OPINION: Do not underestimate inflation’s insidious effects
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For more than 25 years, many of us considered inflation a defeated, benign force. Indeed, it’s reasonable to assert that by 1993, inflation had finally come under control.
Between 1989 and 2001, inflation averaged 2.49%. It became an irritating aspect of everyday life comprising no more than a peripheral impact upon the cost of living. Of course, those living on fixed incomes, as millions of pensioners do, have remained alert to inflation’s debilitating nature.
Yet it’s not that long ago that Chancellor Denis Healy was forced to contend (and, in fairness, with a modicum of success) with an official inflation rate that touched 23%. As wage demands were considerably higher, the unofficial rate was nearer 30%.
In June 1975, as Tammy Wynette occupied the number one spot in the charts (with ‘Stand By Your Man’), few were prepared to stand by Healy, who struggled to enforce a pay policy on British workers as inflation eroded the value of savings and wages alike.
Healy later reflected that adopting a pay policy “is rather like jumping out of a second-floor window: no-one in his senses would do it unless the stairs were on fire. But in post-war Britain, the stairs have always been on fire”.
Almost 50 years on, inflation may be considerably lower than it was, but as it appears to be heading upward again, its effects are no less corrosive. Why? Because unless you’re receiving a higher return on your savings than the rate of inflation, your spending power is being reduced.
Let’s assume that inflation is currently 2.5%. If you pay no tax, then to keep pace with inflation, you must be generating a minimum of 2.5% on your savings. If, however, you pay tax at 20%, your savings must be enjoying a gross return of at least 3.1% just to stand still. Good luck with that.
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In other words, if the return you’re receiving on your savings is less than inflation, you’re losing money. If you pay tax, however, you need to earn much more than inflation.
Imagine you’re a basic rate taxpayer who deposits £10,000 in a bank account paying a fixed 2.75% for 10 years. Over the same decade, inflation remains constant at 2.5%. At the end of the period, your savings would be worth £9,704.89, a real rate of return of minus 0.3%. Even financial fantasies can be frightening.
HMRC analysis reveals that around three-quarters of money going into ISAs is held as cash, rather than being invested in stocks and shares.
The ISA wrapper allows savers to receive their returns tax-free, so let’s revisit the above example and assume that our basic rate taxpayer puts her £10,000 into a cash ISA paying 3.1%t over 10 years (such a rate was available only seven years ago). You may think that a decade from now, she would be miles ahead of the game, but the dark spectre of inflation guarantees otherwise. Even if inflation remains consistently low, at 2.5%, and our saver pays no tax on her cash ISA, her real rate of return, taking inflation into account, will be just 0.6%.
Clearly, taking what appears to be the ‘safe option’ and depositing too much in cash (it’s prudent to keep some cash readily available) in an ISA or, worse still, in a bank account, can prove enormously expensive because even comparatively low rates of inflation eat away at its value.
Can investors circumvent the inflation problem? The short answer is ‘no’, but with pensions rarely out of the news, it seems that a critical mass of people are finally addressing the likelihood that most of them will live to a ripe old age.
While enjoying longevity beyond our ancestor’s wildest dreams might be considered an enormous privilege, the harsh fact is, it will only become so if we, not the state, can afford to fund our old age.
Pensions are (or should be) high on the agenda for anyone of working age. As annual individual ISA allowances are £20,000, it’s clear that mixing the tax advantages of both pensions and ISAs makes great sense. Here’s the point: if you appreciate the benefits of saving for your old age, don’t be fooled into taking the seemingly ‘safe’ option and keeping everything in cash.
Shares are inherently riskier, but they can offer considerably better longer-term returns and, as inflation looms, could be combined with other investment strategies such as buy-to-let to spread risk. Whichever mix you choose, do not underestimate the insidious effect inflation can have on your hard-earned cash.
For more financial advice, check out Peter Sharkey’s regular blog, The Week In Numbers.