The Silent Erosion

December 14th, 2011

Over the past couple of decades inflation has been both stable and low, but recent government figures show inflation has now peaked above five per cent with RPI (Retail Prices Index) inflation running at around 5.4% in October.

Rising inflation causes us all problems, not only increasing our household expenditure but also eroding the ‘real’ value of our savings and investments, this article looks to explain this further and  at ways of trying to combat the effects.

Why has inflation been on the increase?

A key reason for this has been the increase in VAT to 20% as shops and service providers inevitably passed this 2.5% increase on to the consumer, meaning that the impact on the price index was almost immediate.

This, however, does not account for the full increase in inflation which has persistently run above target.  Part of the reason for the increase has been due to high utility, transport, and clothes costs which pushed up the overall cost of living.

To further compound the issue research by Saga shows that the “real” inflation rate for the over-65s is running close to 6.4 per cent. This is due to the disproportionate amount of income that pensioners spend on food and fuel.

The immediate impact for households is that based on just 12 months ago and assuming household expenditure was £20,000, to maintain the same standard of living now you would need to spend £1120 more – for the over-65s this figure is even higher at £1280.

Although inflation is unpredictable, there is still light at the end of the tunnel.  The Bank of England’s latest inflation indicate a fall to below 2% by the end of 2013 – One of the reasons for this is that, as inflation is measured over a 12 month period, the effects of the 2.5% VAT rise will soon ‘fall out’ of the equation.  However, despite expectations that inflation will fall in 2012, there are all kinds of factors which contribute to the headline rate and, if inflation remains high, the Bank of England may find tightening monetary policy will be too little too late.

What steps can be taken to ease the impact of inflation?

Make cash-savings work harder

Basic-rate taxpayers need a savings rate of at least 6.5% to be earning a real rate of return on their deposits after tax and inflation.

This is difficult to achieve in the current market, where even the best tax-free cash ISAs pay only 3.3%.  Even in this climate, however, savers should consider maximising their tax free ISA allowances of £5,340 in a cash Isa (these limits rise to £5,640 for cash from April next year) rather than leaving savings in accounts paying even lower rates of taxable interest.

Also, fixed-rate bonds, tend to offer higher rates of interest. A handful of providers offer index-linked bonds that can shelter savings from inflation. These are designed to pay the annual rate of RPI plus a certain additional percentage per year if kept for the full term, although it should be remembered that RPI can fall and there are likely to be restrictions on being able to access your money – In addition interest is usually only paid on maturity (rather than monthly or annually)

Review Household Expenses

Gas and electricity price rises are behind the most recent spike in inflation.  It is a double whammy because fuel bills are more expensive and higher inflation erodes the value of the income or savings used for monthly bills.

To counter this you may wish to consider:

•    The various grants for energy efficiency and therefore reduce ongoing usage
•    Shop around for a different energy provider to obtain a lower rate or even enter into a fixed price contract so that bills will not increase for a set period. The down side of the fixed deals is that you will not benefit from any potential falls in the cost of raw materials i.e. Gas, although many contracts would allow you to pay to exit them should this be desirable.
•    Change your payment method or combine the utilities you purchase to obtain discounts.

There is no perfect answer but, although many of us look to shop around for food or clothing to reduce our outgoings we do not often consider whether we are getting the best deals on things like utilities, insurance plans and other such expenditure.

Pensions

The recent Quantitative Easing programme undertaken by the Bank of England has caused pension annuity rates to fall.  This is because annuity rates are linked to the yields on Government bonds – When the Bank of England buys Government bonds this has the effect of pushing up bond prices and reducing the yield on them, and unfortunately, these are also the bonds annuity providers buy to supply annuitants with an income.

For example, a £100,000 pension pot could have bought an income for a 65 year old male of about £7,000 in March this year with the best provider.

By September this had fallen to £6,500 and October it had slipped again to £6,250. But delaying buying an annuity and hoping rates will improve is often simply not an option.

Those retiring may need to look at all the options.  With inflation forecasts uncertain it may be that (depending on your circumstances) a combination of retirement income options are appropriate in order to “hedge your bets” and provide a decent level of starting income whilst factoring in some protection against inflation.   As ever it is important that you seek financial advice in respect of the best solution for you.

Investments

As well as cash savings, you may wish to consider the long-term effects of inflation on your investments.  What matters is planning for future inflation expectations – it is important to remember the ‘headline’ inflation figures represent past inflation.   For example, exposing part of your portfolio to a well-diversified portfolio of equity funds (paying strong dividends) can be a good hedge against inflation, although these types of investments do not include the same security of capital which is afforded with a savings account.

It is important to stress, however, that inflation, is not the only (or necessarily the most important factor) when making investment decisions – For example, certain investments may carry more risk than you are willing to take and therefore financial advice is essential.

Whether you are looking for advice on the most appropriate retirement income options, looking to make your saving work harder, or just general advice on how best to arrange your finances please feel free to contact us for further guidance.

The value of your investment can go down as well as up and you may not get back the full amount invested

Levels and bases of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor