Inflation Buster – The Erosion of Savings

Investing

Alistair Hardie

13th February 2014 at 10:39am

This week’s quarterly Inflation Report from the Bank of England got me thinking about my own rainy day fund. Is inflation still eroding my savings? After all, inflation is continuing to fall, now down to 2%*. But while a lower inflation rate is better news for some, there’s still an impact on your savings.

How tax reduces my savings income

Surely, I thought, the current rate of interest I receive will protect the value of my savings. On checking, I discovered the introductory rate had expired and I was now earning 1.25%.  I noticed in the small print that 1.25% is the “gross rate” (i.e. before tax is taken off) so the real rate of interest is only 1.00%, assuming basic rate tax of 20%. But while a lower inflation rate is better news for some, there’s still an impact on your savings. This real interest rate would reduce further to 0.75% for a 40% tax payer.

This means that headline rates of interest don’t give you the full story – unless you’re saving in a Cash ISA, where there’s no extra income tax to pay.

How inflation reduces my buying power

Surely an interest rate of 1.00% would not be too bad as I remembered the BBC headline from just before Christmas – UK inflation rate falls to four year low in November.

I read the article again. It still made good reading to me as the Office for National Statistics said that there had been slower increases in food and energy prices.

However an interest rate of 1% against a rate of inflation of 2% clearly suggests the value of my cash savings will go backwards.  That’s because inflation causes prices to increase faster than my savings grow, so my ‘buying power’ decreases. But what does this look like in real pounds?

Calculate the impact

The internet has various calculators which allow you to check the impact of inflation on your savings. It’s a real wake-up call when you find that savings of £50,000 could be worth around £40,000 after 10 years, with inflation at around 2% in that period.

Can I reduce the inflation risk?

Hopefully by now, you’ll see how inflation is a risk to cash savings.  That’s why it’s a good idea to think about how much you really need in cash savings, and how much you might feel ready to invest in the stock market. It’s a real wake-up call when you find that savings of £50,000 could be worth around £40,000 after 10 years, with inflation at around 2% in that period. There’s potentially higher returns which could help to combat the impact of inflation, although you need to be ready for the ups and downs of the stock market.

When it comes to ISAs, you have the choice of a Cash and/or a Stocks and Shares ISA, and you can mix and match a bit of both.  So you don’t have to put all your eggs in one savings basket.  If you’re looking for some tips on ISAs, check out my earlier blog here.

Make a plan for your savings

Cash savings can suit if you’re saving for an emergency fund or something in the short term.  A Stocks and Shares ISA is more for the longer term.  If you’ve not really thought about what you’re saving for, it’s worth sitting down and thinking about your goals and making a plan. Here’s how to do it.

Take a step back, get your plan in place, and with a good mixture between cash savings and longer term investments, you’re better armed against the impact of inflation.

*www.bankofengland.co.uk/publications/Pages/inflationreport/infrep.aspx

The information in this blog is not financial advice. A Stocks and Shares ISA is an investment. Its value can go up or down and may be worth less than you paid in.

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