The trouble with instant access and fixed rate bonds
With returns on longer term fixed rates failing to hit the mark, there are signs of a worrying trend of savers using instant access accounts for money which would normally have been tied up within a fixed rate bond. Although this is perhaps understandable in the current market, there is also little optimism among savers that rates will pick up any time soon and inflation is only adding to the problem. We take a closer look at what is happening in order to understand the impact this may have and why considering all of the options available is more important than ever before.
Economic snap shot
The news that inflation fell to the Bank of England’s target of 2% for the first time since 2009 has had little impact on the savings market as the economic reality of day to day living continues to be a test for all concerned. Real wages also continue to fall as the increase in earnings falls far short of the rise in the cost of living, thereby reducing the spending power of take home pay for those at work.
For those who are retired, even those fortunate enough to have a pension that increases in line with inflation, they will still be feeling the pinch from their savings as they continue to experience the low levels of interest rates on offer. For the millions who elected to take out a level pension at retirement they are suffering on both counts.
Meanwhile, the base rate has been kept on hold at 0.5% which brings with it the realistic prospect in March that savers will have suffered five years of this record low, during which time they have had to endure a number of policies designed to get the economy back on track but which have the unfortunate side effect of pushing interest rates even lower.
Banks offering no favours
The Funding for Lending scheme in particular, which gave banks a cheap source of cash to lend as mortgages, meant they no longer needed to fund these deals from savers – as a result, interest was cut on many deals. This has also meant banks have been systematically shoring up the amount of saver’s cash on which they pay no interest. According to the Bank of England, the amount held in these accounts has increased by a fifth in the past year as banks have become awash with cash so that they do not need to pay struggling savers extra interest.
The result is that not only do they not want or need to attract new money, but since the start of the year there has also been an increasing trend of banks reducing the best-paying deals. Halifax, HSBC, Santander and Lloyds have all cut their savings rates with National Savings & Investment and NatWest to follow suit shortly. So if you are expecting savings rates to go up any time soon, you are almost certainly in the minority.
The fixed rate bond
This has created the unusual scenario of banks not wanting to find themselves at the top of the best buy tables and so when one name cuts its rates, another will follow suit as they simply do not want to attract your money. This has resulted in decent fixed rate deals in particular disappearing at an increasing rate.
Historically the traditional mainstay for every saver, when your fixed rate product matured it was simply a question of feeling comfortable with the prevailing rate being offered and deciding how long to tie up your money for. When rates in excess of 5% were freely available, the need to think about whether this was the right product was rarely challenged. How times have changed…
A losing battle
If we look at the current crop of fixed rate bonds available, the leading rates on offer range between 1.9% and 3.25% depending on whether you want to tie your money up between 1 and 5 years respectively. The rates are lower if you want to secure a fixed rate within a Cash ISA.
Therefore, although you continue to be rewarded with higher interest rates for tying up your money for longer, the upside of knowing exactly what rate you will get, when you will receive it and for how long must now be balanced against the wider economic challenges we face.
One of the most important considerations before making any decision is to understand the potential impact of inflation. In combination with our own tax treatment and the effect of any charges on our returns, this can have a significant effect on the most important reason for parting with our hard earned cash – the return we get in our pocket or the ‘net return’.
3.25% fixed per annum may look like a competitive rate in the current climate, but if inflation is running at 2% and you are a basic rate tax payer, your net return is only 0.6% each year whilst higher rate tax payers are losing money in real terms. It only takes a nudge up in inflation and the situation becomes even worse and more pronounced, especially over time.
Instant access to the rescue?
On the basis that banks and building societies hold £1.1trillion of our savings, it is even more worrying that there are also signs that savers are giving up chasing better rates of interest because the difference between the best and worst is so small. Bank of England figures from January reveal that the amount in ‘non-interest bearing accounts’, which includes current accounts, jumped by £21 billion in the past 12 months to more than £130 billion whilst the amount in instant access accounts also rose by £54.7billion. Savings in fixed rate bonds and notice accounts, which traditionally pay higher rates, fell by £38 billion.
The returns on many fixed rate bonds are so dire that savers can often do better in a standard instant access account. For example, Halifax pays just 1.4% to savers willing to tie up their money for a year whilst higher returns, albeit not fixed, can be achieved elsewhere on an instant access basis. So the trend is for savers to move their money into instant access but in the hope of what? Inevitably this will be in the hope of fixed rates increasing but the consensus view is that this is not likely any time soon. All the while, the risk being taken is that this money is not even keeping up with inflation so for how long do you let this continue?
The risk of doing nothing
The main risk of doing nothing is the impact inflation will have over time. With instant access losing you money in real terms and fixed rate bonds not offering much of a premium for tying up your money, even if you think that inflation could average at the Bank’s 2% target for the rest of this year, it only takes a small increase and suddenly you could be losing significant amounts in real terms.
Failing to understand the real impact inflation can have on your capital can produce painful results, especially over time. Based on the current economic outlook, arguably there has never been a more important time to make sure your capital is working as hard as it can. Not only must we ask ourselves what we are buying when committing to fixed rate bond, we should also be considering what alternatives are available since unfortunately the current market for savers leads us to a tough decision – either lose money in real terms from a savings account, or take on more risk.
ISA season upon us
With ISA season upon us this is also a timely opportunity to make the most of this valuable tax break which for basic rate tax payers increases any interest paid by 25% and for higher rate payers by 66% so is certainly not to be ignored.
Those looking for transfer options for their existing ISAs or to make sure they use their Cash ISA allowance of £5,760 or their Stocks & Shares ISA allowance of up to £11,520 must do so by the 5th April. Please note that the tax treatment of ISAs depends on your individual circumstances and may be subject to change in the future.
Consider your options carefully
With interest rates looking likely to remain low for quite some time the pressure is firmly on savers to consider the impact of record low savings rates, inflation and tax on the net returns we receive from our capital. Settling for the paltry returns on offer from banks or simply failing to take any action at all could prove extremely costly at a time when the need for income and growth from our savings is so high.
Recent trends are seeing savers looking to take on more risk with some of their capital in the hunt for potentially higher returns in an attempt to offset falling fixed rate bond yields. But whichever route you decide to take, with such a wide range of options available it is wise to consider all of your options very carefully indeed.
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are at all unsure of the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice.