How to protect your savings from inflation

Most people's savings lose more than £150-worth of buying power every nine years.

Six in ten Britons don't know what savings interest rate they're getting and the average saver keeps the same account for over nine years.

So says Saga Personal Finance. And my educated guess is they can't to too far wrong.

I think the reason that most people don't know what they're earning is they don't take savings interest seriously enough. So, here are two good reasons to care about the rate you get.

Preserve your wealth

A new savings account will typically pay a fair or good rate for one year or less. Loyalty beyond this time usually earns you nothing.

This is a problem, because our money steadily becomes devalued by inflation (rising prices). Hence, our savings enable us to buy less as things become more expensive.

Let's say you save £1,000 in your first year including interest. You stick with your savings account for another eight years despite the rate dropping to virtually nothing.

Let's say that inflation during those eight years averages 2%. Even with such low inflation, your money becomes considerably devalued. At the end of that time, you'd need £1,170 to buy the same things that you could buy today for £1,000.

To put that another way, your £1,000 in eight years will buy only as much as £850 does today. You've lost £150-worth of buying power! Consider also that 2% is historically very low. The higher the inflation rate, the worse it is for savings.

To preserve your wealth you need to earn enough interest to counter inflation.

Increase your wealth

To increase your wealth, you need to earn even more interest. It's not always possible, but you should attempt to do so, because it'll offset the years when the top savings rates are lower than inflation.

If you simply match inflation then you'll be able to buy the same amount of goods in eight years as you can today - even though your savings pot is growing. However, if you beat inflation, you'll be able to buy more things as your savings pot grows faster than the cost of goods.

If inflation runs at 3% for eight years, your £1,000 in savings will buy you only as much as £780 will today and you'd need an extra £270 just to stay where you are. However, if you earn an average 4% per year, you'll have an extra £370, meaning your can actually buy more than you could today.

How to do it

To preserve your wealth, you need to get a savings rate, after tax, that is as close to your inflation rate as possible. To increase your wealth you need a higher inflation rate.

Firstly, estimate your personal inflation rate using this tool. If that's too technical, use the national average inflation; I suggest you use the Retail Prices Index measure if you have a mortgage and the Consumer Prices Index if you don't. You can find the figures here.

Then compare it with the interest rates available in savings accounts. Most accounts (but not cash ISAs) are taxed, so you need to deduct your tax rate from the savings account's AER (Annual Equivalent Rate). The simplest way is to multiply it by 0.8 if you're a basic-rate payer and by 0.6 if you're a higher-rate payer, e.g. if the rate is 5% AER:

5 x 0.8 = 4%

5 x 0.6 = 3%

Now you need to ensure the interest rate is higher than your inflation rate. The latest figures for inflation are -1.4% (RPI) to 1.8% (CPI). This means basic-rate payers should, on average, be ok if they're earning 2.25% AER (2.25 x 0.8 = 1.8%) and higher-rate payers if they're earning around 3% AER.

For ISAs, there is no need to do any maths, because tax won't be deducted. Just use the ISA's AER as it is.

Plenty of accounts currently beat both RPI and CPI, as this table shows.

Keep it flexible

You should keep a good chunk of your savings flexible in easy access accounts so you can chase the best rates. You don't want to be tied in for weeks if inflation goes up, particularly if it spirals, which is a big possibility inside the next few years.

Stay on top

There's one simple test of whether you're getting a good rate that requires no digging around for old letters or obscure web pages. If you had a fixed rate, tracker rate or a decent guarantee which has now expired. Or if you had none of these but have held your account for more than one year, you will almost certainly be getting a poor rate now.

Banks have to offer higher savings rates to new customers to compete with each other for deposits, but to make large enough profits to satisfy their shareholders they will most likely lower the rates at the first opportunity.

Or be more thorough

That's usually enough for me, but if you want to stay right on top of the best rates, you'll need to get organised. Make a note in your calendar when bonuses, guarantees and introductory deals expire. If these last longer than one year, make a note in your calendar to look again after the first year, because within that time your rate will probably become uncompetitive.

Read all the literature sent by your provider to check for rate reductions, as well as check competitors' savings rates every month or so. That's more effort than most people are willing to do, which means it's more worthwhile if you have a larger savings pot.

Compare savings accounts through lovemoney.com

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