Whatever the state of the economy, the impact of inflation on your savings and investments can be problematic. This applies in good times or bad, as inflation erodes the purchasing power of your money.
To save and invest properly, you need to understand the impact of inflation in relation to financial planning.
This article builds upon the themes originally made in my post of June 2018, Why Inflation is Important to all Investment Decisions.
What is inflation?
Inflation is when money loses value over time. It’s happening constantly – things are generally more expensive than they were a few years ago.
By way of illustration, think about what you could buy with £1 over the past few decades. Let’s consider ‘loaves of bread’:
1971: £1 = 10 loaves of bread
1981: £1 = 3 loaves of bread
1991: £1 = 2 loaves of bread
2021: £1 = 1 loaf of bread
OK, so maybe an artisan sourdough costs more than £1 nowadays. And maybe the prices aren’t exactly right, but you get the point. A quid buys you much less now than it used to and in another ten years it will buy even less. This is owing to inflation. In other words, the “purchasing power” of your money.
Different measures of inflation
The common measures of inflation in the UK are the consumer prices index (CPI) and the retail prices index (RPI). There’s also the newer measure of CPIH, which is CPI that includes the costs of owner-occupied housing.
Each measure is calculated slightly differently, although RPI is usually the highest.
Different rates are used for different things. So, RPI is typically linked to final salary pension payments, car tax and interest on student loans. CPI is often used by the government for things like calculating the state pension, and benefits like Universal Credit.
If you want to know what the current rate of inflation is, see the Office of National Statistics website.
The ups and downs of inflation
Inflation is measured as a percentage change in the prices of a common set of purchases:
- If the inflation rate is 1% (lower inflation), the purchasing power of money will be 1% less a year later.
- If the inflation rate is 5% (higher inflation), the purchasing power of money will be 5% less a year later.
How does inflation affect you?
When you’re thinking about savings and investments, the impact of inflation is important. This is because it makes a big difference to whether you make a profit in real terms, after accounting for inflation.
Say you put your money in a bank account that pays you interest at 1%. A year later you’ll have 1% more money.
But what if inflation is more than 1%? In that case, although you’ve got more money, it can purchase less than the amount that you began with.
If your goal is to make money on your investment, you need to find an account or investment that exceeds inflation. That means the interest you make is higher than the inflation rate.
Can you really beat inflation?
Depending on your circumstances, you might or might not want a product that beats inflation.
This is because generally, to get higher returns, you might need to take more risk.
If it’s especially important to you that you keep your money safe, you might want to an account with lower, fixed interest. You can grow your savings just by adding money to it every month.
To know what’s right for you, it helps to think through your savings goals.
- For short term goals where you plan to spend the money within five years it’s safer to go for a savings account and not worry too much about inflation. That is, unless the rate of inflation is high.
- For long term goals you need to keep inflation in mind when you invest and may wish to take more risk.
Setting savings targets
These targets should be related to the things you want to achieve in the future. Such as buying a new car, saving for retirement or buying a house.
Once set, you can work out how to achieve your targets. Some will be suited to long-term investments, some to short-term savings.
How to mitigate the impact of inflation
Some savings accounts are index-linked which means that they’ll pay interest that tracks inflation but won’t always keep up with other interest rates. These get more expensive when the markets are expecting inflation to rise, so the overall return might not beat inflation.
There’s no guaranteed way to protect your money from the effects of inflation.
The only general guideline is that cash savings accounts are generally not the best places to put your money long term. This is owing to the interest being generally below the rate of inflation, so you’re buying power reduces over time.
Savings accounts still have their uses, especially for money that you’ll need to get your hands on soon.
But if you’re planning to save for five years or more, consider investing it.
As ever, you should consult a professional adviser to help work through your personal priorities and savings targets.