Protect your savings from the inflation threat

With inflation rising, Chris Torney investigates whether fixed rate savings are a gamble, and reveals a different way to protect your returns.

Roll up, roll up, place your bets! Yes, the dire state of the nation's finances is forcing thousands of savers to gamble with their money, just to protect their nest eggs from the ravages of tax and inflation.

In order to guarantee the best returns on cash in savings accounts in the coming months and years, savers effectively have to take a punt on how fast interest rates will rise in the wider economy.

That is because the only decent rates available at the moment are to those who are willing to lock their money up for three years or more, with interest agreed in advance.

This may be fine if you're sure you won't need to make any withdrawals during that period. But in putting your cash away for so long at a fixed rate, you are hoping that inflation, as well as interest rates on other accounts, will not rise very quickly, leaving you behind.

Why are we in this mess?

There are two main reasons why savers are so desperate to improve their lot at the moment.

First of all, the Bank of England's base rate has been anchored at 0.5 per cent since last March, giving account providers a great excuse to slash rates.

This has been especially bad news for savers, most notably pensioners, who rely on regular interest payments to supplement their incomes.

But to make matters worse, inflation is on the rise. According to the latest figures, the Consumer Prices Index (CPI) rose to 2.9 per cent in December, and the Bank of England expects it to peak at 3.5 per cent in the next couple of months.

With inflation at 3 per cent, a basic-rate taxpayer needs to earn interest of 3.75 per cent just to stand still. Higher-rate taxpayers need a whopping 5 per cent to make sure the value of their cash is not eroded in real terms.

The only way to get returns anything like that is to sign up for a fixed rate bond for two, three or five years.

What is the gamble?

Let's say you put £10,000 into ICICI Bank UK's HiSave Account, with a fixed rate of 4.7% a year until this time in 2013, but no early closure or withdrawals (minimum investment £1,000).

That 4.7% certainly looks pretty healthy today - 4.2% above the base rate, well above inflation and substantially more than you could earn on a leading easy-access account. Coventry Building Society, for example, is paying 3.15% on its postal account, which includes a 1.15% 12 month bonus. It also has a £1,000 minimum initial deposit.

So if the base rate stays low for the next three years, and inflation drops back, you'll be quids in with the ICICI account.

But imagine the base rate starts rising later this year, perhaps to curb further increases in inflation.

If the base rose to, say, 3% by the end of 2010, the best savings accounts could be paying 5% or more, even with instant access. Your 4.7% from ICICI would no longer be attracting such jealous glances - and you'd have to keep your money tied up there for another two years.

Put your cash into a five-year fixed account, and the scope for your decision to backfire - or pay off - increases.

Fixed rate ISAs

Leeds Building Society has a five-year, fixed rate ISA paying 4.6% (minimum opening balance is £1). As the interest on an ISA is tax-free, the 4.6% is the equivalent of a 5.75% annual return on a standard account for a basic-rate taxpayer, or 7.67% for a higher-rate taxpayer.

Nationwide and Birmingham Midshires are also offering five-year Isas at 4.50% and 4.55% respectively.

These rates sound great today, but will that remain the case in a few years' time?

Remember you can only put £3,600 into a cash ISA this tax year, unless you are over 50, in which case the limit is £5,100. This higher annual limit will apply to everyone from the start of the 2010-11 financial year on April 6.

Should you take the risk?

So, the big question is: are interest rates likely to rise so quickly? Most economists think not, and the Bank of England's quarterly inflation report, published last week, appears to back up this view.

The Bank's gloomy prognosis suggests that the Monetary Policy Committee is likely to keep interest low in the short-term to prevent the economy from slipping back into recession, and that the threat from inflation is the least of its worries.

Rates will only rise sharply if the MPC thinks it has to put the brakes on the economy to prevent overheating. The chances of that happening any time soon appear slim - the Bank thinks the current spike in inflation is a blip - but as for what might happen beyond 2011, well, that's anyone's guess.

Remember, it is less than two years since the base rate was at 5 per cent, at which point the leading savings accounts were paying more than 6.5 per cent a year, no strings attached. Those were the days!

And if there's anything we've learned from the financial turmoil of the last two-and-a-half years, it's to expect the unexpected.

Ultimately, though, if you are struggling with the low rates of interest on offer from easy-access accounts at the moment, a long-term fix will give you extra cash plus peace of mind, for a while at least.

You will only really lose out if inflation rises well past 3 per cent and stays there. Given that the government has tasked the Bank of England with keeping inflation below 2 per cent - above all other economic considerations - this should be a risk many are happy to take.

Protect yourself with a hedge

If, unlike the Bank of England, you are worried about rising inflation, you can hedge your position with an index-linked savings certificate from National Savings & Investments.

This is a savings account that pays interest equal to the Retail Prices Index (RPI) of inflation (unlike the CPI it includes housing costs such as mortgage repayments) plus 1 per cent. At the moment, the RPI is at 2.4 per cent, so the certificates are paying 3.4 per cent, tax-free.

They are available for three or five years, and the minimum deposit is £100. No interest will be paid if you have to cash your certificate in within the first 12 months.

To help you make the most of your savings, join our Build up your savings goal where you and other lovemoney.com readers will benefit from all our best tips. And for all the best solutions to your savings dilemmas, why not pose a question on our excellent Q&A tool?

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