Options in a low interest, high inflation world

14/12/2010
by Paul Dicken
Options in a low interest, high inflation world

On 9 December the Bank of England monetary policy committee (MPC) voted to keep the Bank Rate – the key influencer of interest rates for savers – at 0.5 per cent. The MPC last changed the rate in March 2009, more than 20 months ago, to combat the ensuing recession, and since then savers have been hit by rising prices and falling rates.

The Bank of England’s own figures show the average rate of interest on savings accounts for a one to two year fixed term account with a £5000 balance was 4.03 per cent in November 2008 when the Bank Rate was at three per cent.

The Bank Rate was incrementally reduced from the end of 2008, reaching 0.5 per cent in March 2009 and staying there ever since.

Meanwhile, the average interest rate on one to two year fixed term accounts was at 2.71 per cent for £5000 balances in April 2009 but fluctuated thereafter hitting a low of 2.27 per cent a year later in May 2010.

In March this year, Moneyfacts data showed the best available rate on most savings accounts had fallen since November 2009. While rates have fallen away, inflation has remained persistently above the government’s two per cent target rate throughout 2010.

Inflation

Currently inflation is 3.30 per cent which means savers need to be earning around four per cent on interest from their savings for the interest, after tax, to have real terms value; anything lower for a basic rate taxpayer is paying interest at a lower level than the rate at which the cost of living is going up.

A higher rate tax payer needs to find an account paying around 5.30 per cent to combat inflation, especially if they are looking for an income from savings.

Who’s paying?

For cash deposit savings options, attractive rates can be found in accounts paying a level of interest for a fixed term.

One of the leading rates on offer is a five-year fixed term bond from Scottish Widows Bank which currently pays 3.70 per cent annual interest with a minimum deposit level of £10,000. Although, this offer will close shortly and the rate on any new fixed term bonds may differ.

Current products on the market for shorter terms are also offering competitive rates and with the added flexibility; although, no short term accounts are likely to be paying over the 3.30 per cent level of inflation.

A popular fixed-term for current savers is three years because most economists believe interest rates will not begin to rise until late 2011 and then it is likely any rise will be small and incremental.

Beyond three years, some investors believe the Bank Rate will have risen to a level where more attractive savings rates will be available.

One year accounts can pay rates around the three per cent mark, such as the Post Office online bond which will pay three per cent annual interest for a year on deposits from £500.

Higher returns

Structured deposit accounts can offer capital protection and inflation-beating returns over a fixed term.

The Royal Bank of Scotland (RBS) Royal Deposit Plan 7 pays 4.10 per cent annual interest for a three year fixed term. The capital is protected provided that the counterparty is able to meet its liabilities – in this case Ulster Bank an RBS subsidiary. The minimum investment is £3,600 and exit fees apply to withdrawals within the fixed term.

Fair Investment savings and investment analyst Julie Smith said: “With interest rates remaining low and inflation remaining above the government’s target, structured deposits can offer competitive interest rates while still giving similar protection to that of cash products.”

Structured investments, linked to the performance of the FTSE 100, can also provide a level of income from an investment often over longer fixed terms of five years.

The Investec FTSE 100 Bonus Income Plan pays annual interest at 6.50 per cent or monthly interest at 0.52 per cent with potential bonus payments dependent on stock market performance. Return of the initial capital invested is dependent on the FTSE 100 not falling below a certain level and the counterparty, in this case Investec Bank, being able to repay investors.

ISAs

With interest rates available for savings sitting around or just above inflation it is more important than ever to be accruing interest without paying income tax. The tax charge on savings accounts will for a basic rate tax payer shave 20 per cent off the interest earned.

The main advantage of the Individual Savings Account (ISA) is the ability to save up to £10,200 (if invested in stocks and shares) or £5,100 if just investing in cash each year, without incurring tax on income earned.

However, Bank of England data shows the average annual interest paid by cash ISAs was just 0.40 per cent in October this year, illustrating the importance of shopping around when it comes to ISAs.

Several cash ISAs currently available pay over two per cent, while structured deposit plans are available as cash ISA options which can pay inflation-combating rates, such as the Royal Deposit Plan.

© Fair Investment Company Ltd