Inflation is the enemy of savers; its very existence reduces the purchasing power of your money over time. Right now everyday budgets are being squeezed, and the returns on savings accounts aren’t keeping up. Could a simple ISA be an effective solution?
Inflation gauges how prices fluctuate over time by measuring the price growth of a shopping basket of goods and services.
In a growing economy, consumers and businesses spend more and this demand pushes prices higher. When demand weakens, it takes price growth with it and the economy enters a period of disinflation, before deflation – falling prices – takes hold.
In the UK, the government sets an inflation target that the Bank of England adapts its monetary policy to meet. By cutting the interest rates, the Bank of England makes saving unattractive and encourages spending by making the cost of borrowing cheap.
To weaken inflation, the Bank of England will increase the bank rate to make the cost of borrowing more expensive and discourage spending.
How inflation affects savings
Inflation reduces the purchasing power of your money over time and if the returns on your savings or investments can’t keep up, your money is losing value.
Imagine you had £10,000 and put it in an easy cash ISA with a 1% return. After one year, you would have £10,100. If inflation reached the Bank of England’s target of 2%, however, the real value of your savings would have fallen to £9,800 – below your initial deposit.
As the return from your savings account has failed to keep up with inflation, you won’t be able to buy as much with your money as you could 12 months ago.
It can be easy to forget about the silent threat of inflation on your savings, especially when the returns on cash ISAs are only just showing signs of a recovery from record lows. One way to protect your savings from the eroding nature of inflation is to invest it.
What is a stocks and shares ISA and how can it help?
Whilst investment strategies can become complex, there are simple ways to make your money go further. One of the simplest solutions is an ISA.
When you invest, you could be required to pay tax on the profit and income you make from your money. This can eat into your returns and delay you from achieving your financial goals, potentially stopping you from offsetting inflation.
Everyone has an annual capital gains tax allowance of £11,300 in the 2017/18 financial year. If you pay the higher rate of income tax, you’re eligible to pay capital gains tax of 20% on the profit you make when you decide to withdraw that money.
If you put your money in an ISA, you won’t have to pay a thing. You can put up to £20,000 in an ISA each year, and your investments can grow and generate income tax-free. The more of your money you keep, the more protection you have against the impact of inflation.
The ISA allowance increased to £20,000 for the 2017/18 financial year, which means you can save or invest up to this amount across a number of ISA products. It’s a case of use it or lose it, however, as your allowance can’t be rolled over into the next year.
It seems simple, but the ISA tax wrapper can be crucial in helping you offset the impact of inflation and achieve your financial goals quicker.
How to invest in an ISA
Those fed up with the negligible returns on their cash ISAs are turning to the financial markets in the hunt for larger returns to offset the impact of inflation. By taking on more risk, investors can expect higher returns – although investments can go down as well as up.
If you want to invest, where should you look on the market for the best protection?
When you invest in the financial markets, there are a number of different investment opportunities available to you.
More risk-averse investors might prefer bonds, which are a debt investment. Investors wanting to take on a bit more risk might look to equities. When you buy a share in a company, you essentially own a small slice of it – when it performs well, so does your investment, and vice versa.
Equities can be used as a good hedge against inflation. Companies are able to pass on rising prices to customers, and higher prices can underpin higher company earnings.
Fixed income, however, doesn’t have such a clear-cut relationship. Inflation causes interest rates to rise, which decreases the value of existing bond holdings due to the inverse relationship between interest rates and bond prices.
Bonds might offer you reliable income, but as this usually remains the same until maturity, inflation chips away at the value of these returns.
There are other options. Floating-rate bonds have coupons that are linked to key interest rates, and inflation-linked bonds are issued to by the government and tied to inflation.
All investments carry risk, however, and it’s important to remember to factor in the impact of inflation when calculating your returns.
There are pros and cons to every investment, the key is diversification. If you spread your money across geographies and asset classes you can hope to offset any losses with gains made elsewhere in your portfolio.
You also need to make sure the investments in your portfolio suit your investor profile. We all have different goals we’re trying to achieve and different requirements of our investments to suit our family life.