Get Real With Your Savings!

Don't get too fixated with the interest rate that your savings earn. What's important is to preserve the future buying power of your pot.

In some ways, savings accounts are like icebergs, because nine-tenths of the important stuff is concealed below the surface. The visible tip of the savings iceberg is the headline savings rate -- a figure usually advertised in large print, with the nasty stuff tucked away in the small print.

I always argue that savers shouldn't get too hung up on this headline savings rate, because there's much more to saving than simply picking the best interest rate. In fact, to be a smart saver, you need to watch out for three different rates:

1. the interest rate -- usually expressed as a yearly gross (before-tax) rate and an AER (Annual Equivalent Rate);

2. your personal tax rate -- the higher your tax rate, the more interest you forfeit to the taxman; and

3. the general rate of inflation -- a yearly measure which takes rising prices into account.

While most savers grasp points 1 and 2 above, many of us forget about point 3, perhaps because we cannot control the prevailing rate of inflation. Nevertheless, your goal as a saver is to preserve the current and future value of your cash pot, after taking tax and inflation into account.

An ideal world for savers would be one where interest rates are high, but inflation is low, which produces a high `real' (after-inflation) return. However, when interest rates are low and inflation is high, then real interest rates can turn negative. In other words, thanks to steeply rising prices, the buying power of your savings can be eroded over time.

Rate cuts kill the savings habit...

In order to bail out reckless and over-stretched borrowers, the Bank of England has slashed its base rate. After four cuts in a row, it has dropped from 5% in early October to just 1.5% today. Given this 3½ percentage-point cut, it's no surprise that banks and building societies have taken a knife to their savings rates.

Even before this month's half-point cut in the base rate, savers were grumbling. A survey from number-one building society Nationwide BS last month found that almost half (48%) of adults believe that government policy discourages them from saving, up from 41% of respondents in November.

Even worse, Nationwide BS found that under a quarter of consumers (23%) say now is a good time to save. These committed savers are outnumbered two to one by the 47% of people who say now is a bad time to save. This helps to explain why nearly one in four adults (24%) saves nothing, and under half of us (47%) save regularly.

...but falling inflation will help savers

Here's a question for you: in terms of the buying power of your money, which of these savings accounts is more attractive?

Although account A pays a double-digit rate of interest, an even higher rate of inflation wipes this out, producing a negative real return. However, although account B pays just 4% a year, inflation of 2% reduces this to a real return of 2% a year. Therefore, all else being equal, account B produces a better return for savers. The good news is that the general rate of inflation is coming down, as you can see from the table below:

Annual inflation, measured by the Retail Prices Index (RPI)

Of course, inflation is a backward-looking measure, so the RPI shows price rises over the previous twelve months. Having peaked at 5% in July, the RPI dropped to 3% in November, with further falls expected. So, with a few savings accounts paying 4% a year before tax, it's still possible to earn a real return on your savings. This will be some small comfort to struggling savers.

Finally, I think that the powers-that-be need to do more to encourage saving, because the UK faces its worst financial hurricane in at least a generation. So, if you're thinking about saving more, then don't be put off by low rates. Having a bigger cash safety-net always makes sense, especially in times of economic uncertainty. By shopping around for a Best Buy savings account and using tax-free accounts, you can maximise your return. What's more, as inflation starts to fall, your savings will become more valuable as their buying power improves!

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