Inflation-proof your savings

Jeff Salway from 04.07.07

In March this year, inflation breached the 3% mark and while this is still a long way off the 27% peak experienced in 1975, it's the highest level seen in the UK since the mid-1990s.

So although inflation remains historically low, its creep upwards is bad news if your money is squirreled away in savings or if you live on a fixed income, such as a pension. This is because inflation determines the real return on your savings. For example, 3% inflation would reduce £100 to £86.26 in just five years and almost halve it over 20.

The first step is to check how much of your money is in an environment where a rise in inflation will reduce how much it grows. If it's all in a typical deposit account, the tax reduces the amount you get and leaves it at the mercy of inflation.

Saving

The best instant access account at the moment is Icesave from Landsbanki, but at 5.95% a year before tax, this still leaves taxpayer's savings at risk. That's why it's important to use all your annual individual savings account (ISA) tax-free allowance - currently £3,000.

With the retail price index at 4.5%, savings accounts are not a good option; basic rate taxpayers need 5.75% gross to beat inflation, while higher rate payers need 7.67%, which is rarely achievable.

It's best to opt for an ISA promising to at least match the Bank of England base rate. Bradford & Bingley, for example, currently offers 6.15%, but this is fixed and any interest rise of more than 0.25 percentage points will wipe out any above-inflation gains. This puts cautious investors in a difficult position, but the good news is there are a number of alternatives that can stop your cash being eroded by inflation.

Gilts and bonds

Index-linked National Savings & Investments (NS&I) certificates guarantee to beat the RPI (retail prices index) rate of inflation over three or five years. The certificates offer a guaranteed rate of interest above inflation, although they have to be held until maturity to earn the full amount. The current three and five year rates are 1.35% plus inflation - and, this is tax-free, so the equivalent gross rate for basic rate taxpayers is 7.31%, and 9.75% for higher rate taxpayers.

Another safety first option is index-linked gilts, government issued bonds where both the interest rate and the redemption value rise in line with RPI. But while this means inflation won't eat into the value of the bond, the interest rate is lower than that on conventional bonds.

According to Barclays Capital, RPI needs to be over 3% for index-linked bonds to be a better bet than normal bonds, but they're suitable if you want to invest in bonds and believe inflation will go on rising. However, index-linked gilts aren't such a good deal when inflation falls.

The best way to access investments such as these is through a bond fund.

A less secure option is guaranteed equity bonds (GEBs). These run for a fixed term, are linked to stockmarket performance and usually guarantee to return your investment in full if the market drops. But while this sounds like the best of both worlds, they don't actually invest in equities, so they don't get the full benefit of any growth, and many have performed woefully.

But, while bonds and tax-free savings accounts are likely to offer cautious investors a degree of protection from inflation, the best hedge will always be to have some money invested directly in equities - ideally through funds.

Historically, moderate inflation has been kind to equity investors. Shares inherently overcome inflation because company profits will rise if there's an increase in the cost of goods and services. Severe inflation is another matter, however, because of the knock-on effect on the economy.

Your risk can also be reduced by keeping a decent amount of money in cash or bonds - you don't need to switch all your money into equities to avoid inflation risk.

Low-risk funds

UK equity income funds generally invest in established, low-volatility companies that pay strong dividends every year. Among the best are Invesco Perpetual Income and High Income funds, the Rathbone Income fund, and Jupiter Income.

Other low-risk areas include the cautious managed sector, where funds can invest no more than 60% in stocks or property. And, multi-manager funds, which offer diversification by investing across a range of funds from bonds to high-risk equities, rather than taking stakes in individual companies.

It's possible to cash in on the very factors that are driving inflation upwards - energy prices - by investing in commodity-based funds. A lot of multi-manager funds offer exposure to commodities, while funds like the JP Morgan Natural Resources specialise in them.

Commercial property is a useful home for your ISA money. Some funds invest in actual properties like the New Star and M&G Property funds - while others, like the Aberdeen Property Share fund, invest in property company shares.

Then, there are areas like gold, wine and collectibles. Gold prices have consistently stayed above inflation and were trading at record highs last year. Lyxor Gold Bullion Securities (GBS), on the London Stock Exchange, tracks the price, while some equity funds - most notably, Blackrock Merrill Lynch Gold & General fund - invest in gold-mining firms.

Wine is another great inflation-busting investment. Wine indices grew 14.7% a year on average between January 1990 and January 2006, more than double the FTSE All-Share Index and easily abreast of inflation. And, as it's a wasting asset, it's free of capital gains tax.

You also need to think about inflation when it comes to making your pension pot last as long as possible. The big issue here is annuities, which can be significantly eroded over time as prices rise. Alternatively, you could consider an inflation-linked annuity.

What's inflation and how is it measured?

Since December 2003, the UK has used the CPI (consumer price index), which tracks changes in prices of selected common household goods (including utilities) as its inflation measure.

The government's CPI target is 2%, but if the rate moves by more than one percentage point either way - that is, it breaks out of the range 1-3% - the governor of the Bank of England must write to the chancellor explaining why.

Avoid the tax trap

There's no point beating inflation if all the gain then goes on tax, so use your tax allowances wisely. The main one is your annual individual savings account (ISA) tax-free allowance, whether it's cash, equities or both. You can currently invest up to £3,000 in cash and £4,000 - or the whole £7,000 - in equities. These amounts will change to £3,600, £3,600 and £7,200 respectively next April. Use this before you consider options that aren't tax-free.

With shares performing well in recent years, more people are making gains above the individual capital gains tax (CGT) tax-free allowance of £9,200. Too many fail to make use of their own and their spouse's annual exemption, but taking full advantage every year can help you keep your nose in front of inflation. The same goes for pensions - you can now put equity and property funds in your pension, which is very tax-efficient.