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Inflation station

Created:

21 May 2010

Written by:

Maike Currie

No one - not even the governor of the Bank of England - is sure which way inflation will go. Some predict that once the full impact of the government's money printing exercise (quantitative easing) is felt inflation will go through the roof. Others argue the global economy is likely to face a few years of very low growth, which tends to be deflationary. Either way, the latest consumer price index (CPI) figure showed an acceleration from 3.4 per cent to 3.7 per cent, while the retail prices index (RPI) jumped from 4.4 per cent to a 19-year high of 5.3 per cent. This spike in inflation, together with record low interest rates, is having a detrimental effect on savers' wealth.

Savers' plight

The increase in inflation figures means a basic-rate taxpayer needs to find a savings account paying at least 4.63 per cent to prevent their savings pot eroding away. A higher-rate taxpayer needs to find an account paying 6.17 per cent, while taxpayers in the new 50 per cent tax band would need a savings account that pays at least 7.41 per cent.

According to figures from Moneyfacts, this leaves basic-rate taxpayers with a choice of 20 accounts to break-even, with only one account available to higher-rate taxpayers. Furthermore, the accounts on the market that do beat inflation are only likely to be suitable for a small proportion of savers. To qualify for these accounts, savers need to open a fee-paying current account, invest in a riskier investment product or commit funds for five years.

Paying 8 per cent, the HSBC Preferential Saver is the only product that beats inflation for higher-rate taxpayers, but savers need to hold or open a fee-paying account with the provider to qualify. Thereafter, the amount that can be invested is restricted to £250 a month (£3,000 over the one-year term).

As for easy access savings accounts, moneysupermarket.com reports that currently none of the 257 easy access savings accounts for balances of £1,000 pays enough interest to offset the effects of inflation and tax. The top paying account in this space is the Coventry Building Society 1st Class Postal account which offers an interest rate of 3 per cent.

Switch to stocks and shares

Kevin Mountford, head of banking at moneysupermarket.com, says that given the low number of products that offer a return above inflation, savers need to keep a close eye on the interest rate, especially on fixed-term accounts as rates may come crashing down after the term ends. "There are things you can do to maximise the return on your savings. For example, it's a no-brainer to utilise your tax-free individual savings account (Isa) allowance which increased in April to £5,100 for cash savings, and consumers need to be aware of any withdrawal penalties attached to their account," he says.

Unfortunately, low interest rates mean cash Isas now pay an average 0.42 per cent in interest, according Bank of England figures, with some paying as little as 0.1 per cent a year. Top paying instant access Isas that accept transfers in only offer around 2.75 per cent - much less than the rate of inflation.

Given this paltry state of affairs, many advisers are encouraging savers to transfer underperforming cash Isas into stocks and shares Isas. This won't affect other Isas or reduce your £10,200 allowance, as the entire amount can be put into a stocks and shares Isa in a single year. Cash Isas only permit £5,100.

"Obviously, there is a risk in moving away from cash, but that has to be set against a guaranteed loss due to inflation from the vast majority of cash Isas. And that will still remain true if inflation falls back, as many forecasts suggest," says Anthony Yadgaroff, managing director of Mayfair-based discount broker Allenbridge. "Over the longer term, shares Isas have given better returns than deposits; of course, shares can go down as well as up, and past performance is not necessarily a guide to the future. So it has to be emphasised that switching into equities and bonds is for longer-term money - not cash that might be needed soon, as the transfer process cannot be reversed," he adds.

Better monthly income

On the brighter side, two new savings accounts launched this week offering an interest rate of 5 per cent could provide savers some much-needed relief. Northern Rock has launched a regular saver account paying 5 per cent fixed until June 2011. One drawback is that you have to open and manage the account in a branch; however, on the plus side you can withdraw without notice or charge. The maximum you can pay in is £250 a month.

Coventry Building Society is offering a five-year fixed-rate bond option at 5 per cent which can be opened in a branch, online or by phone, and comes with the option of monthly interest payments.

Of course, the risk with both these offers is that if interest rates do start to pick up, your money will be tied up for a few years. But with the Con-Lib government determined to keep interest rates low, an offering such as the Coventry account could be a useful vehicle to maximise your monthly income.

Inflation-linked investments

Not everyone is convinced that inflation will return with vengeance. Andrew Wilson, head of investment at wealth adviser Towry, argues that given the anticipated rises in personal taxes and reductions in government spending, it seems unlikely that inflation is going to be an ongoing problem in the UK, even though it is undoubtedly "sticky" at the moment.

That said, a properly constructed investment portfolio should always contain an element that can perform during times of unexpected inflation but also disinflation, both of which are perfectly plausible outcomes from here.

On the inflation side of things, you can get direct capture via index-linked gilts - with the added sweetener of tax-fee capital gains. A simple way to invest is via a fixed-income exchange-traded fund (ETF) such as the iShares GBP Index Linked Gilts.

National savings and investments (NS&I) certificates are also regarded as a core way to inflation-proof your savings. You get a guaranteed tax-free rate of return, higher than inflation measured by the RPI, if held for the full certificate term. They are currently available in three- and five-year terms and are sold in issues, which allow savers to invest up to £15,000 in each.

Mr Wilson suggests global index-linked bonds as another option. "These provide greater diversification and many won't deflate the principal should prices actually fall. Furthermore, yields are currently higher than in the UK," he says.

International diversification is always good, and foreign currency assets are another investment that can help protect against inflation in your home country as inflation weakens your base currency.

Real assets

"Real assets are also a crucial element to any portfolio, commercial property being a good example, and have good inflation-hedging characteristics. In fact, property has also performed better than many other asset classes during times of deflation too," says Mr Wilson.

Other 'real assets' such as commodities have also traditionally been seen as powerful hedge against inflation. But Mr Wilson warns that an expensive and over-owned asset may not perform as hoped, and this view could be taken on commodities at today's levels. That said, the fact that gold can perform in both inflation and deflationary environments makes it a must for an inflation-proof portfolio.

A bit of inflation is usually indicative that the economy is back on the move, and therefore could signal a good time to be invested in equities. But Mr Wilson warns that equities are best viewed as only a partial hedge against inflation. "It is always worth bearing in mind that there are differences between high inflation, steadily increasing inflation, and a genuine inflation shock. The latter would initially be extremely negative for equities, and most financial assets," he says.