Don't be fooled - the truth around inflation and your savings

Don't be fooled - the truth around inflation and your savings

24 July 2012 / by Oliver Roylance-Smith

The second successive reduction to the headline rate of inflation is certainly a welcome one; however, it could also give us a false sense of security. We take a closer look at what this latest reduction really means when making decisions around our savings and investments.

A quick round up

The latest figures for the headline rate of inflation, as measured by the Consumer Price Index, were announced last week by the Office for National Statistics (ONS) which revealed that the annual rate fell by 0.4% in June down to 2.4%, with the Retail Price Index also falling, by 0.3% down to 2.8%.

Although still well above the government’s target of 2%, these results mark a second consecutive fall in inflation with CPI at its lowest level since November 2009. At face value this is good news and certainly gives a feeling of things moving in the right direction.

The bigger picture

However, the headline rate itself is not the only factor we should consider before parting with our hard-earned money. When considering where to put our savings, it is imperative that we consider what the real net return will be.

The real net return is the amount we receive back in our pockets after taking into consideration all of the factors which have an impact on our savings. We therefore have to consider, in particular, the tax we will pay as well as the effect inflation will have on the buying power of our money.

Tax

There aren’t many certainties in life, but tax is something which most of us just have to accept. Basic rate tax payers pay 20% tax on any interest, with many providers deducting this at source unless you can forward an R85 form telling them you are a non-taxpayer.

Since it is the gross rate that is usually advertised, you will have at least the basic rate of tax deducted at 20%, so it is important to understand the impact this will have. 4% gross is 3.2% after 20% tax whilst 3.5% gross equates to only 2.8% once the tax man has had his share. For higher rate taxpayers, this rate of tax is doubled at 40%. A gross rate of 4% per annum is therefore reduced to 2.4% whilst 3.5% gross will only provide a net of tax return of 2.1% - an important consideration indeed.

Please note that this information is based on current law and practice which may change at any time.

Inflation

Tax is only the first element to remember as this gives us our net return. The other important consideration is inflation, since a net rate of 3% cannot be considered a healthy return if the cost of living as measured by inflation has increased by 4%, since you are actually 1% worse off.

In a nutshell, in order to provide a positive return after inflation and tax, you would need to earn above the following headline rates:

Tax status
Minimum return (CPI)
Minimum return (RPI)
Non taxpayer (0% tax)
2.4%
2.8%
Basic rate taxpayer (20% tax)
3.0%
3.5%
Higher rate taxpayer (40% tax)
4.0%
4.7%
Additional rate taxpayer (50% tax)
4.8%
5.6%

What this also tells us is the importance of maximising our ISA allowance whenever possible, since the cumulative effect over time allows a significant sum to be protected against the effects of taxation.

You must also take a view on inflation

So is the fact that inflation has come down such a big deal? Is this avoiding the real questions we should be asking?

The easiest trap to fall in to is to make a decision based on the good news that inflation has come down for two months in a row to its lowest level since November 2009. What this tells us is that for every penny earned now above the various rates detailed above (dependent on your tax rate), we are making a net return. Combined with a fixed rate from a well known bank, certainly up to the value of £85,000, and we can feel pretty safe around the fact that our capital is secure – not risk free, but not far off…

However, what must be understood is that inflation is a backward looking measure – i.e. it measures the rate of inflation over the last 12 months. It tells us nothing about what will happen in the next 12 months, let alone looking beyond this timeframe, and yet 1,000s of us each day make decisions which tie us in for much longer periods without considering its impact.

So what will happen?

Although making any sort of prediction is by its nature fraught with uncertainty, we must understand that the rate of inflation is based on what has already happened and that it could change and change quickly – so be prepared.

There are a wide number of variables which can contribute to the rate of inflation and none of these are static. A further £50 billion will be pumped into the economy over the next four months and the government has also recently launched their funding for lending scheme. It will be several months before we are able to understand the impact of both initiatives but if these schemes fail, what alternatives are there?

Plan B

With the UK officially in recession territory once again and the IMF last week cutting its growth forecast for the UK by 0.6% for 2012 and 2013 (down to 0.2% and 1.4% respectively), another negative official estimate for the second quarter from the ONS (due tomorrow) would come as no surprise.

Plan B would seem to be that if the schemes do not work, lower interest rates could be on the horizon, as the minutes from the latest Bank of England meeting showed a softening towards this as a viable option – further bad news in the short term for savers.

If the schemes do work then the increased money flow throughout the economy could lead to increased inflation, again bad news for savers in the short term. Although increased interest rates could follow, this is a difficult landscape to navigate.

Your options

There are a number of accounts offering between 3% and 3.5%, all of which tie you in for 1 year or less. However, the range of leading rates in the 2 to 5 year space is only offering between 3.75% and just over 4% - a tiny margin, and so you are offered nothing at all for committing for a period of longer than 1 year.

If you do tie in now and inflation goes up by only a small amount during your fixed term, your real return could quickly evaporate. The point to note here is not to act now and tie yourself in by basing your decision on the current rate of inflation – you must take a view of what could happen in the future, which is where the range of alternatives to fixed rate bonds could provide a viable option.

Remember, remember

Of course the reduction to inflation is good news. High inflation is one of the hardest challenges to face, especially during a period of record low interest rates, and so any reduction is met with open arms. The critical point is that these are very unusual and temperamental economic times – understanding what is really going on is difficult to get to the bottom of, let alone what might occur in the future.

But always remember that tax, inflation and interest rates each bear an important part on the net return from our savings. We must be prepared for what might happen and not be frustrated by finding ourselves tied into something which ends up providing us with a negative return after tax and inflation, purely because we ignored the factors which can affect our savings.

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