "Of course, if inflation rises to 5 or 6 per cent, that amounts to a much more significant level of overall protection, but it will still always lag inflation."
If you do want to buy index-linked gilts, there are several routes. Individual securities can be purchased from the Debt Management Office (www.dmo.gov.uk). "The advantage of owning individual gilts is that you know the amount of income you'll receive in advance, and also that the capital value at maturity will be the issue price uprated for inflation over the term. Additionally, capital gains on disposal are not subject to tax, although income payments are," says Robert Lockie, investment manager at Bloomsbury Wealth.
He points out, however, that DMO transactions are made by post, so you won't know your sale price in advance. "If you want to know the sale price, you'll have to use a stockbroker, which could be more expensive; it's particularly important to minimise costs on low risk/low return assets such as these," he adds.
For greater diversity and easy trading, one low-cost alternative to individual gilts is an exchange traded fund linked to the whole index-linked gilt market, such as the iShares £ Index-Linked Gilt ETF. Alternatively, you could buy an actively managed index-linked bond fund. Either way, there will be an extra layer of costs, although this can be as low as 0.15 per cent for the Vanguard index-linked gilt fund.
If you fancy the fund route into government bonds, you could consider a broader-based and more strategically run inflation-linked vehicle, such as Kames Inflation Linked Fund. Manager Stephen Jones says that although index-linked gilts still constitute the core of the strategy, he is able to look beyond the UK, to government bonds from Europe, the US, emerging markets and elsewhere.
"In generic terms, inflation is likely to be a global phenomenon that affects yields from all these countries to a greater or lesser extent," he says. "Having a mix means not only do we reduce risk through diversification across different economies, but also we can access the significantly better rates being paid in some other countries."
The Kames Fund can also include other assets including corporate index-linked bonds from the likes of Tesco and United Utilities, gold, and the underlying resources where price rises tend to spark wider inflation, such as agricultural commodities and energy.
If you're prepared to move up the risk ladder from government bonds, one possibility is to own the individual index-linked retail bonds issued by a handful of large UK companies including Tesco, Royal Bank of Scotland and Severn Trent Water. The higher risks associated with companies rather than governments come with correspondingly higher returns: the Severn Trent bond, for example, pays a real inflation-adjusted return of 1.3 per cent.
The bonds can be traded on London Stock Exchange's Order Book for Retail Bonds. "But check the tax treatment first, as some are taxed very unfavourably if they're not held in a tax shelter such as an Isa or pension scheme," warns Mr Lockie. Fund investors could access this theme via the M&G UK Inflation Linked Corporate Bond Fund.
ALTERNATIVES FOR INFLATION PROTECTION
The options for inflation-linking extend beyond bonds. Gold is one asset that has long been used to hedge effectively against inflation, but it too has seen serious price increases in the aftermath of the banking crisis and many commentators believe it is not a sensible bet at its current $1,800 mark. "The gold price has also become quite volatile as a result of the growth in the ETF market, which is one of the principal ways to access it," comments Jason Hollands of Bestinvest.
Other low-volatility investments with an inflation link include listed infrastructure funds. "These have differing exposures to PFI projects in the UK, with the highest being HICL," explains Stephen Walker, head of equities at Ashcourt Rowan. "Their investments in projects such as hospitals and schools deliver cash flows generally linked to RPI, so if inflation rises, so should their returns and the dividends they pay to shareholders. HICL currently yields around 5.5 per cent, which is around a 2.5 per cent real yield." However, these popular funds are mostly trading on premiums to net asset value.
Mr Walker also highlights the merits of commercial property funds, where most rents are index-linked, though weak economic growth could mean rising vacancies that would damage the overall income stream.
Shares of large companies in defensive sectors such as utilities, tobacco and oil typically pay dividends rising in line with inflation (though there is no guarantee of that); they are another important option if you're looking at a broad inflation-beating portfolio.
The bottom line is that there is no perfect solution: if you want to beat inflation then you'll need to live with some element of risk - but diversification across a range of suitable assets can help to mitigate that.
