Beware the molten menace of inflation

Even a small increase can leave savers out of pocket, writes Sam Dunn, so make sure your account offers 'real' returns

It attacks our spending money, creeps up on our savings and can eat away at our pensions. Yet inflation, the dreaded rise in our living costs, is rarely a consideration when choosing where we put our cash.

It attacks our spending money, creeps up on our savings and can eat away at our pensions. Yet inflation, the dreaded rise in our living costs, is rarely a consideration when choosing where we put our cash.

It's easy to dismiss when it barely registers in our daily lives. After all, inflation today has nothing on the mid-1970s, when it nudged 24 per cent, or 1980, when it hit 20 per cent and pushed prices through the roof.

Yet the underlying rate of inflation (the one that excludes the impact of mortgage interest repayments) was running at 2.5 per cent in December, according to the latest figures. That means it had edged up for the third month running - and from 2.2 per cent in November.

So people who pay the basic 20 per cent tax on savings now need an account earning at least 3.13 per cent just to keep up with inflation, independent financial adviser (IFA) Bates has calculated. It's even harder for those who pay 40 per cent savings tax: their account has to offer at least 4.17 per cent.

Even if you don't work, or earn less than £4,745, and pay no tax at all, you'll still need a savings account giving you at least 2.5 per cent to "break even", warns Paul Ilott at Bates.

But given that many of us don't regularly check how much our savings accounts pay, let alone shop around for better deals, there's a good chance that we're being left out of pocket.

"The one thing all savers and investors should aim for is to get a positive 'real' rate of return over and above inflation after taking into account any tax they have to pay," stresses Mr Ilott. "Fail to do that and you might as well spend your money now because it will only buy less of the things you're saving for in the future."

Research from Bates reveals that this rise in underlying inflation has contributed to a sharp fall in the number of accounts offering returns that keep pace with inflation.

Fewer than a third of banks and building societies now offer real returns on your savings if you're a basic-rate taxpayer, it reports. And for higher-rate payers, some 70 per cent of accounts (525 out of 750 surveyed by the IFA) fall short.

"There is a tendency to think that [holding your investments in] cash is risk-free, but this isn't the case when you take tax and inflation into the equation," stresses Mr Ilott.

Tom McPhail of IFA Har-greaves Lansdown says the threat of inflation is "wrongly overlooked", but he warns that it's also an extremely difficult risk to control. "It's the nature of the problem that unexpected things are going to happen."

This can work both ways. For example, pensioners who bought annuities paying rates of 15 per cent in the early 1990s benefit today as low inflation makes a small dent in their payouts.

"However," says Mr McPhail, "it could be that those buying an annuity today paying rates of 6 per cent could see their income eaten into in the future if inflation were to rise much higher."

Anyone with a savings portfolio that aims to generate income will need investments offering capital growth and rising income. That means property (rental income) and equities (dividends), Mr Ilott says.

"For investors who want inflation-beating returns over the longer term, there is more risk in not holding equities and property than there is in including them."

But to guarantee that at least part of your portfolio matches inflation, it's worth considering index-linked gilts.

These are low risk (since they are backed by the government), and the income and capital paid out are linked to inflation.

You could also try index-linked savings certificates from National Savings & Investments (NS&I). These offer a tax-free percentage (usually around 1 per cent) above inflation for a set period.

And take advantage of allowances such as those on mini cash individual savings accounts to reduce your tax bill and leave you with more capital.

If you're married, switch income generated from savings into the name of a lower-tax-paying spouse. And if your spouse doesn't work, there may be no tax to pay at all, assuming their £4,745 income tax allow- ance hasn't been breached.

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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