We show you how even small increases in the cost of living can seriously damage your savings.
When it comes to explaining the problems faced by savers, you'd be hard pushed to find a better quote than this one from Lenin (Vladimir Ilyich Ulyanov; leading light in the Russian Revolution):
"The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation."
To me, Lenin hits the proverbial nail right on the head, because taxes and inflation work together to crush the long-term value of the money in your savings account.
For example, if you're a basic-rate taxpayer, then you lose a fifth (20%) of your before-tax savings interest to HM Revenue & Customs. Usually, this tax is deducted at source by your bank or building society, which cuts interest of 5% a year down to 4% after tax. Higher-rate (40%) taxpayers pay twice as much tax, and usually pay the extra tax via their tax returns. Thus, in this example, their savings interest rate falls to a mere 3% a year. Yuk.
Of course, one way to tackle this tax problem is to stash your cash in savings accounts which don't pay tax on any interest earned. The most popular of these is the cash ISA (Individual Savings Account), into which you can deposit up to £3,000 per tax year, while earning market-beating rates of interest.
On the other hand, it's difficult for savers to avoid the erosion in the value of their money caused by inflation, which is the tendency for prices of goods and services to rise over time. In the UK, we tend to keep an eye on three different measures of inflation: the Consumer Prices Index (CPI), the Retail Prices Index (RPI) and the Retail Prices excluding Mortgage Interest Payments Index (RPIX). You can learn more about these indices here.
Over the past year, the prices of everyday goods and services have been rising at higher rates than they have for some time. Hence, the UK's inflation indices are climbing: in March, the CPI hit a high of 3.1% a year, and the RPI hit 4.8%, which is a sixteen-year high.
But what does yearly inflation of, say, 3% actually mean? In a nutshell, 3% inflation means that a basket of goods which cost £100 a year ago now costs £103. In other words, your £100 last April is now worth only 100/1.03 = £97.09 in today's terms. So, thanks to rising prices, your £100 has lost £2.91 of value in 'real' terms (which means after taking inflation into account).
Inflation hits people on fixed or slowly rising incomes (such as pensioners) much harder than it does workers. This is because workers usually benefit from above-inflation pay rises, so their earnings tend to outpace rising prices during their working lives. What's more, it's vital to appreciate that even small changes in inflation can seriously undermine the value of your money, especially over long periods of time.
Take a look at the table below, which shows how the value of £100 shrinks over time, thanks to various levels of inflation:
How inflation eats away at your savings
Years | |||||
|---|---|---|---|---|---|
Yearly | 5 | 10 | 15 | 20 | 25 |
1% | £95.15 | £90.53 | £86.13 | £81.95 | £77.98 |
2% | £90.57 | £82.03 | £74.30 | £67.30 | £60.95 |
3% | £86.26 | £74.41 | £64.19 | £55.37 | £47.76 |
4% | £82.19 | £67.56 | £55.53 | £45.64 | £37.51 |
5% | £78.35 | £61.39 | £48.10 | £37.69 | £29.53 |
As you can see, with inflation at, say, 3%, £100 in today's money will be worth slightly over £64 after 15 years. However, with inflation at 5%, today's £100 is worth just £48, which is less than half of its original value. So, over long periods, small changes to inflation can do big damage to your wealth.
Finally, if you're worried about inflation, Index-linked Savings Certificates from National Savings & Investments (NS&I) are guaranteed to beat the RPI rate of inflation over three or five years. You can learn more about these accounts in The Good News Behind Rate Rises. Alternatively, you can do what I do, which is to thrash inflation by investing in the shares of well-managed businesses over the long term!
More: Shares Still Beat Bonds