Fight inflation with a savings bond

Robert Powell looks at the bonds that put up the best fight against inflation...

The new year has presented a sliver of relief for savers. Data released earlier this month showed that inflation fell in December for the third consecutive month – down to 4.2% on the Consumer Price Index (CPI).

But despite this marginal fall, rising prices continue to eat into the cash value of savers’ nest-eggs. One way to offset this erosion is by stashing your cash in a long-term savings account.

Keeping ahead of inflation

According to Moneyfacts, basic rate taxpayers need to find a savings account paying 5.25% to keep ahead of CPI inflation after income tax has been deducted. Higher rate taxpayers need to earn 7% interest before they see a real return on their investment.

But savers get short shrift from the banks: the average instant access account currently pays just 0.91%.

A better option for those that don’t need to get at their savings four three to five years is to go for a long-term savings account.

Long-term fixed accounts

The market for long-term fixed accounts is dominated by two relatively small retail bond players: Vanquis Bank and Scottish Widows. Unfortunately neither provider offers an inflation-beating return. But that doesn’t mean the accounts aren’t worth a look:

So Vanquis Bank has the top paying account with a 4.65% AER five-year bond. The downside is you will have to deposit a minimum of £1,000 to get hold of the account. Scottish Widows are close behind with a 4.60% five-year bond. However the minimum deposit for this deal is even heftier, at a huge £10,000.

The two providers also offer three-year versions of these bonds with the same minimum deposit level. Vanquis Bank’s 36-month deal pays out at 4.15%. Scottish Widows’ bond has a rate of 4.00%.

For those with smaller deposits, Halifax has the best range of long-term savings accounts – all with a £500 minimum deposit level. Lock your cash away for five years with the bank and you’ll earn 4.50%, or opt for four years and you’ll receive 4.30%.

The Cambridge BS e-Bond brings up the rear with a 3.65% rate over three years.

But despite these relatively high rates, none of these bonds actually beat inflation – even before income tax is deducted. To get the closest to a real return on your savings, you’ll need to get hold of an inflation-linked bond.

Linked bonds

Inflation-linked bonds have their interest rate pegged to the level of rising prices. So as inflation increases, so does your interest rate.

The Post Office recently rolled out another issue of its popular linked bond, of which there are two types. Tie your savings up for three years and you’ll earn 0.25% over the Retail Price Index (RPI) measure of inflation every 12 months. Lock away your cash for five years and you’ll earn RPI plus 0.5% per year.

The Post Office uses the March RPI reading (published in April each year) to calculate your annual rate. So if RPI is still at its current level of 4.80% in April 2013, the three-year bond’s return would be 5.05% and the five-year bond's would stand at 5.30%.

Obviously, after income tax is deducted the rate on both deals will be brought down below RPI inflation. However you will stay ahead of the lower CPI rate of inflation with the five-year bond (with RPI at 4.80%, it pays out at 5.30% - marginally higher than the 5.25% threshold needed for a real return).

The problem is if inflation drops substantially over the next three to five years, you’ll see your rate go through the floor. The situation could worsen still if a drop in inflation is coupled with a Base Rate rise, as chances are, just as your return is falling, the rates on regular bonds will be increasing.

Early closure of the bond is allowed in exceptional circumstances. However this will be subject to a breakage charge that will eat into your accumulated interest.

Both accounts have a minimum deposit of £500. The bonds start on 27 April and the deadline for applications is 29 March. But be warned, every issue of the account so far has been withdrawn before the closing date.

Inflation-beating ISAs

A further way to beat inflation is to get hold of a long-term fixed cash ISA. These pay out tax-free, so you only need to keep your interest rate up with the inflation figure to protect your savings from rising prices.

According to Moneyfacts, there are currently eight ISAs that beat CPI inflation – all of them four- and five-year accounts. Have a read of The UK’s best cash ISAs to find out which providers offer them.

More: Seven ways to maximise your savings in 2012 | Virgin Money launches ‘no-gimmick’ easy access and ISA deals